Is it Time to Sell US Dollars?

In a matter of 3 weeks, the U.S. dollar appreciated more than 6 percent versus the Japanese Yen and nearly 4 percent versus the euro.  The Dollar Index reached its highest level in 13 yearsbut the dream run in the dollar met resistance on Friday after making an unexpected push higher that took USD/JPY within 10 pips of 114.  The latest pullback / consolidation has many investors wondering if its time to sell dollars.  While there is no question that the dollar is getting ahead of reality and as tempting as it may be to pick a top, the latest pullback is small which means the better trade should be buying the dollar's dips until Fed Chair Janet Yellen tells us otherwise.  It is important to recognize that the spectacular rise in the U.S. dollar and complete collapse in bonds is driven by 3 key factors - new positioning, the prospect of an aggressive fiscal spending program from Donald Trump and the expected impact on inflation.  The Fed has been eager to raise interest rates in order to get ahead of rising inflation and the market thinks they will need to be even more proactive going forward.  To this point - Fed Fund futures are pricing in a 100% chance of rate hike by the Fed next month and nearly 40% chance of another 25bp rate hike by May 2017. The second rate hike is not expected until the middle of next year so the dollar could extend higher if Yellen suggests that it could come sooner. 

 

With that in mind, Trump hasn't even assumed office yet and the market is trading as if an official stimulus program has been announced. Trump has shifted his views on many issues and while we do not expect him to backtrack on spending, passing a stimulus program may take longer than he anticipates.  Also considering the enormous burden of paying for the package, Congress may push for a diluted version that provides slower growth spread out over a longer period of time.  Fiscal spending could take many shapes and may not be as quick and aggressive as the market hopes and for these reasons, dollar bulls and bond bears could be getting ahead of themselves. But in order for the dollar to fall, it needs a catalyst.  We could see more profit taking ahead of non-farm payrolls but the move is likely to be shallow and the chance of further strength is about even.  A lasting reversal in the dollar would need to be driven by less hawkish comments from Yellen.  Besides signaling that a December hike is imminent, she has not provided much guidance on what comes next.  We know that this past week's U.S. economic reports including existing home sales, durable goods, the University of Michigan consumer sentiment index and the Richmond Fed index all beat expectations supporting the idea that the U.S. economy is improving.  Next week's reports including consumer confidence, the ISM manufacturing index and non-farm payrolls should reinforce that view.  However 10 year Treasury yields have increased 80bp over the past 2 months and this rise automatically raises financing costs, tightening financial conditions and effectively does a lot of the Fed's work for them.  Had interest rates not increased so much, Yellen would probably signal an early 2017 rate hike but the 80bp rise in yields is the equivalent of 2 almost 3 quarter point hikes.  We believe USD/JPY is a buy near 112.00 and we expect the currency pair to make another push above 114.00.

 

The euro on the other hand faces a laundry list of political troubles that should keep the currency pair under pressure.  Last week's economic reports continue to show vulnerability in the Eurozone economy particularly for Germany.   Economic activity slowed according to the PMIs and German business confidence declined according to the IFO report.   The big problem for EUR/USD is the yield spread hit a 10 year low this past week. If U.S. rates continue to rise at a faster than German rates, the EUR/USD could make another run for 1.05. This weekend we have the second Le Republican primary with Francois Fillion facing Alain Juppe.  Juppe was originally expected to win last weekend's election but the unexpected victory by Fillion means he could be running against Marine Le Pen, the leader of the far right National Front.  There are many parallels between her campaign and U.S. President Elect Donald Trump's including a crackdown on immigration, French nationalism and anti-globalization.  The uncertainty of French politics should hang over the euro for the next week and possibly even the next few months.  In the near term, the Italian referendum on Senate reform scheduled for December 4th poses the greatest near term risk for EUR/USD.  No polls are permitted 15 days ahead of the vote and the last survey showed the No vote firmly ahead.  The referendum is aimed at streamlining Italy's government decisions by reducing the role of the Senate and regional governments.  Prime Minister Renzi also pledged to quit if the vote is rejected which would create another political crisis in Italy especially as the vote has been viewed as a referendum on EU membership.  Italy's political uncertainty should deter investors from buying euros.  Eurozone confidence, German consumer prices and employment numbers are scheduled for release in the coming week along with speeches from ECB President Draghi.

 

The Canadian dollar and oil will also be in play next week because aside from French/Italian politics and the U.S. non-farm payrolls report, investors will be eagerly awaiting the outcome of the 171st OPEC meeting.  Oil producing nations have pledged to cut production but investors have very little confidence that a substantial deal will be reached by a cartel that is known to backpedal on its promises. On Friday, there were reports that Saudi Arabia would not attend a key breakfast meeting with non-OPEC nations. Algeria's oil minister is also traveling to Iran in what appears as a last minute attempt to convince the country to participate in the deal. These developments suggest that a production cut is not a done deal.  If OPEC disappoints, oil prices will crash sending CAD sharply lower.  However if they reach an agreement even if they fail to reinforce it later, we could see a very strong short squeeze in oil and the Canadian dollar because investors are aggressively short oil ahead of the OPEC announcement. Their decision could overshadow Canada's Q3 GDP report but by Friday, Canadian employment numbers should return as a key driver for the currency.  

 

The Australian and New Zealand dollars rebounded last week but are vulnerable for renewed losses in the coming week due to the extent of their recoveries.  With the exception of New Zealand's Financial Stability Report, there are no major New Zealand economic reports on the calendar.  Australia has retail sales and manufacturing PMI numbers scheduled but the greater focus could be on Chinese PMIs and commodity prices.  While gold prices have been falling, iron ore prices have been soaring, lending support to AUD/USD.  At best, we see the recent rally taking AUD/USD to 75 cents, at which point we believe the currency pair should start to move higher.  Meanwhile 70 cents has proven to be strong support for NZD/USD but with the Fed gearing up to raise interest rates, another retest of that level seems possible.   

 

Finally, sterling is gunning for a breakout after consolidating quietly for the past week.  The big story last week was U.K. Chancellor Hammond's first statement on the Budget.  While the Chancellor lowered its growth forecasts for the next 2 years, he promised more borrowing and investment into innovation and infrastructure.  He announced a new National Productivity Investment Fund of 23 billion pounds and plans to double UK Export Finance to make it easier for British businesses to export. These new spending plans caught the market by surprise and sent sterling sharply higher versus the euro. As for Brexit, Prime Minister May reiterated her plans to trigger Article 50 by March 2017 and exit the EU by March 2019.  The U.K. Supreme court hears the case on Parliament's role in triggering Article 50 at the start of the month but a decision is not expected until next year.  U.K. PMI manufacturing numbers are scheduled for release next week.  We believe sterling will continue to outperform the euro and other major currencies including the U.S. dollar.