Dovish Fed Hits The US Dollar

The US Federal Reserve shifted towards a dovish stance yesterday and asset markets applauded.   Against the background of signs of slowing growth, intensifying trade tensions and growing “uncertainties” about the economic outlook, the Fed removed the previous “patient” stance and instead noted that “act as appropriate to sustain the expansion”.   The bottom line is that the Fed is priming the market for easing as early as July, though the market had already primed itself by moving sharply in terms of pricing in rate cuts over recent weeks.   The market is now pricing in three rate cuts this year and at least one next year, which seems reasonable.

Clearly there are a huge number of uncertainties ahead, making the Fed’s job particularly difficult and the picture could look quite different should the upcoming G20 meeting in Japan (28-29 June) deliver some form of trade agreement between the US and China.  This would likely result in less need for Fed easing.  As I have noted previously there are still a huge number of challenges and obstacles to any such agreement, suggesting that market hopes of an agreement stand a good risk of being dashed.   Until then, risk assets will remain upbeat, with equity markets rallying in the wake of the Fed decision even as bond yields moved lower and gold prices reached a 5-year high.

The USD remains under pressure and took another blow in the wake of the FOMC meeting.  The USD has now lost ground against almost all G10 currencies except GBP amid Brexit concerns over the last month.  This has extended today and the currency looks set to remain under pressure in the short term as markets continue to price in Fed rate cuts.  The tension between President Trump and Fed Chairman Powell is not doing the USD any good either.  The USD index (DXY) is now threatening to break below its 200-day moving average (96.710) though this has proven to provide strong support in the past.  A sustained break below this level could see the USD extend losses against major and many emerging market currencies.

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US dollar under renewed pressure

After hitting a multi month low at the end of last week the USD (index) failed to extend gains this week dropping overnight to 79.592 overnight in the wake of some slippage in US Treasury yields (10 year treasury yields fell to around 2.73%).

Conversely EUR/USD once again breached the 1.39 level despite attempts by European Central Bank officials to convince the markets that the message from last week’s policy meeting was in fact dovish. Markets have yet to be convinced (as do I), however, given that the ECB has yet to put its words into action in terms of further policy easing.

The key to a more sustainable EUR decline / USD recovery is to shake off the bad weather impact on the US economy. This is likely to take place soon although not quickly enough to be revealed in today’s release of US February US retail sales data, which will reveal that core sales remained pressured, leaving the USD without much support.

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US dollar soft ahead of retail sales

The USD has lost a fair bit of ground in February failing to benefit from a renewed rise in US Treasury yields. A more positive risk environment recently has undermined some of the demand for USDs while some negative data surprises such as the ISM manufacturing survey and non farm payrolls have also weighed on demand for the USD.

The release of January retail sales data today will give another opportunity to gauge the path of consumption at the turn of the year but unfortunately for the USD a relatively flat outcome for sales will provide little rationale to buy the currency. The consensus expectation is for headline retail sales to post a 0% monthly reading, while sales ex autis is likely to rise by a measly 0.1%.

In the near term this implies little potential for a USD rebound but over but over coming weeks I expect the USD to rally in line with higher US yields. USD index (DXY) is likely to flatline around the 80 level in the coming sessions before rallying over coming weeks.

US dollar speculative positioning had increased prior to its sell off

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Asian currencies under pressure

The close to 1% drop in the USD index over recent days is misleading in terms of the USD’s performance against emerging market currencies where it has registered strong gains. For example the ADXY (Asian USD index) has dropped to its lowest level since early September 2013 and looks set to decline further as Asian currencies face more pressure. The best performers in this environment are traditional safe havens, especially JPY and CHF while the EUR and Scandinavian currencies have also capitalised on the weaker USD.

The drop in the USD against many major currencies reflects the fact that positioning had reached extreme levels prior to the sharp moves at the end of last week. For instance, net long USD speculative positions (according to the CFTC IMM data) had risen to the highest level since June 2013 while in contrast EUR positioning had dropped to its lowest since July 2013. The subsequent position adjustment will have proved to be a healthy correction that will set the USD up for an eventual rebound and the EUR for a sell off.

The sharp drop in US Treasury yields will undermine the USD further in the near term, however, and the mixed slate of US data releases will offer the currency little assistance. Nonetheless, the USD is expected to stay firm against Asian currencies. Notably capital flows from Asian equity markets have increased over recent weeks, with Philippines, South Korea, and Thailand on track to register outflows for the first month of the year. Against this background it is unsurprising that both the KRW and PHP are the two worst performing Asian currencies so far this year. While I expect a reversal in both, the near term outlook is for further pressure.

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