Is Strong Dollar the Fed’s #1 Problem this Month?

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We all know that the U.S. dollar has had a great month. In the past 30 days, it appreciated against all of the major currencies, rising more than 4% in value versus the Japanese Yen and New Zealand dollar. Since the beginning of the year, the dollar is up more than 7% versus the euro and over 6% against the Australian and Canadian dollars. Even though it gave up part of its gains today, the uptrend in the greenback remains intact. A strong currency is rarely positive for a country’s economy and todays’ report that President Obama said the strong dollar is a problem is in line with the challenges posed by the recent strength of the currency. These reports were denied by the U.S. government, because they would never publicly stray away from paying lip service to their strong dollar policy but in reality the rising dollar is a problem for the Federal Reserve. There are 2 primary consequences of a strong currency – weaker exports and lower inflation. The U.S. is not an export dependent economy and based upon the trade balance, the strong dollar has not been major drag on export activity but corporate earnings have suffered. In the first quarter, big names such as Procter & Gamble, Johnson & Johnson, PepsiCo, Facebook and Delta Airlines blamed weaker earnings on the stronger currency because it reduces their earnings abroad. The impact that a strong dollar has on inflation is more significant. It keeps a lid on price pressures, which normally is not bad if not for the low level of inflation around the world. Yet the latest report showed core consumer prices rising at its strongest pace since June 2013, a sign that inflation is moving back towards the Federal Reserve’s target. So as it stands right now, the strong dollar is not a big problem for the Federal Reserve but it can be a problem if it continues to move higher which is almost a certainty with the central bank preparing to raise interest rates this year. On average, the greenback has already appreciated more than 6% since the beginning of the year and if it rises by another 6% on the back of Fed tightening, it could slow the cycle. Most other countries would welcome a stronger dollar at this stage because it would drive their local currencies lower, encourage exports and boost inflation. With no major U.S. economic reports scheduled for release until Thursday, consolidation and profit taking is likely for the dollar over the next few days. With 125 broken, the next stop should be 123.80.

Behind the 1% Jump in Euro

Euro was the best performing currency today, rising more than 1% versus the U.S. dollar. Better than expected German data kicked off the rally with industrial production and the trade balance rising strongly. As we mentioned in the paragraph above, other countries like Europe would welcome a strong dollar as the weakness of the euro drives economic activity. While Quantitative Easing has played a role in the region’s recovery, the much larger contribution was from the currency. We see this in today’s data – not only did the trade balance beat expectations but more importantly exports rose 1.9% when they were expected to fall by 0.4%. The decline in the dollar also contributed to the euro’s strength along with comments from ECB officials. ECB member Nowotny said the downturn in the Eurozone is over and according to Noyer, a Greek exit would not cause instability for the Eurozone. We beg to differ and see Greece as an ongoing headache for the region especially if Germany is willing to let Greece go. According to Schaeuble, if there are no reforms they are willing to let Greece exit the euro. At the same time, Greek officials continue to reject the EU/IMF proposal so clearly no meaningful progress is being made which should have been negative for the currency and yet euro traded sharply higher today. We believe that selling euros on the 1.13 handle is an attractive opportunity.

EUR/GBP Soars on Euro Strength

The British pound traded slightly higher against the U.S. dollar but fell sharply versus the euro. This of course is due to euro strength and not sterling weakness. Tomorrow’s trade balance report and Wednesday’s industrial production numbers are the most important pieces of economic data on the U.K. calendar this week. However the bigger market movers could be the speeches from Bank of England Governor Carney, Chancellor Osbourne and BoE member McCafferty. The Bank of England is comfortable with the current level of monetary policy but Carney and McCafferty are generally more hawkish so if they touch on monetary policy or the economy, it will most likely help the currency. It is believed that McCafferty is very close to voting for a rate hike but having just lowered their growth outlook last month, chances are the Bank of England will leave rates unchanged for the rest of the year. We are looking for GBP/USD to consolidate this week with a bias to the upside and we see EUR/GBP dipping back below 73 cents.

CAD Shrugs Off Stronger Housing Data

Better than expected Canadian housing market data failed to lend support to the Canadian dollar as USD/CAD traded slightly higher after bouncing off 1.24 support. Canadian housing starts jumped from 183.3k to 201.7k in the month of May while building permits rose 11.6% against expectations for a 5% decline. Between the uptick in manufacturing activity, jump in employment and stronger housing market activity, there are clear signs of recovery in Canada’s economy. The Bank of Canada is in no place to raise interest rates but their outlook will have improved with the latest repots and so we are looking for USD/CAD to drop below 1.24. The Australian and New Zealand dollars traded higher today but the best performer was NZD. No data was released from either country but both currencies benefitted from stronger Chinese trade numbers. China’s trade surplus ballooned to $59.49B from $44.8B in the month of May. Exports and imports declined but the drop in exports was less than anticipated. The decline in imports however was large and has raised speculation about the possibility of additional easing by the PBoC.