Monetary Policy — Not Data — Is Driving Currencies

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 Over the past few weeks a number of currencies hit multi-month lows against the U.S. dollar. The euro, Swiss franc and Canadian dollar, for example, dropped to their lowest level since March versus the greenback while sterling hovers near its three-decade low. On Friday we posed the question of whether currencies would trade on divergences or carry this week and Monday was a classic example of the market over-weighting monetary policy divergences above everything else. The Eurozone reported its strongest PMI index this year and yet the euro continued to fall. The data was very healthy with manufacturing activity in Germany expanding at its strongest pace since the first quarter of 2014. The services index rose from 50.9 to 55.1 -- the largest increase in 3 years. France reported an improvement in manufacturing activity and a slight slowdown in services. The upside surprises are a testament to the positive impact of a lower currency. Under normal market conditions, the strength of Monday’s reports should have driven EUR/USD up 50-70 pips but instead we saw a mild rally that fizzled during the North American trading session. Part of that had to do with better-than-expected U.S. data but at the end of the day, the German-U.S. yield spread is driving EUR/USD. As shown in the chart below, both German bund and U.S. Treasury yields increased Monday while the yield on Treasuries finally stabilized and is now moving higher at a faster rate than bunds. Tuesday’s German IFO report should continue to support the currency but investors will be far more interested in comments from ECB President Draghi. We still believe EUR/USD is near a bottom but it may drop to its next support level between 1.0815-1.0825 before stabilizing -- anywhere below 1.0840 would be a great place to consider fresh longs.

The U.S. dollar traded higher against all of the major currencies thanks to stronger U.S. data and a corresponding uptick in U.S. rates. Manufacturing activity appears to be a bit stronger according to the Chicago Fed National Activity index, which improved slightly and Markit Economics’ US Manufacturing PMI index, which rose to a one-year high of 53.2 from 51.5 in October. House prices and consumer confidence are scheduled for release Tuesday but the main focus will be Friday’s GDP report. Economists are looking for a very sharp rebound in growth but with retail sales weakening in the third quarter, the risk is to the downside. A number of Federal Reserve officials spoke Monday and nearly all policymakers were optimistic. FOMC voter Bullard repeated his view that a rate increase will be needed and that December is the most likely for a rate rise, even though there’s “no urgency” to raise rates. Fed President Evans, a noted dove, said the labor market and economy are doing well and noted that it's good news that inflation is moving closer to target. However he also believes that inflation is too low and there’s a need to show commitment to the inflation target, which indicates that he isn’t eager to see interest rates rise. Dudley and Powell refrained from talking about the economy or monetary policy. While we are dollar bulls, recent data has been mixed and December is a long way from now so we are still waiting to buy on a pullback to 103.

Sterling ended the day virtually unchanged against the euro and U.S. dollar amidst mixed data. The CBI total trends survey missed expectations coming in at -17 versus -5 expected. However the CBI Business optimism index rose to -8, a big improvement from last month’s -47 reading. The details of the report were less encouraging with the employment component falling and prices rising. Losses in GBP were contained by some Brexit headlines -- UK Prime Minister May said Monday that there was “no suggestion” that government is currently seeking a hard Brexit. She also indicated that there would be a series of Parliamentary debates on Brexit, which suggests that Article 50 won’t be invoked easily. Sterling briefly traded below 1.22 but quickly rallied and continues to hold this support level. The main focus for the U.K. this week will be Thursday’s GDP report.


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