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Dollar Rally Gets a “Reality Check”

Boris Schlossberg Kathy Lien

After early gains on the heels of slow Eurozone GDP data, the dollar has come under pressure after disappointing US manufacturing data cast a bit of doubt over the recent improvements to the US economic outlook.

The US dollar (USD) is struggling to hold onto early-session gains after a round of disappointing US economic data came out today. Manufacturing conditions deteriorated in April and May, according to today’s industrial production and Empire State manufacturing reports. Elsewhere, inflationary pressures eased, according to the latest PPI data, and foreigners bought significantly fewer dollars in March, according to the Treasury's international capital flow report.

These reports serve as a reality check for investors who may have grown overly excited about the outlook for the US economy. They also raise some concerns about the sustainability of the improvements seen in April, although it is far too early to tell because the Empire State survey was the only piece of data for May.

Regardless, the decline in the Empire survey was indeed concerning. Given improvements in other parts of the economy, analysts were looking for a small uptick in manufacturing activity in the NY region. Unfortunately, the index dropped from 3.05 to -1.43 in the month of May.

The details of the report showed new orders and shipments turning negative, while inventories and unfilled orders contracted more steeply. This reflects deterioration in sales and inventory growth, which implies stagnation and weakness in manufacturing. Concerns about the sector were exacerbated by last month's 0.5% drop in industrial production.

Producer prices also fell -0.7% last month, compared to -0.6% in March. Softer inflationary pressures will allow the Federal Reserve to keep monetary policy accommodative if officials start to become worried. According to the Treasury data, foreigners bought only $2.1 billion worth of US assets in March and were actually net sellers of US Treasuries for the second month in a row.

While these reports caused an intraday pullback in the dollar, investors feel that today's US economic reports will not have a major impact on how the Federal Reserve feels about tapering asset purchases. The Fed's focus is on jobs, and based on recent jobless claims, there have been further improvements in the labor market.

As long as the next non-farm payrolls (NFP) report does not drop suddenly, we still expect the central bank to vary asset purchases before the end of the year.

In other words, the dollar rally is still for real because the Fed is in a highly enviable position compared to the European Central Bank (ECB), Bank of Japan (BoJ), and Reserve Bank of Australia (RBA). The Fed is thinking about reducing stimulus at a time when the rest are leaning towards increasing support for their economies.

Euro Hit by Slow Eurozone GDP Data

Earlier, the dollar was moving higher after the euro (EUR) was hurt by weaker-than-expected Eurozone GDP data, which printed at -0.2% versus -0.1% expected, pushing the EURUSD pair through the 1.2900 figure in early-London trading. The single currency hit a six-week low against the greenback after GDP reports showed that the Eurozone is now in the midst of its longest contraction since the introduction of the euro.

The broader GDP data was led lower by misses in both German and French reports. German GDP eked out a tiny 0.1% gain in Q1 (versus 0.3% expected), while France saw its GDP contract by -0.2% (vs. -0.1% forecast). The near total absence of growth in the Eurozone’s core economies bodes badly for the region as a whole, indicating that the rebound in economic activity may be a long time coming as the region shows little prospect of pick up.

The market is now witnessing the sharp contrast in economic results between the moribund Eurozone and the surprisingly robust US, a condition that many analysts attribute to the diverging monetary policies of the European Central Bank (ECB) and the Fed. The Fed's aggressively accommodative stance has served to offset some of the fiscal austerity in North America and has translated into better-than-expected growth and improving labor markets.

Meanwhile, the ECB's passivity in the face of the draconian cuts in fiscal spending has resulted in an economic quagmire, with growth in the region at a standstill as deflation takes hold. Continued weakness in the Eurozone economy will only make the ECB more inclined to increase stimulus, or at least become more vocal about this possibility. If the ECB reminds the market that negative deposit rates or purchases of asset-backed securities (ABS) are on the table—which we expect them to do—the EURUSD could extend its losses.

GBP/USD on the Rebound

In the UK today, the labor data printed a bit better than expected, with the claimant count declining to -7.3K from -3.1K expected while the unemployment rate dropped to 7.8%. However, wages rose a measly 0.4% versus 0.7% projected, suggesting that the squeeze on consumer purchasing power continues.

On the positive side, the Bank of England (BoE) report indicated that CPI will continue to decline, although it estimated that inflation will remain above 2% for much of next two years. Overall, the mildly positive tone of the report and the better labor data helped to propel the British pound (GBP), and the GBPUSD pair pushed through the 1.5250 level in London trade. GBPUSD could advance towards the 1.5300 figure as it tries to recover after several days of sharp losses.

Massive Bond Buy Boosts USD/JPY

The USDJPY rally has continued, with the pair taking out the 102.50 level in today’s Asian session after the Bank of Japan (BoJ) announced that it pumped 2.8 trillion yen into Japanese government bonds (JGBs) to stabilize that market.

The volatility in the bond market is the only variable that could scuttle the USDJPY rally, but for now, the situation appears to be under control. With 102.50 taken out, the longs will now target the 103.00 level, as the dollar rally shows no signs of slowing.

By Kathy Lien and Boris Schlossberg of BK Asset Management

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