Week Ahead: Does the Dollar have Legs?

by
Marc Chandler
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There are different ways to measure it, but the dollar just put in its best week of the year. The greenback rose against all the G10 currencies, and the Dollar Index rose by the most since last September. It also appreciated against most emerging market currencies, with the notable exceptions of a handful of Latam currencies. It seems to be an overdue technical correction. Few genuinely believe that the US will default given the ominous consequences, but the dysfunctional appearance weighs on sentiment. The KBW regional and large bank indices tumbled again (~-6.2% and -3.5%, respectively, last week). The market continues to price aggressive rate cuts, with a year-end effective rate of about 4.38% (the effective rate now is 5.08%). That is up from 4% on May 4, but still seems to require some significant development and soon to force the Fed to reverse itself. It is not that it cannot happen, it seems more like a tail risk than the base case. 

On technical grounds, the dollar looked oversold but there is a fundamental narrative that may help frame the correction. The bear story for the dollar has been discounted. Can the pendulum of sentiment swing toward even more Fed cuts? Hawkish rhetoric from a couple Fed officials and the jump in consumers' 5–10-year inflation expectation in the preliminary May University of Michigan survey (3.2% from 3.0%, and forecasts for it to decline) is renewing thoughts of a June hike. The ECB's target rate is 3.25%. The market sees one and maybe two hikes left. And the regional economy looks like it stalled after a strong start of the year. Yes, a winter crisis was averted. Now what? The risks to growth are on the downside. Less than 24 hours after the Bank of England revised away its recession forecast, ONS reported an unexpected 0.3% contraction in the March monthly GDP. It eked out a 0.1% quarter-over-quarter expansion, but, like the eurozone, no momentum going into Q2. The good news is known. 

United States: The focus of the high-frequency data shifts from prices to the real economy near the mid-point of the second quarter. The world's largest economy is proving more resilient than many expected, seemingly also the Federal Reserve. The Atlanta's Fed's GDP tracker's final iteration for Q1 growth of 1.1% proved spot on the official initial estimate. It sees Q2 GDP tracking about 2.7%. The stronger-than-expected April auto sales (15.91 mln vehicles, seasonally adjusted annual rate, from 14.82 mln in March and slightly less than 11.5% over April 2022) hint that retail sales likely recovered from March's 0.6% decline. Industrial output may have stalled, and manufacturing production may have stabilized after falling by 0.5% in March. Recall that in Jan-Feb, manufacturing output jumped 1.5% and 0.6% respectively, the most two-months since Oct-Nov 2021. Surveys for May begin with the NY Fed's services and manufacturing surveys and Philadelphia Fed's business survey. Housing starts and existing home sales for April are due, and weakness is likely to still be evident. Meanwhile, the Leading Economic Indicators index looks to have extended its decline for the 13th consecutive month. The duration and pace of the decline is associated with recessions, but expectations for a downturn continue to be pushed out to later this year or early next year. 

The Dollar Index bounced last week and its nearly 1.5% gain was the most since last September. The downtrend had stalled near 101.00, and the week's close near 102.70 was the highest close in almost two months, The five-day moving average crossed above the 20-day moving average for the first time since mid-March. The underlying drags, however, remain debt ceiling drama, the pressure on bank shares, and the aggressive rate cuts the market is pricing in for the Fed this year. Despite the disruption in the T-bill market and the credit-default swaps, a US default does not seem like the most likely scenario, but brinkmanship requires going to the brink. Still, corrective technical forces could lift the Dollar Index further. Overcoming initial resistance about 103.00 could signal gains in the toward 103.50-104.00 area.

Eurozone:  Germany and France reported terrible March industrial production data (-3.4% and -1.1% respectively). Italy's also disappointed, falling by 0.6% instead of rising by 0.3% as the median forecast in Bloomberg's survey projected. These reports more than offset the better Spanish reading (1.5% vs. 0.3% expected). The aggregate figure (May 15) will feed into the details and revisions of Q1 GDP, which was initially estimated at 0.1% (quarter-over-quarter). The preliminary estimate was that the Germany economy stagnated, but the weak retail sales, exports, and industrial production numbers warn that the eurozone's largest economy may have contracted. In turn this points to a downward revision of the aggregate figure. The weakness in the May Sentix survey and poor news stream warns of weakness in the ZEW survey. The bloom is coming off the European rose that dodged a winter energy crisis and now stark economic resurfacing, and it is further behind inflation than the US. In April, eurozone inflation was 7.0% higher than a year ago, and in April 2022, CPI had risen 7.5% over the previous 12-months. The US CPI stood at 8.3% in April 2022 and was at 4.9% in April 2023.

The euro peaked a little shy of $1.11 in late April. As we have noted, the momentum indicators did not confirm the new highs. Yet, a "buy on dips" strategy gave the single currency a resilience, and that ended last week. The euro was closed below its 20-day moving average and the five-day moving average fell below the 20-day moving average for the first time since mid-March. The euro was pushed through support in the $1.0880-$1.0900 area and settled at session lows, around $!.0850. The next chart support is near $1.08 and then $1.0740. A move back above the $1.0940-50 area stabilizes the technical tone.

Japan:  The world's third-largest economy provides its first estimate of Q1 GDP on May 17. The median forecast in Bloomberg's survey is for a 0.2% quarter-over-quarter expansion (0.8% annualized). The economy was flat in Q4 22. Net exports are expected to have halved growth (-0.2%), while inventory accumulation may have added 0.1 percentage to growth. Consumption likely drove growth, rising 0.4%, while business investment has been weak and likely offset the increase in consumption. The GDP deflator is seen at 1.8%, up from 1.2% in Q4 22. On May 18, Japan's April trade balance is due. Seasonally, it almost always deteriorates from March. It recorded a trade shortfall of JPY755 bln (~$5.6 bln) in March. Japan's trade deficit averaged JPY1.73 trillion in Q1 23 and JPY1.13 trillion in Q1 22. Most of the thunder for the April national CPI has been stolen by the Tokyo report that was reported at the end of April. The Tokyo figures are very good approximations of the national figures. In March, the national headline and core (excludes fresh food) were at 3.2% and 3.1%, respectively, 0.1% below the Tokyo readings. The measure that excludes fresh food and energy was at 3.8%, and 3.4% in Tokyo. In April, this measure in Tokyo rose from 3.4% to 3.8%. The risk is that the national figure comes in higher still, which may bolster ideas that the BOJ will adjust policy as early as next month.

The dollar traded between JPY133.75 and JPY135.75 last week and it was covered in the last two sessions. It settled on the highs, which were the best in seven sessions. The greenback has risen in five of the past six sessions. The vagaries of US yields continue to seem like the most important driver of the exchange rate. For the better part of three months, the dollar has been in a roughly JPY130-JPY137.50 trading range. It looks like it can persist a bit longer. The greenback looks poised to test the JPY136.00-15 area. The momentum indicators are constructive, and near-term potential may extend toward JPY137.00, where the 200-day moving average is found. The five-day moving average (~JPY135) approached the 20-day moving average (~JPY134.80) but has remained above it since April 11.

United Kingdom: The Bank of England hiked the base rate last week, and with double-digit inflation, a pause seems unlikely. The hike brought the base rate to 4.50%, for a cumulative move of 440 bp. The swaps market continues to favor a terminal rate between 4.75% and 5.0%. The next labor market report is due May 16. The UK's labor market has been resilient and wage growth firm, and these are important data points for the central bank's reaction function. Sterling is the strongest G10 currency this year, up about 3.0%, and reached its best level since June 2022 last week near $1.2680 before profit-taking kicked in. Sterling snapped a three-week advance, and its roughly 1.5% loss last week was the largest in three months. It finished the week below the 20-day moving average (~$1.2505) for the first time in nearly a month. Ahead of the weekend, it approached the low so far for this month (~$1.2435), which is the top of a band that extends to $1.24 and may offer support. Unlike the euro (and Dollar Index), the five-day moving average has not crossed below the 20-day, but the technical tone is softening. The momentum indicators have turned lower. Even under a shallow correction, given the magnitude of its rally since mid-March sterling can fall toward $1.2350. 

China: It is particularly hard to get a good read on China's economy. Many have long been suspicious of its data, and now it has become even less forthcoming, apparently because some foreign groups have used its data to reveal industry and military ties that serve other countries agenda sanction agenda. One recent indirect approach to try to understand size of China's economy is based on some algorithm related to the light it produces and the takeaway is that the world's second-largest economy may be 10% smaller than official data suggests. China reports April industrial production, retail sales, and fixed-asset investment on May 15. The data is expected to show that the recovery is gaining traction and sequentially improving on a year-over-year basis. However, the weakness in imports and prices are seen as a sign of underlying economic problems and many are looking for more monetary support here in H1. A cut in required reserves seems favored over a rate cut. Property investment (May 15) and new house prices (May 16) will provide clues into the state of the real estate crisis. Between the new limits on access to Chinese data and the crackdown on some foreign firms may discourage portfolio and direct investment flows, and hasten the decoupling, which seems industry (and country) specific.

The yuan fell every day last week against the dollar for a cumulative decline of nearly 0.70%, its largest weekly loss since late February. It was the fourth weekly loss in the past five weeks. Disappointing exports, weak lending, and soft inflation figures bolster speculation that officials will ease monetary policy by the end of Q2. The dollar finished last week above the 200-day moving average (~CNY6.94). There is little to deter a test on this year's high set in February and March in the CNY6.9730-70 area. Should the dollar's correction against the euro and yen continue, a return to the CNY7.0 area is reasonable and implies a dollar gain in percentage terms slightly less than last week's rise. 

Canada: The Bank of Canada remains on a conditional pause announced in January. Growth at the start of the year was stronger than the central bank anticipated, but it remains confident that the economy will slow this year. Canada reports April CPI on May 16, and Governor Macklem reminded that if necessary to bring inflation down, the Bank of Canada could raise rates again. The market thinks it is highly unlikely and continues to fully price in a quarter point cut from current levels late this year. Inflation peaking in June 2022 at 8.1%, and it stood at 4.3% in March. The base effect from Q2 22 suggests scope for a further decline. Making a conservative assumption of a 0.4% average increase per month in Q2 would bring the CPI close to 3% by mid-year. The second half of the year is a different story. Canada's CPI fell ever so slightly in Q3 22 and rose by less than 1% at annualized clip in Q4 22. In Q1 23, Canada's CPI has risen at an annualized rate of about 5.6%. The trimmed and median core rates were sticky through late last year even though they peaked in the summer, but the pace of slowing has accelerated in recent months. Still, in H2, the comparisons will be more difficult. Turning to the March retail sales (May 16), another soft report is likely, but it needs to be placed in the context of the 1.6% surge in January. Like we saw in the US, consumer front-loaded, and February saw a month-over-month decline. US retail sales also decline in March and between the two months, around half of January's gain was offset. In proportionate terms, Canada's retail sales would have declined by 0.4%-0.5%  

The US dollar recorded the low for the month at the start of last week a little above CAD1.3300 and rebounded to CAD1.3565 at the end of the week. The US dollar has surpassed the (61.8%) retracement target of its losses from the April 28 high. There is little from a technical perspective that prevents a return to the CAD1.3650-70 highs seen earlier this month, and even the CAD1.3700-30 area. The momentum indicators are mixed but sentiment toward the Canadian dollar is soft in the absence of a bullish hook. It offers little consolation, but the Canadian dollar's 1.30% decline last week, made it the fourth best performer among the major currencies, after the yen, Swiss franc, and Norwegian krone. It did better than the Australian dollar (~-1.55%) and the New Zealand dollar (~-1.60%). This comparative performance suggests that it might not be about the Canadian dollar, but US dollar. 

Australia:  The central bank's surprise hike earlier this month helped lift the Australian dollar from the lower to the upper end of its trading range from around $0.6600 to $0.6800. The central bank meets again on June 6. The futures market shows a high confidence that it will stand pat. The strong jobs report on May 18 could inform expectations. Australia's jobs market remained strong in Q1. It created 35.4k jobs on average a month, the best quarterly showing since the middle of last year, and all those jobs were full-time positions (average 35.9k). The government's budget, the projected surplus and the new spending initiatives no surprise given the press reports ahead of it. It seems supportive of the economy, but expectations of the trajectory of monetary policy were not altered. 

The Aussie was turned back after the mid-week push above $0.6800. It finished the lower quartile of its two-cent range (i.e., below $0.6650). The risk is that after being rejected at the upper end of its range, it now tests the lower end (~$0.6600). The momentum indicators are poised to turn lower. Last week's 1.55% loss was the largest since the end of February. It has now fallen for three of the past four weeks, but what seems like a trend is in a two-cent trading range. The edges of the range have been frayed but not sustained. We suspect the next big move will be higher, but this does not rule out a downside break first that could toward $0.6550.

Mexico:  The combination of the peso's strength and the gradual easing of price pressures suggest that Banxico will not raise rates at its meeting (May 18). Central Bank Governor Rodriguez recently indicated a pause was possible. The overnight target rate is 11.25%. April CPI stood at 6.25%. The peso has appreciated by about 10.5% against the US dollar this year and is reached levels not seen in six years. The Supreme Court decision to block AMLO's attempt to weaken the election watchdog suggests that alongside the central bank, shares an independence and strength to helps ease broad concerns about AMLO's policies. That said, it is interesting to note that unlike Brazil's Lula, who wanted to reduce the reliance on the dollar, AMLO endorsed the greenback as the world's principal currency. Mexico attracts direct investment to locate in the USMCA and have access to the US market, and this includes Chinese companies. Industries left Mexico after China joined the WTO and now changes in the geopolitical climate, lessons about supply change management, and the rise of economic nationalism are creating a new opportunity for Mexico.

The Mexican peso remains a market darling. Its low volatility and high interest rates appeal to carry strategies. It is stretched from a technical perspective. However, given the wide interest rate differentials, even in a consolidative market, one is paid to be long pesos. The longs have not reason to get out, and new peso buyers are entering it appears on shallow pullbacks. The US dollar reached nearly MXN17.5350 on May 11. The low from 2017 was closer to MXN17.45. It is more a mile-marker rather than technical support (i.e., the price can bring in new demand). In the bigger picture, with the break of the MXN17.82 area, the dollar has unwound half of its gains against the Mexican peso from 2008 (~MXN9.86) to the 2020 high (~MXN25.79). The next retracement (61.8%) is near MXN15.94. This seems too far away to take seriously. Yet, based on current volatility, a move toward MXN16.50 is reasonable by the end of the year (reasonable in this context is one standard deviation from the year-end forward).