Dollar Slips Lower in Dull Dealings

The US dollar is softening in the North American session.  Rising US yields appear to be giving the greenback a thin slice of support against the Japanese yen, against which is it trading at a five-day high above JPY113.00.   
The fundamental backdrop seems more favorable for the dollar than the price action.  It is not only the macro picture of fiscal stimulus and a favorable policy mix but also upside surprise in the recent string of data, including this week’s housing starts (best of the year) and existing home sales (strongest in a decade).  These followed upside surprises in non-farm payroll growth and retail sales.  Nor is market positioning a headwind for the dollar as it was a year ago when gross and net long speculative positions in the futures market were extreme.  
The Dollar Index has been pushed through last week’s low, a little below 93.30, is in nearing important support just ahead of 93.00.  A break would signal a move toward the 92.50-92.60 area, matching the lows of this month and last.    The driver of the Dollar Index is the euro, of course.  It is testing the air above $1.19 for the first time since the first of the month, when it peaked near $1.1940, after having been as high as $1.1960 in late November.   We are suspicious of the price action being recorded in what appears to be very thin markets. A move back below $1.1870 would justify our skepticism. 
Sterling is moving higher after coiling in progressively narrower trading ranges to start the week.  However, the high from the end of last week, almost $1.3450, remains intact.  At the same time, the price action has reinforced the significance of the $1.33 floor.  
The Australian dollar was turned back at the end of last week from $0.7700.  It is consolidating in a narrow trading range this week, with support found near $0.7640.  For the better part of the first half of December, Australia’s two-year yield slipped below the US two-year yield for the first time in 17 years.  However, guided by the central bank, it appears the talk of a rate cut next year have been quashed, and the market has upgraded, on the margins a chance of hike next year.  The two-year spread is now about eight basis points in Australia’s favor compared with a little less than five at the end of last week.  
The US dollar rose to five-month highs against the Canadian dollar yesterday.  However, this does not appear to have signaled a breakout.  The US dollar is back within the two-month-old trading range.  Support is pegged in the CAD1.2800-CAD1.2820 band, while the lower end of the range is near CAD1.2660, and was itself penetrated briefly earlier this month.
The cross-currency basis swaps continue to normalize after last week’s frantic moves.  The three-month premium (over LIBOR) for dollars against euro and yen are now back to around their 50-day averages of about 50 bp.  The premium over sterling has also narrowed to about 30 bp.  The premium over Canadian dollars began snapping back yesterday and is near 50 bp now, which is still quite extended.    
Two major central banks meet this week:  Sweden’s Riksbank and the Bank of Japan.  The Riksbank met earlier today, and the BOJ meets tomorrow.  The Riksbank was somewhat more dovish than expected.  As anticipated it left rates on hold and chose not to renew its bond-buying program.   Inflation has returned to target, the economy appears to be operating at capacity, wages are rising, and the currency has weakened on a trade-weighted basis.    
The dovish twist came from its decision to reinvestment maturing issues and coupon payments starting in January and running through the middle of 2019.  Operationally, this means that the balance sheet will temporarily increase at the start of next year and again at the start of 2019.  The decision was made over the objections of the two deputy governors (Floden and Ohlsson).   When everything was said and done, the krona was little changed against the euro and near this month’s average (SEK9.95)  
The BOJ meets tomorrow, and there is no expectation of a change in policy. It seems clear that the BOJ has been successful in targeting the 10-year yield (+/- 10 bp on either side of zero), and by doing so, it has had to buy few bonds that the JPY80 trillion official target suggests.  In the 12-months through November, the BOJ bought about JPY61 trillion of JGBS.  But few have seen this as tapering, and a further reduction is anticipated next year.   
The core inflation rate that the BOJ targets stood at 0.8% in October.  The core rate, which the ECB does not formally target, but which is nevertheless important and Draghi often refers to it, stood at 0.9% in the preliminary December estimate.  Draghi’s critics are from his hawkish flank.  Owing to the personnel shift on the BOJ Board, Kuroda’s critics have emerged on his dovish side.

Encouraged by higher US yields, the dollar is firm against the yen.  It is approaching a trend line drawn off the November high (~JPY114.75) and the high from earlier this month (~JPY113.75).  It is found in the JPY113.55-JPY113.60 area today and tomorrow.   

Catalonia goes to the polls tomorrow to elect a regional government.  The pro-independent parties got 48% of the popular vote and 53% of the seats in the 135 member parliament.  The polls suggest the pro-independent parties are unlikely to do better in the popular vote, but that the pro-unity parties may not secure a majority either.  

There are various scenarios, but one likely scenario is that Podemos plays a determining role.  Podemos offers a nuanced position, favoring unity but also a binding referendum.  From Madrid’s point of view, the constitution forbids a binding referendum for independence.  

The approaching election has not unsettled investors.  Spanish bond has outperformed Italy over the past week.  Italy’s political risk, amid speculation of a March election, seems more significant than Catalonia’s election.  Spanish bonds have been unable to keep pace with Portugal’s bonds, which enjoy the two-step upgrade by Fitch ahead of last weekend.  


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