Dollar Slumps, but Driver may Not be so Obvious

The US dollar is being sold across the board today.  The US Dollar Index is off 0.65% late in the European
morning, which, if sustained, would make it the largest drop in two weeks.

The proximate
cause being cited by participants and the media is weak US data that is
prompting a Fed re-think.
  However, we are a bit skeptical.
  It is not that the US data has been strong,
or that Fed officials have been touting the need to hike like many regional Fed
Presidents did earlier this year.  Rather our skepticism is based in the prices themselves.

Begin with the
widely cited Bloomberg calculation of the odds interpolated by the Fed funds
futures strip.
  Presently, its calculations shows an
18% chance that Fed funds will be at 50-75 bp at the end of September, 20.7% in
November and 37.9%  in December. After the disappointing retail
sales report at the end of last week, the probability was all lower at 16%,
17.5%, and 36.8% respectively.  Moreover,
on August 1, Bloomberg calculated the probability at 18%, 19.4%, and 31.5% respectively.      
This sampling
does not suggest that the market’s expectations of Fed policy have changed much
over the past fortnight, and to the extent,
they have changed, the odds are a little greater not less. 
 The performance of the US two-year note also suggests
that, if anything, the market has moved in the opposite direction of the
narrative widely offered.  The two-year note is yielding 70 bp, the same as at the end of last week and two
basis points higher than on August 1.  
So if shifting
views on Fed policy does not seem like the most likely explanation, is there a
better one?  
we note that the US dollar technical condition seems vulnerable to us (Dollar’s
Downside Beckons in the Week Ahead
).  Second, a fundamental case may be found with the $37.45 bln coupon payment
that the US Treasury makes this month and the $54.56 bln in bond maturities.
 That is $92 bln of capital looking for a home.  The new issuance of
$62 bln in securities absorbs nearly two-thirds of it.  That still leaves
$30 bln to be invested.   Due to the
cost of hedging new US-dollar denominated investments, the hypothesis is that a
chunk of this money is being repatriated or invested in other higher yielding
bond markets, with Japan, a key player.
The dollar has
approached JPY100.
is in important psychological area, though the Brexit low was almost
JPY99.00.  The lowest close was on July 8 near JPY100.55.  The JPY100
level also may be a neckline to a possible head and shoulder pattern, which
could be an unusual but not unprecedented continuation pattern rather than a
more traditional reversal pattern.  The pattern is about JPY7.5, which
translates into a measuring objective of near JPY92.50 if the neckline is successfully violated.
The euro is
going for the ride.
  It has reached the 50% retracement
objective of the decline since May 3’s brief push above $1.16 at $1.1265.
 The 61.8% retracement is found near
$1.1350.  The German ZEW, the main eurozone data today, was mixed.  The
assessment of current condition jumped to 57.6 from 49.8; well above
expectations for 50.2.  However, the forward-looking
expectations component showed considerably less improvement than expected.
 The 0.5 reading is better than the -6.8 reported in July but poorer than the 2.0 expected.  
The heavy US
dollar tone offers sterling some reprieve.
  Yesterday, it finished the North
American session at its lowest level in more than 30 years (~$1.2880).  Despite
today’s recovery, it has been unable to resurface above previous support around
$1.30.  The July inflation report had been
cited as the first “hard data” since the referendum, but the
impact of sterling’s sharp drop is barely detectable. Consumer prices slipped
0.1% on the month, while the year-over-year pace quickened to 0.6% from 0.5%.
 The core rate eased to 1.3% from 1.4%.   That said, import prices
did surge.  The 6.5% annualized pace is the most since the end of
To be sure, the
Bank of England expect the decline in sterling to boost measured inflation. 
 However, it recognizes it as a transitory phenomenon.
 Policymakers want to look through it.  The prospect of
currency-induced price pressures (as opposed to, say, capacity constraints) has
not and will not prevent the BOE from easing policy.    Sterling’s
weakness and the decline in interest rates help cushion the economic shock for
the UK.  
In the US,
three economic reports are featured:  CPI, industrial and
manufacturing output, and housing starts.
  Consumer prices are expected to be
flat in July for a 0.9% year-over-year increase (from 1.0% in June).  The
core rate is expected to be steady at 2.3%.   If the median forecasts are
in error, we suspect the risk is on the upside, perhaps due to medical service
costs picked up in last week’s PPI report.  

Industrial and manufacturing
output are expected to have increased,
albeit at a slower pace than June.
 Industrial output is
expected to have risen 0.3% after 0.6% in June (though we suspect the risk here
is on the upside perhaps due to utility output). Manufacturing production
is expected to have risen by 0.3% after a 0.4% rise
in June.  If this is accurate, it would be the first time since
March-April 2015 that manufacturing output rose two consecutive months.  

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