Greenback Still Trying To Turn

Rarely in the foreign exchange market is there a V-shaped extreme.  Most of the time, the high or low is a process that is carved over time.  Although the explanation of the dollar’s weakness here in H1 vary, we continue to believe that the longer-term cyclical rally, the third since the end of Bretton Woods is intact.  
The key driver, the divergence of monetary policy broadly understood, may be obscured from time-to-time by other factors, such as positioning, political issues, financial arbitrage opportunities, economic surprises, and the like, but it remains intact.  In fact, we would go one step further, and suggest the divergence of policy has not yet peaked.  

The Federal Reserve will likely raise rates again and begin to shrink its balance sheet, while the ECB and BOJ continue to expand their balance sheets and maintain not just low, but negative rates.  Our correlation work continues to find most of the bilateral pairs strongly (relative to their twenty-year history)  co-move with nominal interest rate differentials.  

The market’s response to comments by the Deputy Governor of the Bank of Canada illustrates the power of this force.  She suggested that the strength of the recent data (e.g., 3.7% Q1 GDP, 77k new full-time jobs in May and average of nearly 43k year-to-date) may warrant the central bank re-examining the level of accommodation that is appropriate.  The Canadian dollar rallied around 2.5% in response (over a few days), as the two-year yield jumped about 20 bp, as did the implied yield of the Dec 17 BA futures. 

Similarly, the unexpected three dissents (making for a 5-3 decision) at the BOE to hike rates immediately lifted sterling nearly two cents.  The implied yield on the December 2017 short-sterling futures contract rose nearly 20 bp by the end of the week. The poor data (higher inflation, lower wages, less shopping) proved too much, and sterling was turned back after meeting a 38.2% retracement of the election-shock losses.  

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