The US dollar is having one of its best days in three months. It is coinciding with the push in 10-year yields above 2.70% and the two-year yield at its highest level since 2008 (~2.13%). It may have been encouraged by a push back against the ECB hawks who want to end QE as soon as possible and preannounce an end date.
We argue that the market has exaggerated the timing of peak divergence. It is still at least a year away. The market feels more confident that the Fed will be raising interest rates this year starting in March. By the time the ECB will raise its negative 40 bp to negative 30 bp or negative 20 bp, the Federal Reserve will have raised interest rates by between 50 bp conservatively and 100 bp by their own estimation. The Fed’s balance sheet will shrink by roughly $420 bln this year, while the ECB’s will expand by at least 270 bln euros and the BOJ’s by around JPY40 trillion.
Rate differentials were not the driver last year, but that does mean that they should be disregarded. We recognize that there is not a linear relationship between interest rates and exchange rates, but see the continued widening of the differential rate differentials, mostly due to an increase in real interest rates, though term premium is also rising. We think the market has been too quick to discount the constructive US policy mix and too quick to anticipate the changes in BOJ and ECB policy.
Market positioning and sentiment seems extreme, but today’s bounce does not appear to be sufficient to break the bears. We see today’s price action as a retracement of the last leg down that began January 17-18. Key support for the euro and sterling held (~$1.23 and $1.3980 respectively). The critical level for dollar-yen is near JPY110.25, but it could not even resurface the closer hurdle near JPY109.50.
Hence, the dollar is poised to pull back in a classic Turn Around Tuesday. The magnitude of the retreat and the shape of it will help determine whether this is the start of a more sustained recovery of the dollar. The economic data focus turns to Japanese employment and household spending (including retail sales), and the first look at Q4 EMU GDP. Tomorrow night Trump speaks ahead of Wednesday’s FOMC meeting, where a hawkish hold is the most likely outcome.
Japan’s labor market is tight. Pressure has been alleviated by women, elderly, and foreign workers but there are limits on this course. Consumption appears to be on the rise as the expansion broadens. In December 2016, overall house spending fell 0.2% year-over-year. The November 2017 increase of 1.8% likely overstates the case, and it may pull back a bit in December.
The recovery in the eurozone strengthened and broadened in 2017. The PMIs and monthly data suggest another strong quarter was recorded. The median forecast is for a 0.6% increase that matches Q3. The risk is on the upside.