US Dollar: Three reasons behind the rally

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Last week ended on a high note with the non-farm payrolls report triggering a sharp rally in the U.S. dollar. With no U.S. economic data on the calendar today, the dollar extended its gains against most of the major currencies. The euro and the New Zealand dollar performed the worst against the greenback while the Japanese Yen held onto its gains. A quick scan through the charts will show that the EUR/USD is the only currency pair that has staged a meaningful sell-off since the Fed’s decision to increase Quantitative easing. This implies that investors are still quite bearish U.S. dollars but they are growing more particular about which currencies they choose to short the dollar against. In order to gage whether the rebound in the dollar is here to stay, we need to breakdown the 3 primary factors behind the dollar rally:

  1. Profit Taking and Consolidation - There is no question that profit taking and consolidation is the primary reason why the dollar extended its gains. In our daily report on Friday, we said the lack of significant economic data this week will leave investors reflecting on the strong non-farm payrolls report. Since September the U.S. dollar depreciated significantly in anticipation of additional stimulus from the Federal Reserve and now that the central bank has obliged, investors need a new catalyst to take the dollar even lower. Unfortunately the recent improvement in U.S. economic data reduces the need for more asset purchases beyond the amount announced last week. In fact, it even raises the possibility of the central bank paring back their asset purchases prematurely.

  2. Skepticism Within the Federal Reserve – The dollar also benefited from weekend comments by Federal Reserve President Warsh who made a point to say that the central bank did not make an "unconditional or open-ended commitment" and specified that should "certain objectives (be) satisfied, purported benefits disappoint, or potential risks threaten to materialize," the Federal Reserve could alter its policies. These comments imply continued skepticism and flexibility by a central bank that is not entirely convinced that additional large scale asset purchases will do the trick. Warsh is traditionally one of the more hawkish members of the FOMC and in his commentary this afternoon, he said frankly that “asset purchases may fail to benefit the economy.” The Fed is still adapting as they go which undermines their conviction about their last policy action. Federal Reserve President Bullard who is one of the more dovish members of the FOMC believes that we will see the impact of the stimulus measures as soon as 6 months from now and that the benefits outweigh the risks. There continues to be debate and disagreements within the central bank and the kids are never happy when their parents are fighting.

  3. Risk Aversion – The dollar also rebounded because of risk aversion. Fresh concerns about the Irish banking sector have made investors nervous (this is discussed in further detail in the euro portion of this report). The record high reached in gold prices confirms that investors remain worried about the global economic outlook. The non-farm payrolls report on Friday failed to engineer enough optimism to turn investors bullish on the U.S. economy. One month does not make a trend and everyone from the Federal Reserve to investors will need to see a few more months of consistent data before they can grow confident about the U.S. recovery. Taking these factors into consideration, we know that despite the improvements in U.S. data, it will not be easy to turn the market bullish U.S. dollars. With the Federal Reserve doing all that they can to keep interest rates low, there is very little incentive for investors to buy dollars. There are no major U.S. economic reports this week which means that for the time being, the dollar should avoid significant losses but the strong payrolls report will not be enough to turn the dollar around . The fate of the dollar this week will hinge upon Chinese data and the difficulties in the euro area. Small business confidence, the IBD/TIPP economic optimism index and wholesale inventories are the only U.S. economic reports scheduled for release on Tuesday.

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