Dollar rallies again on continuing emerging market sell off, dismal European inflation data

admin03/Feb/2014Currency Updates

The flight from risk assets continued last week, although the themes in which investors focused shifted somewhat. Emerging market currencies, equities and bonds generally moderated their losses towards the end of the week, whereas every major G10 currency save the Yen suffered significant losses against the dollar. The year-to-date table of asset returns looks like the exact opposite of last year: gold and Government bonds show strong positive returns, whereas equities, in particular Japanese and emerging market stocks, have suffered heavily. One significant piece of macroeconomic news that has not received sufficient attention was the release on Friday of Eurozone inflation. It dipped .2%, against all expectations, and is now set at 0.7%, far below the ECB target and uncomfortably close to the 0% level. We now expect some action from the ECB at its meeting next week: either a cut in rates or significant news regarding the ever-delayed facility for easing SMEs access to credit.


Last week brought another solid batch of macroeconomic news out of the UK. The GDP report printed close to expectations, around 2.8% in annualised terms. The details were also quite solid. The only downward surprise came from construction, which unexpectedly contracted a tad over 1% in annualised terms. Given the buoyancy of house prices, we think it is quite likely that this weakness will reverse next quarter. We think that this data will allow the Bank of England to remain in its wait’and’see stance and expect no change in policy or communique at the MPC meeting next week. Sterling continued to behave as a low’beta version of the Euro, as it has so far this year, a trend that we expect to continue.


The ordinarily dull inflation releases in the Eurozone have lately become a point of focus for investors. Last Friday, the data provided yet another nasty surprise. Inflation confounded expectations of a rise to 0.8%, and instead dipped to a new cycle low of 0.7% YoY. It is true that the dip was driven by energy, and core inflation nudged up 0.1% to 0.8%. But it is no less true that the ECB has never put much weight on the headline/core dichotomy, and that actual inflation is diverging further and further, not only from the ECB’s official target of “close to, but just below 2%” but from its own recent forecasts. We think that the news warrant further ECB action, and the key question is whether Draghi will be able to overcome German opposition. The situation is serious enough that we expect he will, just barely. We expect either a cut in rates that would include negative deposit levels, or some major announcement regarding the ECB plan to purchase securitised SME loans in order to help smaller companies finance themselves. At any rate, whether the action materialises or not, the reaction of the Euro to the outcome of the meeting will be very informative in terms of the near term direction for the common currency.


The US also had a strong GDP growth report out last week. The headline print came in at 3.2%. Further, the details were generally strong. The only weakness was in housing investment and Federal Government spending. Neither is likely to continue, giving the continuing housing recovery and the agreement on the debt ceiling reached late last year. Therefore, we regard the report as providing strong support for our view that US growth will top 3% in 2014 and therefore the Fed tapering of monetary stimuli will continue on schedule.


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