US economy outperforming much of the developed world and market watchers contemplating Fed’s exit from QE policies

By Mike Jones

NZD

Currency markets exploded into life last week, as the USD blasted higher. The move was centred on USD/JPY, but all of the major currencies were affected. As a result, the NZD/USD finished the week 2.8% lower around 0.8300.

Importantly, at least part of the rally in the USD last week was driven by ‘fundamentals’. US bond yields rose steadily through the week.

Not only is the US economy continuing to outperform much of the developed world, but market watchers are now starting to contemplate the Fed’s exit from QE policies.

Last week’s selling pressure on the NZD/USD was exacerbated by a) a drop in commodity prices, itself mostly driven by the firmer USD (the CRB index fell 1% on Friday), and b) an unwinding of speculative long positions.

We’ve long warned about this risk. And while IMM net NZD long positions are off their highs, they remain elevated, suggesting room for further NZD downside.

For this week, general sentiment towards the USD will be the most important driver of the NZD/USD. Whether or not the greenback’s rally continues will largely depend on the relative strength of some key US data. Tonight’s retail sales data are the first cab off the rank.

Negative momentum and the convincing break below 0.8360 leaves us with a downside bias for  the NZD/USD this week. However, we don’t think the currency is embarking on a sustained downtrend.

Support in the 0.8160-0.8200 region should hold. Not only is it too early to expect sustained USD gains, but NZ-US relative fundamentals remain strong. Thursday afternoon’s NZ Budget is likely to confirm as much.

We expect to see a fiscal surplus by 2014/15, by way of an economic growth outlook solid enough to cap Government debt at proportions still low by developed-world standards. This should keep the rating agencies happy.

Other important NZ data releases on this week’s slate are retail trade volumes on Tuesday (0.1%q/q expected) and Thursday morning’s dairy auction, for which we expect to see another correction in prices.

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Majors

Across the board USD strength was the dominant theme on Friday night. Following Thursday’s 1% gain, the narrow DXY index rose a further 0.5%.

Friday’s USD strength wasn’t a risk aversion story. Indeed, small gains in global equities and a decline in the VIX index were indicative of a modest ‘risk-on’ tone – something usually associated with a weaker USD.

Instead, increased ‘fundamental’ support from rising US bond yields was the bigger driver. US Treasury yields rose across the curve with slightly larger gains at the long end (curve steepening).

Driving the move was not only a thinly veiled warning from Fed Chairman Bernanke about ‘excessive risk taking’ and ‘reaching for yield’, but rumours the WSJ’s Hilsenrath was about to release an article outlining the Fed’s QE exit strategy.

As with Thursday, the gains in the greenback were led by USD/JPY. The pair made a fresh high within a whisker of 102, aided by the G7’s apparent sanctioning of Japan’s aggressive easing policies.

EUR/USD was pushed below 1.3000, the GBP/USD shed around a cent, and the AUD/USD (briefly) slipped below parity for the first time since June 2012.

The Hilsenrath article was released after the US close. It doesn’t suggest the Fed is on the cusp of tapering asset purchases, just that Fed members are now debating an exit strategy.

This shouldn’t really have been news, which makes us wonder whether positioning played a role in amplifying the magnitude of Friday’s currency moves. Our view is that it is still too early to expect a sustained USD rally.

Whether the gains in US bond yields and USD continues this week will depend on some key cyclical data.

Tonight’s US retail sales figures will be key. The consensus expects a 0.3%m/m decline in headline sales, but the ex-auto figure will probably be the more interesting one given lower gasoline prices in April likely boosted non-auto spending. An upside surprise here would play into the hands of the stronger USD theme.

Aside from retail data, investors will also be keeping an eye on a speech from the Fed’s Plosser tomorrow, the NAHB housing index, April industrial production and housing starts figures, jobless claims on Thursday and the Empire manufacturing index.

Other news:

*Japan investors bought a net ¥310b in foreign bonds last week – the second consecutive net buy week after 6 net sell weeks.

All its research is available here.