USD’s On Fire: Is Euro Headed To Parity?

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.

The U.S. dollar is on fire, rising to its strongest level in more than 13 years. In the past month alone, the Dollar Index is up more than 3 percent and in the last 4 months, it has appreciated nearly 10%. With USD/JPY breaking above 118 and EUR/USD breaching 1.04, many investors are wondering if we’ll see 120 and parity next. Now, 120 USD/JPY is much easier to achieve than parity in EUR/USD but the point is that thanks to the Federal Reserve, the greenback is headed higher. Not only did FOMC raise interest rates, but Janet Yellen described next year’s forecast for 3 rate hikes as a “very modest adjustment.” Which means that if fiscal stimulus provides the jolt to the economy that many market watchers anticipate, we could see more than 75bp of tightening.

But it is important to remember that with this strength, comes major headaches for central banks around the world, including a higher cost of servicing debt, higher inflation (which some central banks will welcome) and a rapidly falling exchange rate. Emerging-market countries have been hit the hardest by capital leaving in search of higher yields and return, along with the growing cost of paying back dollar-denominated debt. We’ve seen significant weakness in the euro, yen and other major currencies, but there’s no doubt that emerging-market currencies have been hit the hardest. Why does this matter to the U.S.? Because weaker global growth could find its way back to the U.S. economy.

The stronger dollar poses a major risk for the U.S. economy — especially in an environment of rising U.S. rates. If the Trump administration doesn’t come up with a major fiscal stimulus package quickly — and the euphoria begins to fade — we could see the economy wobble. That could translate into a major correction in U.S. stocks, the U.S. dollar and Treasury rates. However before jumping into selling dollars, it is important to realize that for the dollar rally to end, dollar bulls need a reason other than year-end profit taking to give up on their trades. The latest economic reports continue to support the greenback’s move. Despite a stronger USD, manufacturing activity in the NY and Philadelphia regions accelerated. Consumer prices also grew 0.2% — in-line with expectations — and jobless claims dropped to 254K from 255K. The NAHB Housing Market Index jumped to its highest level in 11 years. The stronger dollar SHOULD hurt trade, manufacturing and make it more difficult for the Fed to achieve its inflation target. Yet we need to see evidence of that before selling. In the meantime, the greenback remains a buy-on-dip, targeting 120 USD/JPY and a move in the direction of parity for the EUR/USD.

The euro extended its losses Thursday despite a sharp rise in German yields. The single currency fell to 14-year lows versus the greenback on the back of relentless U.S. dollar demand. The latest Eurozone economic reports were mixed. While the German manufacturing PMI report came in stronger than expected at 55.5 vs. 54.6 expected. Services PMI for Germany came in a tick lower than forecast with a 53.8 vs. 55.0 reading expected. The German composite PMI was in line with expectations at 54.8. Eurozone manufacturing PMI also had a stronger showing, printing 54.9 vs. 53.7 expected. Both the services and composite indices were in-line. Meanwhile, the Swiss National Bank kept rates steady at -0.75%. SNB President Jordan repeated that negative rates and currency intervention remains a necessity, noting that the franc is “significantly over-valued.” Europe has trade balance and CPI data on Friday.

The British pound also fell victim to U.S. dollar demand, taking out 1.25 in the process. While Thursday morning’s U.K. retail sales report was much stronger than anticipated, the Bank of England’s monetary policy statement did not include enough hawkishness to inspire gains in the currency. In fact, the statement was relatively subdued. While the central bank repeated its limited tolerance for above-target CPI, BoE felt that inflation may accelerate less than forecast in November due to recent gains in the pound. The central bank also forecast a slowdown in growth next year and these 2 comments combined gave sterling traders the green light to sell. With that in mind, there has still been more upside surprise in U.K. data than Eurozone data. Retail sales rose 0.2% against expectations for stagnation. Excluding auto and gas purchases, retail sales rose 0.5% against a steady reading.

All three commodity currencies traded lower Thursday with the New Zealand dollar leading in losses. The Australian dollar shrugged off stronger labor data while the Canadian dollar extended its losses as oil prices ticked lower. Australia reported a stellar increase in employment for the month, reporting a rise of 39.1k jobs when only 17.6k was expected. In addition to the increase in jobs for November, last month’s employment data was revised to reflect an increase of 15.2k jobs. The unemployment rate for Australia ticked up to 5.7% vs. 5.6% expected, but with the increase in employment, that rate should trend lower in the coming months. The Canadian dollar took a peek above 1.34 before settling under. In addition to the overwhelming increase in greenback demand, the Loonie saw pressure on disappointing data, which showed that existing home sales disappointed with a decrease of 5.3% when an increase of 2.4% was expected. Manufacturing sales for Canada also missed, showing a decrease of 0.8% vs. an increase of 0.4% expected. BoC’s Poloz spoke about the Fed hike Thursday saying that he was pleased to see growing confidence in the US economic outlook and that the BoC had factored a Fed rate hike into its recent views. No economic reports are scheduled for release from the commodity-producing countries on Friday.

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