Dollar Shoots Higher

The combination of the outright deflation in the eurozone and the seemingly immunity of the US economy to the poor global developments has encouraged investors to extend the dollar’s gains. The euro has been pushed below $1.18. Sterling neared $1.50.  And the dollar, which was at three week lows against the yen on Tuesday, near JPY118, is knocking on JPY120 again.    

Meanwhile, yesterday’s recovery in the US equity market has helped lift global markets today. The MSCI Asia Pacific Index rose 1.2%, with only the Chinese markets not following suit. In Europe, the Dow Jones Stoxx 600 is up nearly as much. US shares are trading broadly higher, pointing to around 0.4% opening gains in the S&P 500. Benchmark bond yields are slightly higher, though Greek and Portuguese bonds yields have slipped lower. Oil prices are steady. 

The dollar bullish divergence theme was underscored by the -0.2% preliminary eurozone CPI reported yesterday and the stepper than expected 2.4% drop in German factory orders reported today. The consensus had expected a 0.8% decline after the 2.5% rise in October (revised to 2.9% today). At the same time, the US ADP data pointed to another good monthly national report due tomorrow. The smaller than expected US November trade deficit also showed little sign that the dollar’s strength is biting.

For their part, the FOMC minutes confirmed our interpretation of the policy signals from the Fed’s leadership.  If the labor market continues to heal, as most signs suggests, which includes some preliminary upward pressure on labor costs and wages, then the Federal Reserve is likely to raise rates in the middle of the year, even if there is little if any progress on inflation from here. Recall that the 2004 tightening cycle began with the core PCE deflator (which was not a target then) was near current levels. 

At the same time, the market takes for granted that the ECB will announce a wider asset purchase plan.  It is now debating the “modalities”.  We have argued that the divergence with the euro area had been a key hurdle to such a program, but now that the German economy has lost its momentum, and is also on the verge of outright deflation, the opposition to a larger asset purchase program has softened.