Keep Buying The Dollar Corrections

 |  Includes: FXE, UDN, UUP
by: Tim Clayton

Following key set-piece events of last week, the dollar remains best placed to strengthen over the next few weeks and any corrections will continue to represent a strong buying opportunity. The Federal Reserve remains on track to taper bond purchases in September while the ECB has indicated very strong resistance to both higher yields and a tighter policy. While the Euro could again surprise with its resilience, 2013 EUR/USD lows below 1.25 are realistic and it is a strong sell on any corrective recovery back to the 1.30 area.

The US first-half non-farm payroll average monthly growth of 202,000 is important as even generally dovish Fed members, have stated that consistent employment growth at this pace would be sufficient to allow a reduction in the rate of bond purchases.

There is still a very important risk that it could all go wrong for the economy and Fed, but the sequencing remains extremely important and there will be a very high barrier to a policy reversal at this point. The next Federal FOMC meeting is at the end of July and there is a high probability that the Fed will keep on track for tapering at this meeting. The meeting after that is mid September when markets will be looking for the tapering to take place and they will be very reluctant to reverse course at this point.

The yield spread between US and German 10-year bonds has widened to the highest level for seven years and the two-year gap has also widened to 2013 highs, a combination which suggests the Euro should be trading around or below 1.25.

The Euro does have two factors in its favour. Firstly, the ECB balance sheet is actually shrinking as LTRO repayments continue to trickle through, in contrast to the US where the Fed balance sheet is still expanding. The Euro is also running a sizeable current account surplus which, in theory, provides structural currency support.

ECB forward guidance, however, was a very important indicator that the central bank knows that it must resist any monetary tightening at all cost and will have to consider negative deposit rates. Leaks from the ECB over the past two days strongly suggest growing divisions within the bank with the hawks resisting attempts to cut interest rates further. The leaks also suggest that the doves are looking to marginalise the hawks and push for further policy relaxation at the August meeting.

The current account surplus is also an indicator more of chronic under-demand within the Euro area rather than a healthy external position. In this context, rising temperatures across Europe will also increase the threat of social protests as the toll of exceptionally high unemployment continues to increase.

Portugal's government has, for now managed to patch-up differences and the coalition will stagger on. Greece will the next loan tranche on the basis that its too important to fail ahead of German elections, but overall political support for current Euro-zone policies is continuing slide, increasing the threat of a full-blown political crisis within France and Italy.

The latest German opinion polls continue to point to Merkel's CDU/CSU leading in opinion polls ahead of the September Federal election, but falling short of an overall majority. This will force the German government to maintain a tough stance on bailouts and Euro-zone structural reforms.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.