Dollar Can Strengthen On Improved Yield Spreads

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

Ahead of September's key events, expectations over the next week are likely to be dollar favorable. Given solid claims data, markets will anticipate a robust September payroll release which would keep Fed tapering on track. Yield spreads have already moved in the dollar's favor while market positioning has shifted to being net long Euros. Emerging-market stresses and Syria are very important wild-cards over the next week and will trigger further volatility with the net impact likely to be slightly dollar positive given a reluctance to sell the US currency. Overall, EUR/USD is likely to dip into a lower 1.3050-1.3200 range with a selling opportunity on any initial correction back to the 1.3280 broken support area.

The relationship between 2-year US Treasury yields and German Bund yields remains extremely important for the underlying Euro/dollar relationship. Yield spreads have moved significantly over the past few days as the US advantage has moved from below 0.10% to around 0.16%, the widest for August as a whole. This shift in yields suggests the dollar should be slightly stronger than current levels on valuation grounds.

Thursday's US economic data was dollar supportive with Q2 GDP revised up to 2.5% from 1.7% previously, slightly above consensus expectations. Initial jobless claims also declined to 331,000 in the latest reporting week from a revised 337,000. A notable feature of the jobless claims data has been the consistency over the past few weeks which suggests a solid labor market.

The latest market estimates for the crucial August payroll numbers due at the end of next week are for a non-farm employment increase of around 175,000. Given the recent trends in jobless claims and PMI surveys, there is scope for these forecasts to be revised up slightly over the next few days. If employment growth is around 175,000 or higher, this would maintain expectations of Fed tapering in September which should underpin the dollar ahead of the data.

The ECB will meet next Thursday and President Draghi will need to perform a very important balancing act. He will want to sound encouraging over longer-term prospects, but will also be extremely aware of the dangers surrounding a tightening of monetary conditions. The latest data on bank lending makes grim reading and Draghi will be very aware of the mistakes made in previous cycles when the ECB passively and actively tightened policy as oil prices rose. This time around, the ECB will be much more circumspect and there is likely to be a dovish undertone which would be Euro neutral at best.

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.