USD Strength Expected After Current Retracement

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Includes: FORX, UDN, USDU, UUP
by: FX Analyst
Summary

In addition to the previously stated stronger US economic performance, the USD is supported by monetary divergence.

Current USD weakness is due to technical retracement and also in anticipation to the highly volatile NFP this Friday.

I would expect the NFP to strengthen on stronger US economic condition and better ADP labor data. USD is expected to strengthen again on Friday.

My previous USD article was published on June 2, 2015, and it was titled Explaining Why The USD Is Strengthening, Despite U.S. Q1'15 Contraction. I stated my bullish case for the USD based on Yellen's speech and the fundamental economic data for May. In short, the first-quarter weakness was seen as firmly in the past, and we should look forward to a brighter future. This is why the USD strengthened the following day despite the weak first-quarter GDP data.

The following 2 days, the USD continued to weaken, as seen on the PowerShares DB USD Bull ETF (NYSEARCA:UUP) chart below:

This brings the question of whether I was wrong in the previous article and the USD is set for a future wave of weakness or is this just a technical retracement? This article seeks to address this question. I am still sticking to the bullish stance of the USD, as economic data continues to point to the recovery of the US economy in the second quarter.

Continued Monetary Divergence

Besides the economic recovery, I would also like to bring your attention to the relative monetary conditions. As it is clear in Yellen's speech, the chances of a rates liftoff are still quite high this year. On the other hand, as seen in the recent ECB statement, the ECB is committed to its QE program until its stated completion in September 2016. This is seen from ECB President Mario Draghi's reply to a question as to whether there will be an earlier end to the QE program given the positive inflation results:

"Inflation came out higher than market expectations but not higher than our expectations, and this in a sense has a quite important consequence. It actually strengthened the Governing Council in its decisions, basically in its determination and its conviction that it has taken the right decision with QE, with the size and the design of QE, but not only QE, but also the monetary policy measures that had been taken previously, in the previous months."

Therefore, we can continue to expect the ECB to purchase 60 billion euros of sovereign and corporate bonds each month until September 2016. In addition, there is a hint that it might even increase given the positive results.

Despite its recent economic recovery, the BoJ remains concerned over its inflation outlook, which is far from its 2% inflation target. This quote for the latest May BoJ Statement shows this clearly:

"With regard to the outlook, Japan's economy is expected to continue recovering moderately. The year-on-year rate of increase in the CPI is likely to be about 0 percent for the time being, due to the effects of the decline in energy prices."

Hence the BoJ is likely to continue to pace its QE at 80 trillion yen per year for Japanese Government Bond (JGB), $3 trillion yen per year for Exchange Traded Funds (ETF) and $90 billion yen per year for Japan Real Estate Investment Trust (J-REIT). Hence it is clear that both the BoJ and ECB are unlikely to step off their monetary easing program and they might even go on to greater lengths to ease monetary conditions.

The ECB is particularly determined to go ahead with its aggressive monetary easing despite the fiscal stresses that would arise from time to time as seen in Draghi's response:

"We have shown that all monetary policy measures have some fiscal implications. What matters is, first and foremost, the effectiveness of the monetary policy. In other words, it's called monetary dominance. And we are operating under that principle. This is geared to our mandate, which is maintaining price stability. These fiscal implications are usually dealt in a one-country set-up rather simply. In a multi-country set-up they are dealt in a different way."

Hence the divergence of monetary policy would continue to strengthen the USD, and this is why I am of the view that the recent weakness is merely a transitory retracement.

Anticipating Labor Release

I would also make the point that the USD is retracing in anticipation to the pending labor market. This is in view of the May's disappointment, where the market expected non-farm payroll to grow by 228,000, but the actual growth came in slightly lower at 223,000. The unemployment did drop from 5.5% in April to 5.4% in May as expected. In addition, there are pockets of weakness within the details of the labor market report such as lower-than-expected wage growth and more people being forced to work part time when they would prefer full-time work.

Source: Forex Factory Economic Calendar

The Non-Farm Payroll (NFP) report would be released tomorrow and it would attract large market attention. We can expect increased volatility for USD on Friday as this report is released. However, we have seen the ADP NFP report come out better than expected. ADP is the largest private sector payroll processor and it provides an accurate picture of the current month NFP figures. The Bureau of Labor Statistics provides the official NFP figures across the entire private and public sectors.

Conclusion

My view is that the long USD trade is still intact and it is merely on a short-term retracement path. The upcoming labor market report would be important to determine the future trend of the USD as the labor market had been a bright spot of the US economy. Given the current data, my view is that the labor market report for May would be satisfactory and be another boost to the USD. In addition, the monetary divergence would also support the USD.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.