In December, we had better than expected NFP and the UE drop to 10% from 10.2%. The currency markets believed that this would make the Fed raise rates sooner than expected and the long end of the yield curve saw rates increase almost 65 basis points. This led to a strong US dollar rally against most major currencies. This rally faltered at the end of the month in December. As we headed into January, the expectation was for a positive NFP and it actually was -85k. This led to a sell off in the US dollar and we have retraced half of what the rally was in December.
Today, we get the Beige Book and a glimpse into what the Fed sees to make monetary policy decisions. The key for the Fed is not only economic growth, but the subsequent employment growth. The Fed focuses on employment for a number of reasons, but it is it the primary source for inflation. Wage costs are the biggest source of inflation for the economy. So if employment stabilizes and jobs begin to be created, it's likely that wages will begin to rise as will inflation.
In the last monetary policy statement, the Fed has this as the 2nd paragraph and a stand alone sentence for emphasis: "With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time." Until employment increases and wages look set to grow, the Fed can feel comfortable with the "exceptionally low levels of the federal funds rate for an extended period."
Getting back to the US dollar, the key for the rally in December was a sudden shift in expectations for US rates somewhat in isolation from the other major countries. If everyone begins to grow or begins to simultaneously exit monetary easing, then there will not likely be a US dollar rally if we get good economic/employment data out of the US.
Even then, there are mitigating circumstances such as whether the currency will be allowed to reflect the shift in fundamentals or expectations. China is a great example as the currency is not allowed to appreciate even though the Chinese announced a surprise tightening of monetary policy via increasing reserve requirements.
This is why currencies are difficult to call as you have to not only understand the domestic policy, but also consider it in combination with foreign domestic policy in an environment of market expectations. In currency land, we build on themes that are generated by a consistent set of data/information. This is the momentum you hear about. Again, it's the sudden shift away from these themes that generates the volatility we experience and led to things like a sudden US dollar rally in December.
We have now broken that theme and are awaiting the next to form. This is why I recommended cutting out of the US dollar longs we had on December 29th. We have potential to revert back to a strong US dollar theme if we can get the US to show growth in isolation. Broken themes create a lack of clarity that translates into range trading.
This is where we are right now, wandering the streets looking for our themes.
Andrew B. Busch is Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.