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Why February will be a key month for dollar bulls

Currency traders are in a bind. Has the dollar rally run out of steam and is it ripe for a big sell-off, or has bullish momentum paused ahead of another leg higher? Here are the pros and cons for the currency as we approach several key events in February.

What’s bugging the dollar?

Investors’ second thoughts. Dollar trading in recent months can be split into three phases. The fourth-quarter momentum drove a 7 per cent rise in the index that measures the dollar against its major peers. Phase two was the January retrenchment — the index fell 3.5 per cent, its worst start to the year in more than a decade. The third phase has just begun.

“The so-called Trump trades, and particularly the long dollar trade, have seen a correction this year,” says Athanasios Vamvakidis, Bank of America Merrill Lynch foreign exchange strategist. He expects a volatile upward path for the currency, but says dollar bulls should be “more tactical”.

Why are some dollar bulls relaxed . . .?

The economy. That was the initial driver of the fourth-quarter rally, underpinned by GDP growth and payrolls data. The Federal Reserve warmed up the market for a rate rise and duly delivered in December, then built expectations for three rises in 2017. True, some of the first-quarter data are a bit soft, but this week’s Fed meeting appeared relaxed. As Marc Chandler at Brown Brothers Harriman says, there was “nothing to dissuade investors that it will be gradually raising rates this year”. Friday brings the January payrolls numbers and a strong outcome should revive dollar-buying.

. . . And others distinctly nervous?

Donald Trump. His election victory and expectation of fiscal stimulus and tax cuts provided a parallel reason to the healthy state of the economy for buying dollars. But his combative inauguration speech and the early decisions of his presidency are making traders think anew. First, traders are impatient for Mr Trump to flesh out his economic strategy. Secondly, they are busy calculating the possible global economic impact of US protectionism, on which the president has been more forthcoming. “History shows that the dollar has tended to weaken on tariffs,” says Bilal Hafeez, Nomura FX strategist.

One indicator of the market’s take on the US economy is the real interest, or inflation-adjusted, rate as measured by the 10-year Treasury note yield minus inflation. Like the dollar, it was firmer during the fourth quarter, only to retreat during January.

Is the “currency manipulation” debate having a big influence?

Quite a bit. Traders are fully aware of the frequent invective from the president and his advisers against Germany over the weakness of the euro, Mexico and the peso, Japan and the yen, as the administration inclines towards a weak-dollar policy. But investors are waiting to see whether these verbal joustings amount to firm action. There is an argument, too, that the more rhetoric from the administration the less impact it will have on traders, because market-watchers are more fixated with policy divergence. Alan Ruskin at Deutsche Bank says the US will “struggle to successfully pursue a trade oriented, ‘less strong’ dollar policy for any length of time”, if the Fed is the only major central bank raising base rates this year.

What’s coming down the line in February?

Plenty. Friday’s payrolls data are the next thing on traders’ radar, followed by the Fed’s monetary report to Congress and Janet Yellen’s semi-annual testimony. The foreign exchange market is also awaiting the administration’s budget proposal to Congress, a G20 foreign ministers’ summit and a finance ministers’ meeting, the first major international gatherings since the US election. Towards the end of the month comes the president’s State of the Union address, where policy proposals will probably be fleshed out and help determine the next major move in the dollar.

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