Dollar Remains Firm on Stronger U.S. Outlook

NEW YORK ( BBH FX Strategy) -- The U.S. dollar is broadly higher, continuing Tuesday's rally that intensified after the FOMC meeting. In the eurozone, there were no new developments but the euro made a marginal new low of 1.3031, while sterling is currently flat. The dollar climbed to an 11-month high of 83.51 against the yen, with resistance expected to come in near 84. The Antipodeans are among the weakest performers in the G10.

Global stocks pushed higher following the strong U.S. close. The MSCI Asia Pacific Index is nearly 0.5% higher, while European shares are gaining the second day in a row. The EuroStoxx 600 is currently up 0.7% led by 2.1% gain in banking shares. Fed's annual bank stress tests late Tuesday were well received by the markets so far, with U.S. stock futures pointing to an up open currently.

The eurozone remains quiet, for a change. However, negative dynamics remain in play. The Greek press is reporting that the European Union has asked Greece to detail fiscal measures worth EUR11.7 billion for 2013 and 2014 by June. This comes despite GDP that's expected to contract in 2013 and stagnate in 2014. The EU has already asked Spain to cut an additional 0.5 percentage points of GDP from the 2012 budget, in response to Prime Minister Mariano Rajoy's recent move. As recession deepens, this issue will remain a sore spot in both countries and in others.

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U.S. economic outlook continues to improve. February retail sales were stronger than expected. Equities rallied sharply as a result and, more importantly, the U.S. Treasury market sold off.

The near-term target for EUR/USD remains 1.2974 February low, but a break of 1.2954 sets up a test of the January low around 1.2624. With Friday's pattern still holding true, strong U.S. data continues to translate into a stronger dollar.

This change in dynamics can be seen in the breakdown in the correlation between the euro and the S&P 500. The 60-day rolling correlation on percentage changes has fallen to .4579, nearly half the peak of 0.8550 back in December. The 30-day correlation has fallen even more, to .4058 from .9092 in December.

No major U.S. data today, but markets will get the first glimpse of March with Empire and Philly Fed surveys Thursday. Strong readings there could be the impetus for the next leg of the dollar rally.

The FOMC did tweak its outlook but maintained its pledge to keep rates low through 2014. We continue to believe that QE3 will be difficult to justify with U.S. economic data continuing to firm. Yet with the Fed seemingly intent on anchoring the short end of the U.S. curve, the two-year Treasury yield continues to march higher, now at 35 basis points and nearly double the year's low around 20 basis points.

A big part of the story behind recent dollar strength is the noticeable shift in interest-rate differentials. For instance, as dollar/yen rose Wednesday to the highest level since April 2011, the two-year U.S.-Japan spread is now around 24 basis points, the highest since July 2011. We now target the April 2011 high of 85.53. The two-year U.S.-German spread is now around 15 basis points, near the highest levels since June 2010.

Equity markets in China were down 2.5% bucking the global trend of positive risk appetite. The move was driven by comments by Premier Wen Jiabao suggesting that measures to support the property sector are off the table since prices were still far from reasonable levels. This is surprising to us. We view the risks associated with a sharp correction in housing prices as one of the key concerns in China and would expect the government to start moving to cushion these risks.

Other headlines from Wen's closing remarks for the NPC include further hints that the CNY appreciation trend is over for now and a widening of the trading band is indeed forthcoming.
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