Dollar Pushes Higher; Euro Holds Steady

NEW YORK ( BBH FX Strategy) -- The dollar is trading modestly firmer against the majors in very narrow ranges, gaining some traction after the losses seen Thursday.

The euro is softer, but despite the strong dollar tone seen through most of the week, EUR/USD continues to hold 1.30. Sterling is firmer on the day despite news reports from the UK press indicate that UK Chancellor George Osborne will cut the top rate of income tax from 50% to 40% in next week's budget.

We continue to think a UK downgrade is very likely, as our own sovereign rating model shows the UK at AA. The dollar is a tad stronger against the yen, but needs to push through 84 after stalling out there earlier this week. Global stocks are mostly higher, though the gains are limited as equity markets appear to be taking a breather after another strong up week.

The EuroStoxx 600 is up 0.3%, extending to a new eight-month high with bank shares up 0.4%. The MSCI Asia Pacific index is down 0.2% but S&P futures point to a positive open.

Oil prices have stabilized after the White House denied a decision to tap Strategic Petroleum Reserve has been reached. Rising tensions with Iran could push them higher again.

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It's worth noting that stronger-than-expected U.S. data Thursday did not translate into dollar gains. The transmission mechanism for this relationship lately has been largely through interest rate differentials, and these did not move in the dollar's favor Thursday.

The two-year U.S.-Japan spread rose to an intraday high around 30 basis points Thursday before falling back to 24 basis points, where it currently stands. The 60-day rolling correlation of USD/JPY to the U.S.-Japanese two-year yield at 0.93 is now back at highs not seen since 2010. The two-year rate spread is likely to remain a dominant driver of the USD/JPY but given the shift in speculative positioning in the yen and the potential for a reversal, some further consolidation seems likely for this pair before moving higher.

As such, we would recommend not chasing this pair higher here. The dollar has stalled out around 84, which needs to be cleared before testing the next objective around 85.50, the high from April 2011. Similarly, the two-year US-German spread fell from 16 basis points to 8 basis points Thursday and currently stands at 7 basis points, less than half of the 17 basis points at the start of the week.

With the euro seeing a bounce after the failure to take out the 1.30 level, we need to see these interest rate differentials turn higher for the dollar to give the dollar rally another boost; 1.31 may be a good level to go short the euro.

Oil and Iran

Iran sanctions continue to tighten and oil markets are likely to remain volatile. About 24 Iranian banks will no longer be able to use the Swift messaging service. This move was required under new European Union regulations regarding banks that have had their assets frozen, and a Swift official noted that it was "an extraordinary and unprecedented step."

This is likely to complicate Iran's ability to receive payments for its oil exports, as well as to make payments for imports. Thursday, there were reports that the U.S. and UK had reached agreement to release oil from the Strategic Petroleum Reserve. Though this was later denied, we have long warned that such a move was very likely if oil prices remain elevated. Though tensions seem to have eased recently, the tightening of sanctions may lead Iran to dial up its belligerence again.

Intrade shows odds of a strike on Iran inching up to 38% from a recent trough of 35%, but remain down from highs around 62% back in mid-February. Higher oil prices are one of the biggest risks facing the global economy now.

Mexico's central bank holds its policy meeting and is expected to keep rates steady at 4.5%. The improved U.S. and Mexican outlooks have pushed out market expectations of easing in 2012. However, comments from the last several meetings have been very, very dovish and so despite some firmer economic data of late, we do not think Banxico is prepared to hike rates this year.

Near term, the peso remains hostage to swings in emerging markets sentiment, but we believe the peso will outperform going forward on the improving U.S. backdrop.
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