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Foreign Exchange

FX traders should pay closer attention to the weather

Investors might benefit from asking themselves the following question when deciding how to trade the US dollar – how good has the weather been?

As eurozone developments have ceased dominating headlines, the divergence in international economic fortunes has begun to attract more attention in the FX market. A string of better-than-expected US data in 2012 has driven both US yields and the dollar higher. In fact, the dollar has been the best-performing currency in March.

US non-farm payrolls have been instrumental in driving the better sentiment on US data since the start of the year, printing above expectations three times and adding an average 250,000 jobs per month.

While it is likely a fundamental improvement in the US job market is behind the strong data, analysts at Royal Bank of Canada (RBC) say a very mild winter might have also boosted economic activity – and the 2011-2012 US winter was the fourth warmest since records began in 1920.

RBC looked at data based on the last 15 years of payroll data and consensus estimates, and found that data surprises tend to be positive during warm winters and significantly higher than average.  A warm winter is defined as average seasonal temperature at least one standard deviation away from the mean. 


 Warmer winter weather boosts US payrolls
 
 Source: RBC

“We’ve found that payrolls are much more likely to beat expectations during mild winters,” says Elsa Lignos, FX strategist at RBC. The findings make sense on an intuitive level. Milder weather should have a positive impact on construction activity and retail spending, and there should be fewer working days lost to adverse weather conditions.

Taking the analysis further, Lignos also finds that after a mild winter, payroll surprises during the spring tended to be negative with the surprises significantly higher than average.

“When data beat expectations [during mild winters], assets are re-priced and market participants revise their expectations higher to reflect the incoming data, which in turn makes the next hurdle harder to beat,” says Lignos.

In other words, the upside surprises during a warm winter are roughly offset by downside surprises in the spring.


 A mild winter is paid back in spring
 
 Source: RBC

While Lignos is cautious not to dismiss the improvement in US data, the analysis highlights the potential risks going forward. “If this plays out, we could expect to see more downside surprises in the second quarter and our US economic surprise index turning negative,” says Lignos.

The interesting question is then, how will the dollar react to economic data that falls below expectations?

During periods of heightened risk aversion towards the end of 2011, better US data generated a ‘risk-on’ reaction, which traditionally saw the safe-haven US dollar trade lower.

However, as EuromoneyFXNews has pointed out, a paradigm shift in the way the dollar trades has begun to emerge. The dollar has transformed from being largely a function of safe-haven flows to behaving, at least for now, as a growth currency.

With this in mind, if RBC’s expectations of a negative turn in US economic surprises prove true, then some of the dollar’s recent gains could well be reversed.

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