The US dollar saw significant volatility on Thursday as uncertainty surrounding upcoming Fed tapering and a spike in US Treasury yields complicated decision making heading into Friday’s trading session.

The volatility in the US dollar (USD) today reflects uncertainty about the outlook for the US economy. While tapering by the Federal Reserve is inevitable, the latest US economic reports makes investors wonder whether the central bank is acting prematurely.

The Fed's primary concern is inflation, but according to the consumer price report, inflationary pressures are muted. Growth, on the other hand, is uneven. Based on jobless claims, the labor market continues to recover, but signs of weakness in other parts of the economy suggest that fewer layoffs may not translate into more hiring.

Furthermore, the rise in yields will also make borrowing more expensive, a constraint that could slow the recovery.

See related: A Yield Conundrum the Fed Must Consider

Ideally, the central bank should reduce asset purchases when growth is on an uptrend, not flat-lining, but perhaps policymakers fear that they may not have this luxury. Regardless, there is a lot of skepticism about how tapering could affect the economy, and the concerns have led to big intraday swings in the dollar.

Friday's University of Michigan consumer sentiment index will help clarify the outlook, but only if confidence improves. If it weakens, more doubts will surface. Aside from the U of M survey, housing starts and building permits are also scheduled for release on Friday.

Vital Eurozone Data Due Next Week

Having traded down to a low of 1.3205, the EURUSD staged a strong recovery to end the North American trading session higher. With no economic reports released from the Eurozone, the greenback dictated the direction for the pair, although the euro (EUR) surged around the same time as the rally in gold.

Since the beginning of the month, EURUSD has been trapped between 1.32 and 1.34, and we believe that despite Thursday’s rally, this range will remain intact for the next 24 hours.

Eurozone current account, inflation, and trade data are scheduled for release on Friday, but none of these reports are significantly market-moving for the euro because we already know that trade and current account balances improved significantly in Germany and France in June.

Inflationary pressures, on the other hand, have been more mixed. Germany reported an uptick in consumer prices last month, while France reported a decline, which may be part of the reason why economists are looking for broader Eurozone CPI to fall.

While the Eurozone recovery is still trailing behind the US and the European Central Bank (ECB) is guiding monetary policy lower while the Fed is guiding it higher, EURUSD has not seen much volatility because investors are skeptical about how far the Fed will go.

With such high expectations for the dollar and low expectations for the euro, next week's Eurozone PMI numbers will be key. Stronger manufacturing and service sector activity would confirm that the region stayed out of recession in Q3.

More Standout Data from the UK

The British pound (GBP) extended its gains against the euro and US dollar today on the back of better- than-expected UK retail sales, which surged 1.1% in July. While we have seen spending rise more this year, the three-month average reached its highest level since February 2008, and the year-over-year rate reached its highest since January 2011. Core retail sales were just as strong, giving promise to Q3 GDP.

The details of the report showed solid growth in supermarket sales along with strong online spending. While the recent string of good news will not affect the Bank of England’s (BoE) immediate plans for monetary policy, investors will start to consider whether the central bank's unemployment and growth projections are overly pessimistic.

The break of 1.56 in GBPUSD is significant because it has been a key resistance level for the pair for the past month. The door is now open for a stronger rally to the June high of 1.5750.

A Problem Area That’s Killing the Aussie

The volatility in the US dollar also caused wild swings in commodity currencies, which recovered mid-day losses to end the day higher against the dollar.

New Zealand manufacturing activity improved significantly during the month of July, with the PMI index rising from 55.2 to a nine-year high of 59.5. This marked the tenth consecutive month of expansion for the manufacturing sector, which stands in sharp contrast to Australia, where manufacturing activity has been contracting for 17 straight months.

This divergence explains why AUDNZD has fallen more than 10% since the beginning of the year. Even though there have been more recent improvements in Australian data, the outperformance of New Zealand leads us to believe that AUDNZD is poised to retest its four-year low of 1.12.

While NZDUSD failed at 81 cents Thursday, it may only be a matter of time before this level is broken.

Meanwhile, the Australian dollar (AUD) experienced steeper losses than the NZD, due in part to consumer inflation expectations, which slowed to 2.3% from 2.6% in the month of August. Lower inflation expectations give the Reserve Bank of Australia (RBA) stronger reason to keep monetary policy easy.

Housing market activity in Canada continues to show signs of weakness with existing home sales growing a mere 0.2% last month compared to 3.3% in June. Manufacturing sales and international securities transactions from Canada are the only pieces of data expected from the three commodity- producing countries on Friday.

Japan’s New Bond-Buying Boom

Big moves in the US dollar led to a widely divergent performance in Japanese yen (JPY) crosses. The yen strengthened against the US, Australian, and Canadian dollar (CAD), but weakened against European currencies.

The biggest story out of Japan last night was Cabinet Secretary Suga’s denial that the Abe administration is considering a lower corporate tax to offset the consumption tax. Japanese stocks responded negatively to the news, falling more than 2% as investors express their disappointment about the lack of relief provided to the economy.

If Japan is really denied a corporate tax reduction, the consumption tax may have a more difficult time being passed, especially on the heels of recent economic reports.

Meanwhile, Japanese investors were big buyers of foreign bonds, according to the latest report from the Ministry of Finance. Purchases exceeded JPY 1.614 trillion last week, which was the largest amount since August 2010. Japanese investors have been net buyers of foreign bonds for the sixth consecutive week, and with US yields continuing to press higher, we believe that this is officially a new trend.

By Kathy Lien of BK Asset Management