USD weaker except versus JPY, EUR gains unsustainable

Risk aversion is creeping higher whether due to weaker data and budget concerns in the US, political uncertainty in Europe or tensions in the Korean peninsular. Central banks continue however, to do their utmost to keep monetary conditions sufficiently easy to facilitate recovery.

The Bank of Japan was the latest to do its part under the helm of governor Kuroda, with new measures including a major increase in asset purchases, delivering a positive surprise to markets while pushing the JPY sharply weaker.

Only the ECB appears to lag in terms of central bank activism keeping policy on hold last week despite weak economic conditions are ongoing austerity pain. A series of industrial production releases across the Eurozone including German February IP scheduled for release today will not change the picture materially.

The much weaker than expected US March jobs report in which payrolls increased by only 88k, concern that economic activity is following a similar pattern to previous years ie strength in Q1 followed by weakness in Q2, has intensified. I do not believe this is the case but the jury is still out.

At the least the data will embolden Fed doves who will use the data as evidence that any tapering off in asset purchases should not occur quickly. A series of Fed speeches this week including one by Fed Chairman Bernanke tonight will be listened to very closely to determine whether the jobs report has provoked further caution from the Fed. Moreover, Fed FOMC minutes will be scrutinized to determine how the Fed will adjust the flow rate of asset purchases to the changing outlook.

The overall tone to FX markets is one of broad based USD weakness, with the notably exception of the JPY where the relatively aggressive BoJ stance has provoked a bigger reaction. The EUR has taken advantage of a softer USD but is unlikely to sustain gains around the EUR/USD 1.3000 level given the political problems across the Eurozone and relatively weaker economic conditions.

Indeed, news that Portugal’s constitutional court rejected austerity measures has put at risk the ability of the country to achieve its budget targets and regain access to international bond markets. Meanwhile Cyrpus’ bail in continues to leave a sour taste among depositors across the region while Italy continues to edge towards fresh elections.

Currency frictions

I would like to apologise for the lack of posts over the last couple of weeks. I have been on a client roadshow presenting our macro and markets outlook for 2013 to clients across Asia. Having returned the mood of the markets is clearly bullish as risk assets rally globally. Recovery hopes are intensifying as tail risk is diminishing while central banks continue to keep their monetary levers fully open.

A heavy slate of US data releases this week will keep markets busy but overall I see little to dent the positive tone to risk assets over coming sessions. The main events this week include the US January jobs report (forecast +160k) and Fed FOMC meeting (no change likely) while consumer and manufacturing confidence, Q4 GDP and December durable goods orders are also on tap.

In the Eurozone attention will focus less on data but more on Eurozone banks’ balance sheets, with further capital inflows likely to be revealed, marking another positive development following last week’s strong payback of LTRO funds. Elsewhere, industrial production in Japan is likely to reveal a healthy gain while an interest rate decision in New Zealand (no change likely) will prove to be a non event.

As fiscal and monetary stimulus measures are largely becoming exhausted or at least delivering diminishing returns the next policy push appears to be coming from the currency front. The issue of ‘currency war’ is once again doing the rounds in the wake of Japan’s more aggressive stance on the JPY leading to growing friction in currency markets.

In contrast the easing of Eurozone peripheral strains have boosted the EUR, in turn resulting in a sharp and politically sensitive move higher in EUR/JPY. Central banks globally are once again resisting unwanted gains in their currencies, a particular problem in emerging markets as yield and risk searching capital flows pick up. Expect the friction over currencies to gather more steam over the coming weeks and months.

In the near term likely positive news in the form of large capital inflows into Eurozone peripheral banks and sovereign bond markets will keep the EUR buoyed. The USD in contrast will be restrained as US politicians engage in battle over the looming budget debate and spending cuts despite the move to extend the debt ceiling until May.

GBP has slid further and was not helped by the bigger than expected drop in Q4 GDP revealed last week which in turn suggests growing prospects of a ‘triple dip’ recession. The lack of room on the fiscal front implies prospects for more aggressive Bank of England monetary policy especially under the helm of a new governor and in turn even greater GBP weakness.

Bullish INR but other Asian currencies held back

Although the European Central Bank (ECB) left policy rates unchanged the post meeting press conference effectively opened the door to a rate cut in Q1 next year following sharp downward revisions to growth projections and well below target inflation projected over the medium term. A major casualty of the shift in ECB tone was the EUR which dropped over one big figure from a high of around 1.3089. Technical support for EUR/USD is now seen around 1.2885.

The Baltic Dry Index has continued to decline over recent days sending an ominous signal for growth ahead. Meanwhile, once again politics cast a shadow over European markets as Italy’s government overcame a confidence motion, with ex Prime Minister Berlusconi’s PDL party threatening to withdraw support and bring down the government.

Trading is likely to remain thin today as markets await the US November jobs report. The report will undoubtedly be soft (consensus is for an 85k increase in November payrolls) but as much of the weakness in jobs growth will be due to Hurricane Sandy the market impact is likely to be muted leaving a likely constructive tone to risk appetite going into next week.

Asian currencies continue to take direction from the CNY, with the lack of upside traction in this currency leaving most Asian currencies within ranges despite the fact that equity flows to Asia have been very strong over recent days, with inflows of over $2 billion registered this week alone. The implication is that central banks in the region have become increasingly active in preventing Asian currency strength.

One currency that has a limited influence from the CNY is the INR and this currency continues to outperform on reform hopes. The passage through India’s lower house of parliament allowing foreign investment into retailers was encouraging and hopes have grown that it will be followed by passage in the upper house. Further gains in the INR are seen over coming sessions, with a short term break below USD/INR 54.00 looming.

Euro slipping ahead of Eurogroup meeting

The US September jobs report released last Friday will provide some encouraging news for markets to digest this week but holidays in the US and Japan today will keep trading relatively subdued. The jobs report itself was in any case somewhat mixed, and while the unemployment rate dropped to 7.8%, the actual increase in payrolls was relatively soft at 114k although there were revisions higher to past months.

The US jobs report does not necessarily change the picture regarding US quantitative easing. The Fed and subsequently markets will not change their expectations based on one month’s data. In this respect, any benefit to the USD will be limited although the increase in US 2-year bond yields has already exhibited itself in a firmer USD/JPY exchange rate. Nonetheless, this week’s US data will help maintain the assessment of gradual US recovery, with the Beige Book, trade data and Michigan confidence in the spotlight. US data will continue to look relatively better than in Europe.

Most attention will remain on Europe and the Eurogroup meeting beginning today. The reluctance of Spain to request a formal bailout will be a negative factor for European markets, although Portuguese austerity measures likely to be approved today, negotiations between Greece and the Troika (EU, IMF and ECB) on the next tranche of loan disbursements for the country, as well as potential for Cyprus and Slovenia to request a bailout will also come under scrutiny at the meeting.

Currencies are generally range bound, although EUR/USD is verging on another drop below 1.3000. Spain’s refusal to request for a formal bailout holds risks to the EUR especially if peripheral including Spanish bond yields move higher again. While ECB President Draghi’s commitment to OMT (Outright Monetary Purchases) reinforced last week, will provide some solace to the EUR, it will prove meaningless unless moves ahead with a bailout.

Two of the biggest FX losers so far into October have been the NZD and AUD. The AUD in particular has been struck by the surprise RBA rate cut and faltering commodity prices. AUD/USD looks set for a test of 1.0100 technical support, but direction this week business and consumer confidence data over the next couple of days ands the September jobs report on Thursday.

Risk currencies rally

Following the disappointment from the lack of US Federal Reserve and European Central Bank (ECB) action last week, the US July jobs report provided a fillip for markets. The stronger than expected jump in payrolls (163k) dampened worries about the pace of jobs recovery while the increase in the unemployment rate (to 8.3%) kept alive hopes of more Fed quantitative easing.

Indeed, even the ECB’s decision and statement last week have been interpreted as merely delaying the inevitable, with stronger action expected from the central bank over coming weeks. Against this backdrop, markets will begin the week in positive tone and risk assets are likely to extend gains early in the week.

The highlights on the data calendar this week include two central bank meetings, Bank of Japan (BoJ) and Reserve Bank of Australia (RBA), and the Bannk of England (BoE) Quarterly Inflation Report (QIR). Major policy changes from the former two central banks are unlikely although the BoJ may decide to abolish the 0.1% minimum bidding rate on JGB operations.

As for the BoE QIR a dovish reading is likely which will help to support expectations of further policy action in the UK, which in turn will mean that GBP will underperform. Data releases are fairly thin on the ground, with US trade data, Q2 non farm productivity, German factory orders and industrial production releases across Europe. Overall, we see little to detract from the positive tone to asset markets.

Risk currencies begin the week on the front foot. The EUR/USD reaction to the US jobs data was particularly interesting, hitting a high of 1.2444 as stop losses were triggered on the upside. Further EUR gains will be difficult to achieve, however. Speculative market positioning reveals that EUR short positions have dropped to their lowest level in several weeks, suggesting less scope for further short covering.

The lack of major data releases over coming days within the Eurozone mean that direction will come from Spain and whether the country formally asks for financial support from the EFSF. In the meantime, EUR/USD is likely to edge back to around technical support around 1.2218.

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