US dollar slips as yields pull back

Market sentiment deteriorated overnight as equity markets in the US and Europe declined while commodity prices also dropped. US yields slipped which undermined the USD. Growth downgrades by the IMF and OECD did not help especially given the weaker growth trajectory for some emerging market countries.

Meanwhile, two central banks did not follow the now usual pattern of easing, with the Bank of Canada leaving policy on hold and Brazil’s central bank hiking policy rates although Thailand cut interest rates. A lack of first tier data releases today will limit activity although the tone will likely remain relatively downbeat.

Having failed to take break through 1.3250 at the beginning of the month the EUR/USD will end the month on a softer note. EUR/USD in particular has been very sensitive to yield differentials and the widening in the US Treasury yield advantage over German bunds has been consistent with a drop in the currency pair. In this respect further direction will come from bond markets.

While Eurozone data releases are becoming less negative as reflected in manufacturing confidence data earlier this week and likely to be seen in various economic and business confidence indices today this is in stark contrast to US data releases which highlight strengthening in recovery notwithstanding a likely downward revision to US Q1 GDP today. Consequently it is difficult to envisage EUR/USD strengthening much from current levels, with 1.3030 seen as a strong resistance level.

A narrowing in Australia’s yield advantage, declining terms of trade, weaker China data and a relatively firm USD index have all contributed to AUD weakness. Additionally weak domestic data have fuelled expectations that the RBA will cut interest rates. However, a rate cut at next week’s policy meeting is unlikely especially as the drop in AUD will help ease financial conditions allowing the Reserve Bank of Australia to wait to examine further data before cutting rates again sometime in Q3 2013.

The AUD may find some short term stability around current levels, with support around AUD/USD 0.9528. While technical indicators remain bearish a lot of bad news is already in the price. Further out, I expect the AUD to rebound as reflected by the fact that my quantitative model shows that the AUD/USD is oversold relative to its short term fair value while short speculative positioning is reaching extreme levels.

GBP is another currency that has been battered by a strong USD but while it has lost ground versus the USD over recent weeks it has held up against other major currencies. GBP/USD has rallied overnight as US yields have pulled back but this may prove temporary, with the currency pair vulnerable to a drop below 1.5000 over coming days.

Against the EUR the picture looks more constructive. My quantitative model shows that GBP looks particularly good value against the EUR, with the model producing a “strong sell” signal for EUR/GBP. Limited data releases in the UK this week will mean that GBP takes its cue from gyrations in the USD and EUR while markets look ahead to next week’s manufacturing purchasing managers’ index and the Bank of England policy decision

Firmer JPY and CNY fixings to support Asian FX

The USD has lost steam as US yields appear to have temporarily topped out. The fact that aggregate (minus MXN) USD speculative positioning is marginally below its all time high also points to the risk of position squaring / profit taking on USD longs. However, any downside risks to the USD will be limited.

Consumer confidence data today will highlight the ongoing improvement in sentiment driven by both equity and housing wealth gains. In the debate about early Fed tapering the confidence data will err on the side reducing Fed asset purchases sooner rather than later. Consequently, it seems unlikely that the yields and the USD will drop much further.

Hopes of a calm start to the week were dashed as Japanese equity markets extended their slide and the JPY strengthened. Heightened volatility is frustrating policymaker’s efforts to contain the rise in Japanese bond yields. Although Bank of Japan governor Kuroda noted that Japan could cope with rising interest rates, higher yields could dampen growth at a time when the economy is finally showing signs of life.

Higher JGB yields have led to a narrowing in the US Treasury yield advantage over JGBs, which in turn has helped to push the JPY higher versus USD. Unless the BoJ succeeds in curtailing the rise in yield, USD/JPY is at risk of breaking back below 100.

Like the JPY, the CHF has strengthened in part due to increasing risk aversion. For a change the CHF may garner some direction from domestic news this week, with Q1 GDP, April trade data and the May KoF Swiss Leading Indicator scheduled for release later in the week. The data will likely show that Switzerland is escaping the downdraft from weak Eurozone activity, helped to some extent by the CHF cap.

Encouraging economic news will not imply any change in the CHF cap, however especially given the benign inflation outlook. Higher risk aversion will keep the CHF supported in the near term but any move in EUR/CHF back to 1.24 should be bought into.

The rebound in the JPY and strong CNY fixings have given Asian currencies some support although sideways trading is expected in the near term. Equity capital outflows over recent days in the wake of higher risk aversion suggest some caution, however. South Korea in particular has been a major casualty of equity portfolio outflows this year although a factor that prevented the KRW from strengthening. Our models show PHP and THB as likely outperformers over coming weeks.

After the storm

As last week’s volatility in Japanese markets demonstrates central banks do not have it all their own way. Unfortunately for Japan the risk remains that policy makers spur higher yields without accompanying growth, an outcome that would be highly undesirable, especially if it hits economic activity. Equity markets and risk assets in general came under pressure and safe havens found long lost bids, with core bond yields moving lower and JPY and CHF strengthening.

The heightened volatility in markets was also partly triggered by concerns about the timing of the tapering off of Fed asset purchases, with Fed Chairman Bernanke setting the cat amongst the pigeons by with commenting about the possibility of reducing asset purchases over the next few meetings. Additionally weaker than forecast Chinese manufacturing confidence data came as another blow to markets. While the market reaction looked a tad overdone in it is notable that the dichotomy between growth and equity market performance has widened over recent weeks.

This week is likely to begin on a calmer note, with holidays in the US and UK today. Data releases in the US will remain encouraging , with May consumer confidence likely to move higher although US Q1 GDP is likely to be revised slightly lower to 2.4% due an inventories hit. In Europe, while the trajectory of recovery is starting from a much lower base there will be some improvement in business confidence in May while inflation will be well contained at 1.3% YoY in May, an outcome that will maintain room for more European Central Bank policy easing. In Japan a sixth straight negative CPI reading will highlight jus how difficult the job is for the Bank of Japan to meet its inflation target.

The JPY was a major beneficiary of last week’s volatility helped by short covering as speculative positioning in the currency reached its lowest level since July 2007. A calmer tone to markets ought to ensure that JPY upside will be limited and USD buyers are likely to emerge just below the USD/JPY 100 level. In contrast the EUR has been surprisingly well behaved despite the fact that speculative EUR positioning has also dropped sharply over recent weeks. While the overall trend is lower EUR/USD will find some support on any dip to around 1.2795 this week.

AUD and NZD have been particularly vulnerable in the wake of higher risk aversion and weak Chinese data. Some calm ought to ensue over coming days, with AUD prone to short covering given the sharp drop in speculative positioning in the currency over recent weeks. Asian currencies have similarly been under pressure. Some stabilisation in risk appetite will give relief to Asian currencies this week as will a relatively firm CNY.

Bernanke hits Treasuries, boosts dollar

Fed Chairman Bernanke’s prepared testimony expressed no hurry to scale back policy accommodation given the risks to economy recovery. However, in the Q&A session following the testimony he noted that the Fed is prepared to adjust the current flow rate of asset purchases in response to incoming data. Importantly in terms of timing Bernanke hinted that the Fed could “take a step down in the pace of purchases” in the next few FOMC meetings dependent on the data. While it is likely that many FOMC members want to see more evidence of recovery especially in the jobs market a reduction in asset purchases in Q4 is likely assuming this evidence if forthcoming. The FOMC minutes echoed this sentiment.

Bernanke’s comments and the minutes fuelled plenty of market volatility, with equities selling off after an initial rally and Treasury yields rising, with the 10 year US Treasury yield flying through the 2% level. Commodities dropped and the USD strengthened, with USD/JPY breaking through 103.00. This pattern is likely to be echoed in Asian trading today but much of the market reaction to the Fed has already occurred and it will need more evidence of either stronger US data or more hawkish Fed comments to extend yesterday’s moves. US jobless claims today will take on more prominence in this respect in the absence of other major data releases with the exception of a likely gain in April new home sales.

The USD is set to consolidate its gains over the short term firmly underpinned by higher US bond yields. Funding currencies (JPY and CHF), yielding and commodity currencies (AUD, NZD and CAD ) look most vulnerable to a firm USD although almost all currencies have felt some of the pressure. The net result is that the USD index has reached its highest level in close to 3 years. Given that the rise in US yields may only mark the beginning of a deeper reversal the upside for the USD over coming months could be significant.

Fortunately for Asian currencies they have not been particularly sensitive to USD strength over recent months as domestic factors have taken on more prominence although the KRW and SGD have been particularly sensitive to JPY weakness. Nonetheless, Asian currencies are set to remain under pressure over the short term as concerns of a slowing in capital flows to the region may grow. Singapore’s better than expected Q1 GDP reading (1.8% QoQ) released this morning will do little to stem the pressure. Meanwhile comments by Korean officials on the impact on the country’s exports from a stronger JPY will keep the KRW pressured.

Catching a falling knife

USD/JPY’s pull back is proving short lived as Japanese Economy Minister Amari attempted to backtrack from his earlier comments that warned about the negative impact of a weaker JPY on “people’s lives”. His comments today suggest that Japan’s stance on a weaker JPY has not changed.

Nonetheless, there may be some consolidation in the near term as likely inaction from the Bank of Japan at it policy meeting this week will mean no new stimulus. While no policy change ought to be unsurprising given recent aggressive actions it appears that the market has become addicted to stimulus.

In any case US Treasury yields will need to be eyed for further USD/JPY direction, with a break of the psychologically important 2% level in the 10 year Treasury a likely trigger for a further up move in the currency pair.

GBP has held up well on the crosses while like many other currencies has faced a resurgent USD. Little impact on GBP is expected from today’s April CPI inflation data especially given that any expected decline is set to prove temporary (Bloomberg consensus 2.6% YoY).

More importantly a likely more optimistic set of Bank of England MPC minutes on Wednesday and rebound in April UK April retail sales on Thursday will provide GBP will further support although we suggest looking for any upside on the crosses rather than versus USD.

Is it time to buy AUD? While I don’t want to be accused of catching a falling knife AUD looks reasonably good value especially against other commodity currencies, especially NZD and CAD. While there have been plenty of negative factors pressuring the currency including prospects for more RBA rate cuts, weaker commodity prices, and softer domestic and Chinese data, much of this is in the price.

My AUD/USD quantitative model estimate based shows that it is oversold relative to its short term fair value estimate. Moreover, speculative positioning according to the CFTC IMM data has turned negative for the first time in almost a year. The RBA May meeting minutes (the meeting during the RBA surprisingly cut its cash rate to 2.75) reelased today did not change this perspective given that markets have already priced in one more rate cut in the cycle.

Asian currencies will likely continue to retrace some of their recent losses in the near term. However, domestic factors and growth worries will provide an importance influence, with the IDR for instance failing to benefit from any USD pull back as the government continues to wrestle with a fuel subsidy cut. Meanwhile, weaker than expected growth in Thailand in Q1 2013 cast a shadow over many Asian currencies as concerns of a wider growth slowdown in Asian intensify.

Not so straightforward

To casual observers the global market picture look very good, reflective of an improving growth and earnings story; risk assets continue to rally as central banks keep the liquidity taps open. In reality the picture is not as black and white as the US economy appears to be doing better than most other major economies despite the impact of the sequester and tax hikes while other economies are in differing states of health.

Japan’s turbo charged stimulus measures have helped contribute to a solid GDP growth outcome in the first quarter and to the rally in risk assets but much needs to be done in terms of reforms. Indeed, the jury is still out whether growth recovery can be sustained (just look back at the growth spurts and subsequent declines following past stimulus).

Europe remains in the doldrums as the impact of austerity weighs heavily, with even the core economies facing growing economic pressures. It’s no wonder that the anti austerity backlash continues to grow. While Eurozone data this week may look a little perkier than usual, with gains in the May purchasing managers’ confidence indices and the German IFO business climate confidence survey (both good forward looking indicators) likely, the overall picture will remain one of contraction. All of this will be unhelpful for the EUR which looks set to test its year low around 1.2745 versus USD.

US outperformance is fuelling a rise in US bond yields and consequently a stronger USD as expectations that the Fed will want to taper off asset purchases sooner rather than later grows. Fed Chairman Bernanke’s testimony this week will therefore be closely regarded as clues are sought However, he is unlikely to suggest that the Fed is verging on any reduction in asset purchases. Although US data was mixed last week the recovery theme will continue this week, with housing data and durable goods orders set to record gains.

In Japan the highlight of the week is the Bank of Japan policy meeting. Given the aggressiveness of recent measures expect a pause from the central bank at this meeting although the JPY will remain under pressure as the US / Japan yield differential continues to widen in favour of the USD. Nonetheless, comments by Japan’s Economy Minister Amari emphasising the negative impact of a weaker JPY may help to slow the pace of JPY decline.

The general strength in the USD has contributed to growing pressure on many Asian currencies. Only the THB, CNY and MYR have recorded gains this year. Other currencies including the KRW, TWD, and SGD have been particularly vulnerable to a weaker JPY. A slower pace of JPY decline will help these currencies although the prospects of further monetary easing and regional tensions will dampen any upside in the short term.

Risk assets rallying on trust and hope

The rally in risk assets continues unabated, with equity markets continuing to post record highs. The fact that this is occurring in spite of weaker data from both the US and in particular Europe, highlights the trust and hope that is being placed on central banks to continue to deliver monetary stimulus in the months ahead. While many will question the dichotomy between equity markets, bond yields and economic data, there is little sign of this changing any time soon.

Spurred by a rise in US Treasury bond yields which in turn has been fuelled by better than expected US economic data the USD index has been driven higher. Disappointing data overnight in the form of the May Empire manufacturing survey, US Treasury TIC capital flows, and April industrial production led to a pull back in US bond yields.

Going forward much in terms of USD direction will depend on upcoming data and Federal Reserve speeches, with a relatively full calendar today including April CPI, housing starts and the May Philly Fed manufacturing confidence survey. Additionally there are no less than five Fed speakers on tap today, with any clues on a tapering off of asset purchases sought. The USD index is set to test its 2012 high of 84.10 but is likely to consolidate in the near term given the pull back in yields.

EUR continues to remain under pressure as it edges towards its 2013 lows around 1.2745, with a test of this level expected soon. Weaker than expected Q1 GDP readings from France, Germany, Italy and the over Eurozone dampened any ability of the currency to reverse losses.

The Eurozone has registered six straight quarters of contraction and any recovery is likely to be limited in the months ahead. Pressure on the European Central Bank to provide more monetary policy accommodation will only be reinforced by today’s release of the April CPI data (likely to be confirmed at 1.2%) leaving the EUR under further pressure. Near term technical support for EUR/USD is seen around 1.2772.

The JPY is facing a perfect storm of negative factors including a widening in US Treasury / Japanese JGB yield differentials, improving risk appetite and portfolio capital outflows from Japan. I expect capital outflows from Japan to intensify. Japanese life insurers have accounted for more than 20% of the net foreign securities purchases since 2011, and recent indications show that they are planning to increase their foreign bond buying.

Additionally the Japanese Government Pension Investment Fund has already begun to increase its proportion of foreign asset holdings. Portfolio data released this morning revealed that Japanese investors continued to channel money overseas. Near term resistance for USD/JPY is seen around 103.50.

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