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

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