A volatile period of transition

The drop in the US ISM manufacturing confidence index in May to close to 4 year low failed to have a sustained impact on equity markets. Perversely weaker data is leading to less fears of Fed tapering which in turn is boosting equity markets. Surely equities should fall as data comes in weak but clearly that is not the case. In any case the contraction in the ISM is highly unlikely to presage a new phase of economic weakness.

Markets continue to await central bank meetings and the US May jobs data at the end of the week for further direction but ahead of that volatility whether in the interest rate, FX or equity spectrum shows little sign of dissipating. During a period of policy transition as we appear to be in now, such volatility should be expected but could prove dangerous if prolonged.

The USD has lost ground even as risk aversion has moved higher, a factor that would normally be associated with a stronger USD. The USD received a blow from the weaker than forecast US ISM manufacturing index which led to Treasury yields slipping from their highs.

Hesitation ahead of Friday’s payrolls data may also explain some of the inability of the USD to strengthen and given that aggregate USD speculative positioning reached an all time high last week profit taking on USD longs is unsurprising. However, the move is unlikely to mark the start of a deeper pull back and assuming that the US jobs report continues on an improving trajectory the USD will likely resume its uptrend over coming weeks.

After reaching a high close to 104 USD/JPY has dropped all the way back to below the 100 level. Part of the explanation comes from elevated risk aversion but also heightened volatility in the local equity and bond markets which has prompted USD/JPY liquidation. Is this the end for JPY bears? More likely the pull back will prove temporary especially as yield differentials have actually widened in favour of the USD over recent days.

Meanwhile, capital flow data will continue to be watched carefully to determine whether Japanese lifers and the government pension fund are finally moving money offshore, something that has not happened yet. Strong support for USD/JPY is seen around the 50 day moving average level at 99.08.

AUD/USD has benefitted from a short squeeze and looks to have bottomed out just above 0.96 versus USD which ought to provide a solid base for the currency. AUD looks especially attractive relative to NZD. As I have been noting the AUD has already priced in a lot of bad news and our quantitative model points to upside versus USD. Reflecting this is the fact that speculative positioning has dropped to extreme levels leaving the AUD susceptible to further short covering.

One obstacle to AUD recovery is the RBA but perversely the drop in the AUD over recent weeks will have given the Bank further reason not to ease policy today, which in turn will play well for the currency.

Rather than facing more pressure as would be expected in the wake of weaker US manufacturing confidence data Asian currencies have actually benefitted as the USD has weakened overnight. The PHP has been a star performers and according to my quantitative models is set for further gains. I am wary of looking for much further upside for Asian currencies, however, especially as the USD pull back is likely to prove short lived.


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