The “Great Rotation”

Evidence that the “Great Rotation” is finally beginning to take place has been established. Capital is finding its way into US equities as reflected in recent flow data while flooding out of Treasuries and other fixed income instruments. However, another rotation of sorts is also taking place, with emerging market assets, both bonds and equities, continuing to register outflows much of which appears to be returning to the US.

Given that the Fed has helped to ease the transition process towards tapering, finally managing to establish effective communication with markets, there is little to suggest that this rotation will reverse. Indeed, the US equity risk premium remains high (ie bonds still look expensive relative to equities) despite the recent correction. Nonetheless, US bond yields pulled back last week (10 year yields have fallen by around 15 bps over the last two weeks) a factor that is also helping to take the wind out of the USD’s sails.

Events and data this week are unlikely to alter the dynamics noted above. US data will remain upbeat, with housing market data remaining positive; existing home sales will edge higher while new home sales will drop but largely due to low inventories, while durable goods orders will register solid gains, and Michigan consumer confidence will be revised higher.

Data in Europe will look less impressive but still encouraging as the German IFO and various purchasing managers’ indices record gains, albeit of an uneven nature. More distressing is the ongoing political travails in Spain, Portugal and Italy, factors that will likely continue to undermine Eurozone markets although EUR/USD will likely remain supported due to the recent softening in US yields.

In Japan, the political picture is now clearer, with an unsurprisingly solid election victory for Prime Minister Abe’s LDP, winning a majority in the Upper House with its partner New Komeito. Ultimately this should play for firmer Japanese assets and a weaker JPY although markets will now look for a clear reform strategy to justify such moves.

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Asian FX on the back foot

Sentiment remains upbeat, if not a little subdued as thin summer conditions kicked in. US and European equities rose overnight while 10 year US Treasury yields moved back above 2.5% and the USD continued its grind higher, especially versus JPY ahead of looming Japanese Upper House elections this weekend. A combination of the ongoing impact of Fed Chairman Bernanke’s testimonies to Congress (note he added a little more to his dovish spin in the Q&A session to the Senate Banking Committee yesterday calling tighter financial conditions “unwelcome”), firmer US Q2 earning and positive economic data surprises, have shored up confidence.

This was reinforced by the decision by Moody’s ratings agency to raise the outlook on the US AAA rating from negative to stable. On the earnings front US banks in particular have beaten forecasts while in contrast tech heavyweights disappointed after the close last night, suggesting that sentiment may weaken in today’s session. Additionally news that the US city of Detroit filed for bankruptcy will act to partly counterbalance the positive ratings news. In Europe, firmer UK retail sales and a strong Spanish debt auction boosted sentiment. There is little on the data front today, suggesting a generally flat end to the week.

Against the background of a move higher in US yields and a firmer USD especially versus JPY, Asian currencies generally remain on the back foot, with losses registered overnight. India’s attempts to stem the drop in the INR are having a diminishing impact on the currency, with USD/INR edging back towards the key 60 level. The good news is that capital outflows from the region have been stemmed, with month to date equity inflows of $311 registered. However, this belies the fact that India, Indonesia and to a lesser extent South Korea continue to register outflows.

USD softens on Bernanke, GBP firm, AUD oversold

Fed Chairman Bernanke did not deliver anything particular new in his testimony yesterday but still managed to provide further reassurance to markets. The Fed chief noted that asset purchases are not on a preset course while highlighting that ‘tapering’ will only occur if economic data warrants it. His concerns about high unemployment and very low inflation emphasized the Fed’s commitment to easy policy settings.

Assisted by a weaker than expected housing starts report bonds liked what they heard, with 10 year Treasury yields dropping below 2.5% while equities rallied and the USD softened. Gold struggled however, failing again to break above USD 1300 and settling back into its USD 1270-1300 range.

Overall, Bernanke’s comments remain consistent with tapering beginning later this year, most likely in September. He will repeat the testimony to the Senate Banking Committee today but markets will look for further clues in the Q&A session.

The positive tone will likely creep into Asian trading today in the absence of other key market drivers, with the USD likely to be restrained against both major and Asian currencies although Asian currencies may struggle given the IMF’s more cautious comments on Chinese growth in which they highlighted the growing downside risks to their growth forecast.

GBP/USD has registered a solid recovery since its recent low just above 1.48. Helped by a hawkish surprise in the Bank of England MPC minutes in which the vote was 9-0 to maintain current monetary settings as new governor Carney managed to unite the MPC view, GBP looks well supported in the days ahead.

What’s surprising is the lack of GBP progress against the EUR especially given the relative outperformance of UK economic data recently and prospects of strengthening momentum into H2 13. Given the potential for alternative monetary policy instruments in the months ahead some caution on GBP may be warranted.

Nonetheless, as GBP is positioned short versus both EUR and USD, its downside looks limited and if anything it will register gains versus EUR. Today’s retail sales may be a risk, but any set back to GBP is likely to prove temporary.

A lot of bad news is already priced into the AUD and sentiment has become overly bearish even if Australia’s government and central bank would prefer to see further currency weakness. There is a risk of an AUD rally in the event of better economic news given that market positioning has become extremely short (close to the all-time low).

A combination of improving risk appetite, renewed search for carry, stabilization in commodity prices and reasonably strong growth in China will eventually help to spur the AUD higher. Clearly there are risks to AUD as the transition process to Fed tapering and higher US yields takes effect but assuming that US yields move gradually as opposed to rapidly higher it is unlikely to stand in the way of an AUD recovery.

US dollar grinding higher

As markets await Fed Chairman Bernanke’s semi-annual testimony to Congress over the next couple of days, sentiment has become relatively upbeat. Risk measures have shown improvement over recent weeks as reflected in gains in equity markets and the fall in the VIX ‘fear gauge’. Central banks have done a good job in massaging market fears over higher yields by implementing “forward guidance” and even in the US Treasury yields have fallen although 10 year yields look well supported above 2.5%.

Meanwhile, Q2 GDP data in China yesterday came in as expected revealing less of a slowdown than perhaps feared, while Q2 earnings in the US have for the most part have beaten forecasts so far. There is little to suggest that this tone will change even with a plethora of data releases scheduled for release today. The next trigger for market direction will come from Bernanke’s testimony.

A surprisingly weak reading for US June retail sales failed to take the shine off the USD. A spate of US data releases are on tap today including June CPI inflation, June industrial production and July NAHB housing data as well as the May TIC capital flow data. I do not expect the data to divert the USD’s path.

Given that there has been much talk that capital has been flowing to the US as US yields rise, the TIC data will be quite instructive given that US yields began their heady ascent from early May. Net long term capital flows into US portfolio assets have been negative for the previous three months and Treasuries registered major outflows in April. The USD is likely to continue to grind higher over coming days despite further revelation of capital outflows.

EUR/USD appears to be stuck around the middle of a relatively broad range at present. The build up of negative news including Portuguese political uncertainty, downgrade of France’s credit ratings, and corruption allegations in Spain among other factors, threatens to pressure the EUR lower. However, as has been the case over past months the EUR has managed to reveal an impressive resistance or “Teflon” coating to bad news.

Nonetheless, weak growth and a relatively strong move higher in US Treasury yields relative to German bunds recently suggests that downside risks to the EUR will dominate. A small gain expected in today’s release of the July German ZEW survey will do little to change this perspective.

I retain a bearish JPY stance but the move is not going to be a one way bet. Volatility will remain elevated especially ahead of Japanese Upper House elections. Prime Minister’s Abe’s LDP is likely to win but markets will be more interested in Abe’s reform program.

JPY positioning has become increasingly JPY short over recent weeks but does not look particularly stretched suggesting further scope to build JPY shorts. Fed policy expectations will drive USD/JPY, with a renewed relative increase in US yields required to push USD/JPY sustainably above the psychologically important 100 level.

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Markets taking their cue from China data and Bernanke

After having been on the road visiting clients across Asia over the last two weeks the overall tone to markets feels slightly better than when I left. Risk appetite is improving as central banks attempt to dampen the spike in yields, by initiating “forward guidance”. On balance, markets appear to be making the volatile transition to Fed tapering with less angst than a couple of weeks back.

Despite the confusion over China’s GDP growth target the tone at the start of the week is positive. China’s Q2 GDP slowed compared to Q1 coming in at 7.5% YoY from 7.7% previously but arguably last week’s comments by China’s Finance Minister that China was targeting growth of 7% (later revised in to 7.5%) had arguably done a good job in guiding market expectations lower. In the event the market reaction to the Q2 GDP release was limited.

Aside from China’s data, markets have taken their cue from Fed Chairman Bernanke’s dovish comments last week when he noted that policy will remain “highly accommodative” for the “foreseeable future”. Discomfort at the sharp rise in US Treasury yields will have played a part in spurring such comments, with the net impact being one of improved risk appetite.

Further clarification from Bernanke will be sought during his semi-annual monetary policy report to Congress mid week although he is unlikely to diverge from his recent comments. Nonetheless, US yields and the USD will likely creep higher over coming days helped by firmer data including the June retail sales report today.

Eurozone markets will have little on the data front to digest aside from the German July ZEW survey this week, leaving the fragile state of Portuguese politics in the spotlight. Potential for fresh elections remains a distinct possibility although discussions over forming a new government will continue this week. Overall, this would suggest some underperformance of Eurozone markets and the EUR over the coming days.

In the UK the release of CPI inflation data in June and Bank of England MPC minutes will garner most attention. Inflation is likely to have pushed through the 3% threshold, requiring new governor Carney to write a letter to the UK Chancellor Osborne explaining the reasons for the rise in inflation pressures. Meanwhile the MPC minutes will take a slightly more hawkish stance, with a 7-2 vote expected as Carney will most likely have sided with the majority unlike his predecessor. Against this background GBP is set to gain some ground, especially against the EUR.

Asian currencies made up some ground following the Bernanke inspired drop in the USD last week but given that the region continues to suffer from equity portfolio outflows gains will be difficult to hold over coming days. Nonetheless, the good news is that the haemorrhaging in capital flows to the region has diminished, with only USD 73.6 million in equity outflows from Asia registered month to date.

US dollar buoyed by higher yields, Asian currencies hit

Efforts by the European Central Bank and Bank of England to disassociate themselves from Fed policy actions were overwhelmed by the US June jobs report which revealed a bigger than consensus 195k increase in payrolls and upward revisions to previous months. The data reinforced expectations that the Federal Reserve would begin tapering in September while the data also pushed US yields sharply higher (close to 23 basis points increase in US 10 year yields following the data) and fuelling further USD strength.

In fairness attempts by the ECB and BoE to introduce ‘forward guidance” may eventually garner some success but US yields will continue to dictate market direction, at least until the markets successfully transition to the reality of Fed tapering, which could take several weeks. During the interim expect transitional volatility to continue, with risk assets globally remaining under pressure.

Further detail on Fed policy will be looked for from within the minutes of the June FOMC meeting to be released on Wednesday although it is unlikely that there will be any real divergence from the message delivered by Fed Chairman Bernanke and a host of other Fed officials over recent weeks. Consequently the USD is likely to retain a broadly firm tone as it reacts to the sharp move higher in US yields at the end of last week.

The Bank of Japan will likely be emboldened in its ultra easy monetary policy stance following last week’s ECB and BoE announcements although no further policy action is likely at this week’s meeting as attention shifts to Japan’s Upper House elections on 21 July. The JPY in particular will remain susceptible to USD strength and widening yield differentials, with potential to test USD/JPY resistance around 102.45 this week.

European attention will centre on Greece and Portugal as the former will be the focus of discussions at the Eurogroup / Ecofin meetings today and tomorrow, with officials set to deliberate Greece’s bailout. Attempts in Portugal to resolve political differences between the main coalition parties appears to have garnered some success in a deal which could stave off fresh elections. None of this will help the EUR which is set to remain under pressure as it edges towards support levels at 1.2744 versus USD.

USD strength will also continue to be exhibited versus Asian currencies this week. Equity fund outflows continue to damage regional currencies lower. Since the end of May Asia has recorded around USD 15.4 billion in equity outflows. Total inflows this year have dropped to only around USD 3.6 billion. A renewed fall in the JPY will added pressure to more JPY sensitive currencies such as TWD and KRW but the overwhelming influence is higher US yields and capital outflows which will continue to have particularly negative impact on currencies with external funding needs, especially the INR and IDR.

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