Fed leaves the dollar in positive mood, euro at risk ahead of ECB

The Fed FOMC unsurprisingly left policy settings unchanged but the statement was perceived as less dovish, leaving a sour taste for risk assets. Crucially the statement did not validate market expectations that the Fed would hold off from tapering (reduction of Treasury and MBS purchases) until March next year, leaving the option of an earlier tapering on the table.

The bottom line is that the decision to taper will be highly data dependent, but the impact on markets was to leave the USD firmer and equity markets lower. The reaction is consistent with our view that a lot of dovishness was already priced into the market and that the risk / reward is for a more constructive USD environment.

Improvements in economic data, albeit from a weak level and a contracting balance sheet, have provided the EUR with support over past months. However, gains will not last and we suspect the EUR will be a casualty of relatively better US growth, Fed tapering and higher US yields over coming months. EUR has lost momentum this week and looks vulnerable to further slippage ahead of next week’s ECB meeting.

Soft inflation data out of Spain and German states yesterday highlights the room for the ECB to sound more dovish next week. Although firmer than expected October Eurozone confidence surveys limited some of the downdraft on the EUR overnight and highlighted further evidence of recovery, it is likely to do little to prevent further pressure on the EUR.

A couple of stronger than expected data releases helped the NOK to strengthen both against the USD and EUR. The August unemployment rate came in lower than expected (at 3.5%) while retail sales beat expectations in September (+0.7%). The NOK has been the only G10 currency to strengthen against the USD during October and after previous underperformance against the EUR, NOK looks set to make further gains against the latter.

One hurdle may be the announcement of Norway’s daily foreign exchange purchases for the coming month. Over September and October FX purchases were NOK 100 million per day and there is little reason to expect any change in November. Assuming that the October manufacturing PMI also registers some improvement tomorrow there is little to stand in the way of further NOK strength. We retain our long NOK/CHF trade idea.

Awaiting the Fed

Another positive day for US equities overnight reflected the ongoing gradual but steady improvement in risk sentiment. The USD also managed to shake off some of its malaise, rising against most major currencies although US Treasuries continued to flat line. Data in the US did little to change expectations for the Fed FOMC policy decision tonight; headline retail sales dropped (-0.1%) in September but core orders looked healthier (0.4%), while US consumer confidence slipped by more than expected in October (71.2) and US house prices rose (0.93%) in August.

Direction will be limited ahead of the Fed outcome where markets hope to garner some clues on the timing of the beginning of tapering. However, given that the consensus has clearly shifted to a March 2014 beginning of tapering it is difficult to see how the Fed could build on already dovish market expectations. Ahead of the Fed decision we will be able to assess further evidence on the state of the private sector jobs market, with October ADP jobs scheduled for release.

Given the risk / reward around today’s Fed meeting we remain constructive on the USD, with further albeit gradual recovery ahead. Indeed, it is encouraging that the EUR failed to hold onto gains even after ECB member Nowotny effectively gave the green light for further EUR strength when he noted that policy makers `have to live with` a strong EUR. EUR will continue to look a sell on rallies above 1.3800.

Nototny’s sanguine tone is not shared elsewhere as reflected in attempts by RBA Governor Stevens to talk down the AUD this week or by NZ’s central bank, noting that the strength of the NZD could give scope to delay interest rate hikes. GBP also seems to be failing to shake off the after effects of relative dovish comments by Bank of England MPC members over recent days. The overall winner appears to the USD especially as a lot of dovishness is already priced into the currency.

The USD is also set to take a firmer tone against Asian currencies over the short term. Asian currencies most sensitive to USD strength are SGD, MYR and PHP and these currencies will be most exposed in the short term to further downside risks. IDR also looks vulnerable given the continued outflows of equity portfolio capital from Indonesia over recent weeks (month to date outflows USD 175 million). KRW looks more stable although disappointing September industrial production data released this morning will put a firm cap on the currency.

US dollar stable, yen primed for weakness, Aussie dollar slips

The USD index looks to have settled at a relatively weak level around 79.00 aided by the stabilisation of US Treasury yields (10 year around 2.5%). Upside for the USD will be restricted given a likely run of softer economic releases this week including September retail sales, and October consumer confidence today.

The data may help to support expectations that Fed tapering may not take place until March / April next year although the Fed FOMC decision later this week will hopefully give more clues on this front. In any case the USD may already have priced in softer data and delayed tapering expectations, suggesting that the risk / reward will increasingly turn more USD positive over the coming weeks.

USD/JPY looks set to move higher over coming weeks breaking out of its recent range. Relatively higher US Treasury yields versus Japanese JGBs yields, improving risk appetite and improving technicals (USD/JPY remaining above its 200 day moving average) will be supportive for renewed upside in the currency pair.

While the Bank of Japan is unlikely to act this week on policy the risks of further action will only increase over the coming months as it becomes apparent that reaching and sticking to its 2% inflation target will not be possible given current settings. In turn, the JPY is set for further downward pressure.

Does the slippage in AUD over recent days presage a strengthening in the USD? AUD and USD (index) have registered a strong negative correlation over the past three months, with the former benefitting from weakness in the latter. Over recent days the USD appears to have stabilised while AUD has lost steam, with pressure intensifying in the wake of comments by RBA Governor Stevens who attempted to talk the currency down.

I doubt the AUD will fall much from current levels but the absence of key domestic data (only private sector credit growth and building approvals on tap this week) will focus attention on external factors, namely the Fed FOMC outcome and in particular Chinese manufacturing confidence at the end of the week.

Bad news is good

Risk assets retained their positive performance into the end of last week, with US equities closing the week higher and the VIX ‘fear gauge” closing lower while 10 year US Treasury yields continued to pivot around 2.5%. Meanwhile the USD remains on the back foot finding little help from data releases especially last week’s September employment report. Friday’s release of September US durable goods orders similarly disappointed, with core orders coming in weaker than anticipated. The bad news is good philosophy of markets means that weaker data is helping to aid expectations that Fed tapering may be delayed, in turn boosting risk assets.

This week will bring much of the same. There are a plethora of US data releases on tap including September industrial production today, retail sales, CPI inflation and October consumer confidence and ISM manufacturing. Additionally there is a Fed FOMC meeting this week although no surprises are expected at this meeting. US data releases will look relatively soft but given the market mood this will bode well for risk assets. The jury is out with regard to the timing of tapering but increasingly many are looking for it take place in Mar/Apr 2014.

Europe has a more limited data calendar including the Bank Lending Survey of credit conditions and economic sentiment indicators. These will look a bit more positive than previous months. In Japan September jobs data and industrial production are on tap. Additionally two central bank meetings from the Bank of Japan and RBNZ will not result in any surprises, with policy set to remain unchanged.

It is difficult to see the USD achieving much of a recovery against the background of relatively weaker US data releases although it does appear that a lot of bad news is already priced in. The fact that US Treasury (10 year) yields have stabilised around 2.5% will help to limit any further downside pressure on the USD. Moreover, even if US data are softer this week, much of the market has already pared back tapering expectations into next year, suggesting little scope for expectations of a further tapering delay.

USD/JPY is finding some support around its 200 day moving average at 97.38 and given the stability in US yields will find some support in the near term. EUR/USD remains supported and will likely benefit from more encouraging Eurozone data releases this week but gains above 1.3800 are beginning to look increasingly stretched. GBP/USD pulled back from its highs around 1.6248 last week despite a reasonably good 0.8% QoQ Q3 GDP reading. This week’s UK data is likely to be little softer, with manufacturing confidence (PMI) likely to edge lower for a second straight month, a factor that could undermine GBP further.

Bad month for the US dollar, gold benefiting

Any market rally predicated on poor economic news was always going to look tenuous at best and this appears to have been the case following the disappointing US jobs report this week. Concerns about a tightening in short term Chinese money market rates and about the magnitude of bad loans written off by Chinese banks in the first half of the year were sufficient to trigger a drop in risk assets yesterday, with losses failing to be recovered thereafter.

News in Europe was a little better, with the Spanish economy emerging from a two year recession. The positive data tone in Europe will be echoed today, with flash Eurozone purchasing managers’ indices (PMI) set to reveal relatively resilient manufacturing and service sector confidence readings. Cautious trading is likely in the near term, with Chinese PMI data set to give direction.

It’s been a bad month for the USD and the news keeps on it getting worse. This week’s disappointing US September jobs report and consequent paring back of Fed tapering expectations has renewed the status of the USD as a funding currency. At a time when risk aversion and implied FX volatility have dropped to multi year lows, attraction for yielding currencies is set to strengthen.

This does not bode well for the USD over the short term but the picture could change if US yields rise again over coming weeks. Indeed, one of the key reasons for the strengthening in EUR/USD over recent weeks has been a narrowing in the Treasury-Bund yield differential but I expect this to reverse as US yields rise. Much will depend on the data flow but as yet I am unwilling to throw the towel in for my medium term positive USD view.

USD/JPY has been pressured lower as the yield advantage between US 10 year Treasuries and JGBs has narrowed. The delay in Fed tapering expectations also means that the relative balance sheet positions of the Fed and BoJ will be less negative for the JPY over coming months than previously expected. Additionally capital outflows from Japan have yet to materialise; although there has been a net outflow of portfolio capital from Japan over recent weeks it is small relative to strong inflows over previous weeks.

Even the historically strong correlation between JPY and risk appetite has broken down recently as indicated by the absence of JPY selling pressure even as risk appetite has improved. Disappointment with the progress of reforms are also acting to limit JPY downside. As a result the prospects of a sharp rally in USD/JPY over coming weeks is receding.

Gold has been a key beneficiary of the weakness in the USD and lower US bond yields. Supporting its gains is seasonal demand around this time of the year especially from India although notably ETF demand has yet to pick up significantly. Despite its recent rally the upside potential for gold looks limited and USD 1350 looks like a major cap. In the near term gold is likely to gyrate around its 100 day moving average at 1324 but further out we expect a decline in prices to resume.

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