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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