Tough Times for the US Dollar

The US dollar had an awful July, with the USD index dropping by around 5% over the month, its worst monthly performance in 10 years. A range of factors can be cited for USD weakness including an asset allocation shift to assets outside of the US, worsening news on US Covid cases over recent weeks, improved risk appetite, US election concerns, lower real yields and fiscal cliff worries, among other factors.  Gold has been a particularly strong beneficiary of the malaise in the USD and declining real yield yields.  The Fed’s pledge to keep on aggressively supporting the economy and likely strengthening of forward guidance in the months ahead suggest that any increase in US interest rates could be years off.

It is still difficult to see the recent weakness in the USD resulting in a deterioration in its dominant reserve currency status though the longer the factors noted above remain in place, the bigger the danger to longer term confidence in the USD. As a reminder of such risks Fitch ratings downgraded US AAA credit rating to a negative outlook.  I do not expect markets and the USD to be impacted by the move, but it does highlight a worsening in US fundamentals.  While other currencies are still a long away from displacing the USD dominance in FX reserves, financial flows, FX trading and trade, the longer term risks to the USD are clear.

That said, the USD caught a bid at the end of last week resulting in a sharp retreat in the euro (EUR) from heavily overbought technical levels.  It is unlikely to be a coincide that this occurred as US Covid cases showed signs of peaking while cases in many parts of Europe began to accelerate, resulting in delays to opening up or renewed tightening of social distancing measures there.  US stocks have also continued to perform well, despite much discussion of a rotation to value stocks.  Solid earnings from US tech heavyweights solidified their position as leaders of the pack.  It is too early to say that this is the beginning of a USD turnaround, but the currency is heavily oversold in terms of positioning and technicals, which point to room for some respite.

Turning to the week ahead attention will be on July global Purchasing Managers Indices (PMI) data beginning with China’s private sector Caixin PMI (consensus 51.1), and the US ISM survey (consensus 53.6) tomorrow.  Central bank decisions include the Reserve Bank of Australia (Tue), Bank of England (Thu), Reserve Bank of India (Thu) and Bank of Thailand (Wed).  No change is likely from the RBA, BoE and BoT, but expect a 25bp cut from RBI.  At the end of the week two pieces of data will take precedence; US July jobs data and China July trade data.  US-China tensions will come under further scrutiny after President Trump vowed to ban TikTok in the US while pouring cold water on a sale to a third party.

 

US Dollar Sliding, Gold At Record Highs

Risk sentiment has turned south and the US stock rotation out of tech into value has gathered pace, with the Nasdaq ending down for a second straight week.  Gold is turning into a star performer, registering a record high today, while the US dollar continues to lose ground.  Economic activity is slowing, second round virus cases are accelerating in places that had previously flattened the curve, while US- China tensions are heating up.  Attention this week will centre on US fiscal discussions while US-China tensions remain a key focal point.

Reports suggest that Senate Republicans and the US administration have agreed on a $1 trillion coronavirus relief package.  This will be the opening offer in discussions with Democrats (who had passed a $3 trillion package in House in May), with less than a week before unemployment benefits expire.  Whether the $1 trillion on the table will be sufficient to satisfy Democrats is debatable and a figure of around $1.5 trillion looks plausible. Time is running out and pressure to reach a compromise is growing.   Further uncertainty will likely weigh on US markets in the days ahead.

US-China tensions remain a key focus for markets. Worries about a dismantling of the Phase 1 trade deal still looks premature even as China has fallen behind in terms of purchasing US imports.  The closure of the US consulate in Chengdu following the closure of the Chinese consulate in Houston will be seen as a proportionate move, that is unlikely to escalate matters.  Nonetheless, a further escalation is inevitable ahead of US elections in November, with a broad array of US administration officials becoming more aggressive in their rhetoric against China.  As such, further sanctions against Chinese individuals and companies could be on the cards.

The week could prove critical for the US dollar given that it is breaching key technical levels against a host of currencies, with the currency failing to benefit from rising risk aversion recently. While not a game changer the European Union “recovery fund” is perceived as a key step forward for the EU, a factor underpinning the euro.  Key data and events over the week include the Federal Reserve FOMC meeting (Wed), US (Thu) and Eurozone Q2 GDP (Fri) and China purchasing managers indices (PMI) (Fri).  US Q2 earnings remain in focus too.  Before these data releases, today attention turns to the German IFO survey (consensus 89.3) and US durable goods orders (consensus 6.8%).

 

US Earnings, Virus Cases, Dollar & Data

Last week US equities registered gains, led by value rather than momentum stocks, with US equities closing higher for a third straight week amid low volumes and declining volatility.  However, the S&P 500 is still marginally lower year to date, compared to a 17% gain in the tech heavy Nasdaq index.  In theory this implies more room to catch up for value stocks vs. momentum but I wouldn’t bank on it. If the surge in virus cases equates to renewed lockdowns, the value stock story will likely fail to gain traction until either the virus curve flattens again or a vaccine is found.

Unfortunately Covid-19 infections continue to accelerate, with more than 14 million cases confirmed globally, but mortality rates are likely to be key to the extent that lockdowns intensify. US, Latin America and India are at the forefront, risking another downturn in global activity if lockdowns intensify at a time that concerns about a fiscal cliff in the US have grown.  All of this has to put against vaccine hopes, with some success in various trials, but nothing imminent on the horizon.

Meanwhile the US dollar (USD) remains under pressure, continuing its grind lower since the start of this month, with the euro (EUR) capitalizing on USD weakness to extend gains as it targets EURUSD 1.15.  The USD has maintained its negative relationship with risk, and sentiment for the currency has continued to sour as risk appetite has strengthened.  It’s hard to see the USD turning around soon, especially given uncertainty about renewed US lockdowns, fiscal cliff and US elections.

Over the weekend European Union leaders’ discussions over the “recovery fund” failed to reach a deal though there has been some softening from the “frugal four” on the issue of grants vs. loans.  However, after a third day of meetings there was still no agreement on how much of the recovery fund should be distributed via grants versus loans.  Despite the lack of agreement EUR continues to remain firm against USD and approaching key resistance around 1.1495.

US Q2 earnings remain in focus and this week is particularly busy, with tech earnings under scrutiny (including IBM today).  Last week banks were the main highlight of the earnings calendar, with US banks reporting a very strong quarter in trading revenues amid heightened market uncertainty and volatility, but large loan loss provisions. Aside from earnings expect more jawboning from US officials over China. While there is some focus on whether the US will target Chinese banks with sanctions, it is still likely that the US administration will avoid measures that will roil markets ahead of US elections.  

On the data and event front, highlights over this week include Australia RBA minutes (Tue), Eurozone PMIs (Fri) and policy rate decisions in Hungary (Tue), Turkey (Thu), South Africa (Thu), and Russia (Fri).

Market Volatility Continues To Compress

The US Independence Day holiday kept trading, market activity and volatility subdued for much of last week.  In any case equity markets and risk assets have been struggling on the topside and appear to be losing momentum.  Markets are being buffeted by conflicting forces; economic news has beaten expectations. For example, the US June jobs report was better than expected though total job gains of 7.5 million in recent months are still only around a third of total jobs lost.  In contrast, worsening news on Covid 19 infections, with the WHO reporting a one day record high in global infections, threatens to put a dampener on sentiment.  Consolidation is likely, with Summer trading conditions increasingly creeping in over the weeks ahead. As such volatility is likely to continue to be suppressed, aided by central banks’ liquidity injections.

Over recent weeks geopolitical risks have admittedly not had a major impact on markets but this doesn’t mean that this will remain the case given the plethora of growing risks.  China’s installation of new security legislation into Hong Kong’s basic law and the first arrests utilizing this law were in focus last week.  A US administration official has reportedly said that the president is considering two or three actions against China, and markets will be on the lookout for any such actions this week, which could include further sanctions against individuals are more details of what the removal of HK’s special trading status will entail.  Meanwhile the US has sent two aircraft carriers to the South China Sea reportedly to send a message against China’s military build up in the area, with China’s PLA conducting a five-day drill around the disputed Paracel Islands archipelago.

Data releases and events this week are unlikely to lead to a change in this dynamic.  At the beginning of the week attention will focus on further discussions between the UK and EU over the post Brexit landscape while in the US the June non-manufacturing ISM survey will garner attention.  So far talks on a trade deal between the UK and EU have stalled though there were hints of progress last week, even as officials admitted that “serious divergencies remain”.  The US ISM non-manufacturing survey is likely to move back to expansion (above 50) but is increasingly being threatened by the increase in Covid infections, which could yet again dampen service sector activity. On the policy front there will be fiscal updates from the UK and Canada on Wednesday against the backdrop of ramped up spending, and monetary policy decisions by the Reserve Bank of Australia (RBA) and BNM in Malaysia on Tuesday.  The RBA is widely expected to keep policy unchanged while BNM may cut rates by 25 basis points.

 

Markets Facing a Test of Reality vs. Liquidity

Risk assets ended last week under pressure (S&P 500 fell 2.4%) as some US states including Texas and Florida began to reverse opening measures and Anthony Fauci, the infectious diseases expert, warned that some states may have to return to full “shelter in place”.  Banks were among the worst performers even as they came through the Fed’s stress tests in reasonably good shape.  The Fed did however, cap buybacks and dividend payouts for the 33 banks that underwent tests. However, the reality is that banks were hardly likely to increase dividends over the next few months, while the 8th biggest banks had already suspended buybacks.  Perhaps what spooked markets was the news of “additional stress analyses later in the year”.

It feels like equities and risk assets in general are facing a test of reality vs. liquidity. It’s hard to fight the growth in excess liquidity global (G4 central bank balance sheets minus GDP growth) which has risen to its highest rate since Sep 2009, coinciding with a solid run in global equities over that period.  Clearly forward earnings valuations have richened but while absolute valuations appear rich (S&P forward price/earnings ratio has risen to 24.16), relative valuations ie compared to low global rates, are more attractive. This hasn’t stopped the intensification of concerns that after a solid market rally over recent months, the entry of a range of speculative investors is leading to a Minsky Moment.

Investor concerns range from the fact that the rally has been narrowly based, both in terms of the types of investors (retail investors piling in, while institutional have been more restrained) and type of stocks (momentum vs. value), the approach of US Presidential elections in November and in particular whether there could be a reversal of corporate tax cuts, as well as the potential for renewed lockdowns. Add to the mix, geopolitical concerns and a certain degree of market angst is understandable. All of this is having a growing impact on the market’s psyche even as data releases show that recovery is progressing somewhat on track, as reflected for example in the New York Fed’s weekly economic index, which has continued to become less negative and the Citi Economic Surprise Index, which is around its highest on record.

China, which was first in and now looks to be first out is a case in point, with growth data showing ongoing improvement; data today was encouraging, revealing that industrial profits rose 6% y/y in May though profits in the first five months of the year still fell 19.3%, with state-owned enterprises recording the bulk of the decline.  While there are signs that Chinese activity post-Covid is beginning to level off, domestic consumption is gradually improving. This week, market activity is likely to slow ahead of the US July 4th Independence Day holiday but there will be few key data highlights that will garnet attention, including June manufacturing PMIs in China and the US (ISM), and US June non-farm payrolls.

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