Data, Earnings, Central Banks and Virus Cases In Focus

Risk appetite took a turn for the better at the end of last week despite an array of the usual suspect risk factors (accelerating Covid-19 cases, US-China tensions, rich valuations). This kept the US dollar under pressure given the inverse relationship between equities and the USD over recent weeks.  Market positioning continues to show sentiment for the USD remaining negative (CFTC IMM data revealed that aggregate USD speculative positions have been net short for 15 out of the last 17 weeks, including the last 5).  Increasingly risks of a US fiscal cliff as stimulus programs run out, with Republicans and Democrats wrangling over more stimulus and US Presidential elections will be added to the list of factors testing market resilience in the days and weeks ahead.

This week there are several key data and events including China June trade data (Tue), China Q2 GDP (Thu), US June  CPI (Tue), US June retail sales (Thu), Australia June employment data and several central bank decisions including Bank of Japan (Wed), European Central Bank (Thu), Bank of Canada (Wed), Bank Indonesia (Thu), Bank of Korea (Thu), and National Bank of Poland (Tue).  Aside from economic data and events the path of virus infections will be closely watched, especially in the US given risks of a reversal of opening up measures.  Last but not least the Q2 earnings season kicks off this week, with financials in particular in focus this week.  Low real yields continue to prove supportive for equities and gold, but very weak earnings could prove to be a major test for equity markets.

On the data front, Chinese exports and imports likely fell in June, but at a slower pace than in the previous month, China’s Q2 GDP is likely to bounce, while US CPI likely got a boost from gasoline prices, and US retail sales likely recorded a sharp jump in June. Almost all of the central bank decisions this week are likely to be dull affairs, with unchanged policy decisions amid subdued inflation, although there is a high risk that Bank Indonesia eases.  The EU Leaders Summit at the end of the week will garner attention too, with any progress on thrashing out agreement on the recovery package in focus.  Watch tech stocks this week too; FANGS look overbought on technical including Relative Strength Index (RSIs) and more significantly breaching 100% Fibonacci retracement levels as does the Nasdaq index, but arguably they have looked rich in absolute terms for a while.

There has been plenty of focus on the rally in Chinese equities over recent weeks and that will continue this week.  Last week Chinese stocks had their best week in 5 years and the CSI 300 is up close to 19% year to date.  Stocks have been helped by state media stories highlighting a “healthy” bull market, but the rally is being compared to the bubble in Chinese stocks in 2014/15, with turnover and margin debt rising.  At that time stock prices rallied sharply only to collapse.   However, Chinese equity valuations are cheaper this time and many analysts still look for equities to continue to rally in the weeks ahead.  China’s authorities are also likely to be more careful about any potential bubble developing.

Why the JPY will weaken

While I continue to forecast JPY weakness over the coming months the JPY is currently being buffeted by various forces. Elevated risk aversion has limited the downside for JPY as the currency has once again found a safe haven bid although it has weakened as risk appetite improved slightly overnight.

Going forward, I expect US Treasury yields to move sharply higher as the US economy gains momentum and loses the shackles of bad weather, pressurising USD/JPY higher. Additionally likely further easing by the BoJ in April / May will contribute to downward pressure on the JPY.

Separately Japan has shifted from possessing a relatively strong broad basic balance surplus (current account + direct investment + portfolio flows) to a deficit, a factor that will undermine the JPY over the coming months.

JPY, EUR and GBP view

It is highly unlikely that the Bank of Japan adjusts policy at its meeting later this week but further action next year remains likely. More importantly for USD/JPY will be the actions of the Fed this week and the subsequent move in US yields. US 10 year yields have struggled to sustain a move above 2.9% recently, reducing the yield advantage over JGBs and in turn pulling USD/JPY back from its highs.

It is only a matter of time before US yields resume their uptrend and in this respect the outlook remains for more USD/JPY upside. Nonetheless, I am cognisant of the large short (CFTC IMM) JPY position in the speculative market, which into year end suggests plenty of scope for position squaring and short USD covering.

The EUR is set to end the year on firm note but further upside looks limited and the risk / reward favours selling the currency from current levels. Although economic data reveals continued improvement as reflected in the flash Eurozone composite purchasing managers’ index yesterday, much in terms of recovery expectations is in the price.

While a strong basic balance (current account + FDI + portfolio flows) continues to underpin the EUR I do not expect this to persist. Nonetheless as many bears have found out the EUR is a difficult currency to sell and while EUR/USD is likely to increasingly struggle on its approach to 1.3800, any sell off will not be rapid unless the ECB belatedly adopts a more aggressive monetary policy stance.

Like the EUR, GBP is struggling to push higher, as profit takers emerge and a dose of reality sets in given the magnitude of its rally versus USD over recent months (around 10% since July). The rationale for GBP’s gains are clear; surprisingly good economic data and a reassessment of monetary policy implications. However, GBP bullishness has resulted in net long speculative positions reaching their highest since 15 January 2013.

Further GBP gains will require yet more positive economic surprises but this is unlikely to be delivered in the jobs data, inflation data and Bank of England MPC minutes over coming days. Consequently GBP/USD is unlikely to extend gains above 1.6300 in the near term.

Limbo ahead of Fed FOMC meeting

A mixed session overnight leaves markets with little direction ahead of the Bank of Japan and Federal Reserve FOMC meetings today. There was no stimulus for markets from the meeting of European officials yesterday while Greece’s debt swap has failed to boost confidence.

Overall there is a real hesitancy for investors to take positions, with both volumes and volatility remaining very low. For instance the VIX volatility gauge has dropped to its lowest level since May 2011 while my measure of composite FX volatility continues to languish at relatively low levels compared to last year.

The USD has little to fear from the Fed FOMC meeting tonight. If anything it may even benefit from a less downbeat statement from Fed Chairman Bernanke following the meeting. Growing speculation that the Fed will embark on some form of sterilised quantitative easing, i.e. not printing any more money, bodes well for the USD too.

Ahead of the FOMC decision a firm February retail sales report will help add to the plethora of evidence revealing stronger signs of US recovery. A key indicator to watch in this respect is the (National Federation of Independent Business (NFIB) report of small business confidence which should also strengthen. Importantly for the USD the data should also help to maintain pressure on US bonds, keeping yields elevated and in turn the USD supported.

The BoJ meeting today will not deliver any surprises, an outcome that will likely leave the JPY largely unmoved. Speculative sentiment for the JPY has shifted negatively as reflected in the latest CFTC IMM report which reveals the biggest short position in the currency since April last year.

Crucial in pushing the JPY weaker has been the widening in bond yield differentials with the US, thanks largely to a rise in US bond yields. The 2-year yield gap is now around 20 basis points, the highest gap since August 2011. This will help to keep USD/JPY supported but my quantitative models suggest that the upmove may be overdone in the short term, with a correction lower in prospect to technical support around 81.44.

Euro and yen downside risks

The lack of progress on a second bailout for Greece will keep markets nervous, leaving risk assets vulnerable to further slippage. The USD will be a beneficiary in this environment. Weak Eurozone GDP data for Q4 2011 released today will contrast with relatively firm data including industrial production and the Empire manufacturing survey in the US, leaving the story of US economic outperformance intact.

EUR has lost steam and looks vulnerable to a further correction lower. The fact that EU finance ministers have cancelled a meeting due to be held today means that markets will have to prolong their wait for an agreement on a second bailout package for Greece.

News that Greece’s political leaders will send a commitment to European officials today that they will implement further austerity measures will give some reassurance that things are moving in the right direction but a looming deadline for debt redemption in March will mean heightened nervousness.

Admittedly the market is still short EUR but positioning has moved close to its 3-month average suggesting a less potential for aggressive short covering. Following the downgrade of ratings of several Eurozone countries yesterday and a likely drop in Q4 2011 Eurozone GDP today, caution will be the prevalent theme today, leaving EUR/USD on the back foot and opening the door for a test of technical support around 1.3026.

The Bank of Japan’s decision to increase its asset purchase program and set an inflation goal had an immediate negative impact on the JPY. A sharp drop in GDP growth in Q4 last year, persistent deflation pressures and more aggressive action from other central banks pushed the BoJ into action.

Will there be any follow through on the JPY? USD/JPY had already been under some upward pressure in the wake of the widening in US bond yields versus Japan. The move by the BoJ will result in even more of a widening in yield differentials especially given that the BoJ actions means there will be an increase in official purchases of Japanese government bonds, helping to suppress JGB yields.

In the near term USD/JPY has broken above its 200 day moving average level, paving the way for a test of the 31 October 2011 high around 79.55. Further out, our bond forecasts show that both US and Eurozone 2-year bond yields will increase relative to Japanese yields over the coming months, supporting our forecasts of USD and EUR appreciation versus JPY.

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