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%).

 

Sour end to the week

It’s a sour end to the week for markets. Just as emerging markets (EM) were beginning to see some signs of stability, a surge in US Treasury bond yields (hitting a high of 3.23%) acted to fuel another round of pressure, pushing bond yields higher globally while denting equity market sentiment.   As a result EM equities took another beating and EM currencies fell against a resurgent USD.

The surge in US yields followed a run of strong US data including a gauge of service sector sentiment (ISM non-manufacturing index hit a new expansion high) and strong private sector jobs data (ADP jobs report).  Constructive comments from Fed Chairman Powell on the economy, supporting expectations that US interest rates will be hiked again in December, added to the upbeat mood on the economy.   At the time of writing attention is focused on the US September jobs report which is unlikely to detract from the upbeat US growth story.

US-China tensions are another factor weighing on sentiment.  While there has been no sign of any progress on trade talks even as the US agreed trade deals with Canada and Mexico, criticism by US Vice President Mike Pence on Chinese policy, has weighed on Asian markets.  There appears to be no sign of any appeasement between the two countries, suggesting that tensions will not easy anytime soon.

Any hope of a recovery in risk assets especially in emerging markets as we go into the final quarter of the year are beginning tofade.   After losing ground over much of September the USD has bounced back with a vengeance, while US assets continue to outperform much of the rest of the world, attracting even more capital.  While heavy long USD positioning and increasingly stretched US equity valuations hold risks against further gains in both, markets are not yet willing to run from US assets.

Swiss franc to remain strong

Given the uncertainties enveloping both the US and Europe safe haven and various emerging market currencies have looked increasingly attractive. Currencies that remain on top in the current environment are the CHF and to a lesser extent the JPY, much to the chagrin of the Swiss and Japanese authorities. Indeed, in reaction to unwanted CHF strength the Swiss central bank, SNB unexpectedly cut interest rates and said it will increase CHF liquidity to the money markets. The CHF fell in the wake of the announcement but the impact may prove short lived.

Both the JPY and CHF have registered a strong correlation with risk aversion over the last 3-months, strengthening as risk aversion has intensified. In particular, the CHF has been the best performing major currency this year and shows no sign of turning around despite the fact that it has already strengthened by around 21% against the USD and over 12% against the EUR. The Swiss National Bank had even ceased from intervening in the currency markets given the lack of success and pain on the SNB’s balance sheet.

The Japanese authorities last intervened in the FX market in March 2011 following the devastating earthquake in the country. However, despite the fact that the JPY has strengthened after a brief period of success, the authorities have been reluctant to intervene since. The major explanation for a lack of intervention is that the Japanese authorities blame the drop in USD/JPY on USD weakness rather than inherent JPY strength. A more accurate reason is that the yield differential between the US and Japan has narrowed, leading to JPY strength versus USD while more recently rising risk aversion has pushed the JPY higher.

I am bearish on both the CHF and JPY over the medium term but clearly any drop in these currencies is taking longer than initially anticipated. Higher relative yields taken together with some normalisation in risk appetite will help but the risks at present are still skewed for further CHF and JPY strength in the short term given that risk aversion remains elevated. The fact that peripheral bond spreads in Europe have continued to widen will only raise the attraction of the CHF as a safe haven currency so despite the SNB’s new measures, it may do little to prevent further strength in the currency.

Asian currencies at multi-year highs

Asian currencies are stronger in the wake of a sharp improvement in risk appetite following the approval of Greece’s austerity measures. The rally in Asian FX is revealed in the ADXY (an index of Asian currencies) index which is approaching a test of its 2nd May high around 119.26 around its highest level since August 1997. Technical indicators have turned more bullish, with the ADXY breaking above its key moving average levels (20, 50 & 100 day) and the 14-day relative strength index also turning higher.

The Asian FX rally has been led by the KRW, the Asian currency that has had the highest correlation with risk over the past few weeks. Given that risk aversion has dropped sharply since mid June it is no surprise that this currency has strengthened the most. USD/KRW is trading around its lowest level since August 2008. Strong equity capital outflows had kept the KRW on the back foot over much of June but there has been a bounce back in flows recently. However, USD/KRW is likely to find it tough to break below 1060 over the short-term, especially given likely resistance from the local authorities.

The THB, the worst performing Asian currency in June, has rapidly reversed some of its losses. The THB looks set to consolidate its gains following a decisive election result which saw the opposition Puea Thai Party gain control of parliament. The biggest relief for markets was the fact that the outcome was relatively clear cut, suggesting a potentially a smooth handover of power. Nonetheless, the currency has already jumped and after having dropped to around 30.40 from a high of around 31.01 USD/THB is likely to trade off gyrations in risk appetite.

The fact that the USD has lost some ground in the wake of firmer risk appetite and better news in Greece has also allowed Asian currencies to strengthen although it’s worth noting that amongst Asian currencies only the MYR has maintained a significant correlation with the USD index over the past 3-months. In other words, although USD weakness has helped to facilitate Asian currency strength, the recent strengthening in Asian FX is more likely to have been due to a rebound in capital inflows to the region.

Further Asian FX gains are likely over the near term especially as China continues to fix the CNY higher versus USD but given the recent rapid gains in some currencies, there is a risk of growing official resistance and intervention to slow or stem Asian FX gains. Moreover, the end of QE2 in the US suggests that the downside risks for the USD in general are not likely to be as prevalent, with a potential recovery in the USD over H2 likely to stand in the way of strong Asian FX gains over coming months.

Greece’s trials and tribulations

Two main influences on markets continue to weigh on sentiment. Firstly the trials and tribulations of the eurozone periphery remain centre of attention. The failure of Greek Prime Minister Papandreou to win cross party support for austerity measures at the end of last week highlights the problems Greece is facing both domestically and externally.

Reports that European officials are negotiating tough bailout conditions including major external intervention in terms of tax collection and privatisation suggest that gaining further aid will not be easy. The second weight on market sentiment is global growth concerns, with a string of disappointing data releases over recent weeks leading to an intensification of concerns about the pace of recovery.

Markets will likely remain nervous in this environment and it is difficult to see risk appetite improving to any major degree. This has proven bullish for bond markets, with the tone set to continue this week. Currencies remain in ranges and holidays today in the US and UK will likely result in thin trading. The resilience of the EUR to peripheral concerns has been impressive but at the same time Greek concerns will limit any gains. Meanwhile, gold and precious metals look to remain well supported, with gold’s safe haven bid remaining solid.

USD sentiment has improved sharply according to the latest CFTC IMM report which reveals that net USD short positions have been cut in half over the last two weeks with positioning well above the 3-month average. Conversely net EUR longs continue to shrink as speculative investors off load the currency. The fact that the EUR is not weaker than it is points to the influence of official demand for the currency, especially from Asia.

This week will likely be dominated by ongoing discussions about Greece and given the opposition to austerity measures and potentially strict bailout terms, forging an agreement will not be easy. Reports suggest that around half of Greece’s financing needs until the end of 2013 could be accounted for without new loans via privatisation and changes in terms for private bondholders, with Europe and the IMF needed to lend an additional EUR 30-35 billion on top of the EUR 110 already slated.

Data releases are likely to take a back seat but there will still be plenty of attention on the key release of the week, namely the May US jobs report. The market looks for a 185k increase in payrolls, with the unemployment rate edging lower to 8.9%. This would mark the lowest payrolls reading in 4 months. Clues to the jobs data will be garnered from the May ADP jobs report, ISM manufacturing survey and consumer confidence data earlier in the week.

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