US dollar weakness providing relief

The US dollar index has weakened since mid-August 2018 although weakness in the broad trade weighted USD has become more apparent since the beginning of this month.  Despite a further increase in US yields, 10 year treasury yields have risen in recent weeks to close to 3.1%, the USD has surprisingly not benefited.  It is not clear what is driving USD weakness but improving risk appetite is likely to be a factor. Markets have been increasingly long USDs and this positioning overhang has also acted as a restraint on the USD.

Most G10 currencies have benefitted in September, with The Swedish krona (SEK), Norwegian Krone (NOK) and British pound (GBP) gaining most.  The Japanese yen (JPY) on the other hand has been the only G10 currency to weaken this month as an improvement in risk appetite has led to reduced safe haven demand for the currency.

In Asia most currencies are still weaker versus the dollar over September, with the Indian rupee leading the declines.  Once again Asia’s current account deficit countries (India, Indonesia, and Philippines) have underperformed most others though the authorities in all three countries have become more aggressive in terms of trying to defend their currencies.  Indeed, The Philippines and Indonesia are likely to raise policy interest rates tomorrow while the chance of a rate hike from India’s central bank next week has risen.

As the USD weakens it will increasingly help many emerging market currencies.   The likes of the Argentinian peso, Turkish lira and Brazilian real have been particularly badly beaten up, dropping 51.3%, 38.5% and 18.8%, respectively this year.  Although much of the reason for their declines have been idiosyncratic in nature, USD weakness would provide a major source of relief.  It’s too early to suggest that this drop in the USD is anything more than a correction especially given the proximity to the Fed FOMC decision later, but early signs are positive.



No relief for risk assets

Perhaps unsurprisingly given the tumultuous build up to the poll the Crimean referendum resulted in an over 90% vote to leave Ukraine and join Russia according to Russian state media. Risk assets were already under pressure leading into the vote and the news is not going to help sentiment in any way, with the West already denouncing the result and Russia seeing it as a validation of its stance. Further sanctions and other punitive measures are likely to be announced leading to a heightening of tensions and increased risk aversion.

Our risk barometer is already well into “risk hating” territory highlighting the intensifying pressure on risk assets and demand for safe havens. Consequently expect the likes of the CHF, JPY and gold to remain under upward pressure and anything with high beta to be under downward pressure.

There is also plenty of data and events to capture the interest of markets this week, with the Fed FOMC meeting capturing top billing. Unsurprisingly no change in policy is expected, with a USD 10 billion taper set to be announced. Fed Chairman Yellen is set to highlight that the bar remains high to any slowing in the pace of tapering while more qualitative guidance is set to be announced.

On the data front US data will remain weather impacted but nonetheless, February industrial production is set to reveal a small gain today while manufacturing surveys will reveal some improvement in March. Additionally housing starts are set to rebound in February. However, Treasury yields are likely to be capped despite more encouraging data as safe haven demand intensifies, leaving the USD also restrained.

In Europe the data flow is less numerous and what there is will support the view that more action is needed by the European Central Bank (ECB) to ease policy. February CPI inflation is set for a downward revision while the German ZEW investor confidence index will slip further.

Risk assets under growing pressure

The growing turmoil in emerging markets is inflicting damage on risk assets across the board and no let up is expected in the near term. Even the rally in US Treasuries has failed to provide any relief to risk assets given the weight of negative sentient. Whether triggered by concerns about a slowing in Chinese growth, Argentina’s letting go of its currency support, and/or political tensions elsewhere such as in Thailand and Ukraine or a combination of all of these, the picture looks increasingly volatile.

Additionally, earnings and valuation concerns are acting to restrain equity markets. Finally, lurking in the background as another weight on asset markets is Fed tapering, with a further USD 10 billion reduction in asset purchases expected to be announced by the Fed this week (Wednesday). The combination of the above spells more bad news in the days ahead, with risk assets set to remain under pressure this week.

Amid the growing gloom in global markets there are still some key data releases and events that will garner some attention this week. In the US as noted the Fed FOMC meeting is the main event, but December new home sales today, January consumer confidence tomorrow and Q4 GDP on Thursday will also be important. However, the former two releases are set to record declines implying a mixed slate of US releases this week.

In Europe, coming off the back of some encouraging flash purchasing managers’ indices the January German IFO business climate index will record its third consecutive gain, while Spanish GDP is set to record its second consecutive quarterly gain. A slight rebound in January inflation is unlikely to stand in the way of a further reinforcement of forward guidance by the European Central Bank.

In Japan Trade data reported today revealed an 18th straight month of deficit while inflation data will reveal that the Bank of Japan still has a lot of work to do to reach its 2% inflation target implying that there will be some discomfort with the recent rebound in the JPY. Finally, expect no change from the RBNZ at its policy meeting on Wednesday, which will leave the NZD under further pressure.

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.

USD edges higher, AUD supported, KRW in focus

US equities and risk assets in general edged higher overnight as US politicians edged towards a budget deal. The nomination of Janet Yellen as next Fed Chairman was met with a positive reaction from risk assets as it was perceived that she would be more likely to maintain the easy policy of her predecessor, with markets in any case delaying expectations of tapering into next year.

The Fed FOMC minutes released overnight gave little clarity on the timing of Fed tapering however, but it did highlight the split within the FOMC between those wanting to begin tapering in September and those preferring to wait. More consolidation is likely today as markets await political developments in the US.

Contrary to our expectations the USD has actually edged higher over recent days shaking off some the pressure associated with the budget impasse in the US. News that President Obama will meet around 20 senior Republicans from the House following a similar meeting with Democrats highlights progress of sorts, with hints of compromise in the air.

A slight uptick in US bond yields has managed to provide the USD with a semblance of support and further consolidation is likely in the short term as market fears over a US default gradually recede. Indeed, it appears that the USD is in a bottoming out process at present, with short term pain likely to give way to medium term gain.

GBP has lost ground over recent days undermined yesterday by disappointing August manufacturing/industrial production data and a worse than expected trade deficit. The data is unlikely to affect the outcome of today’s Bank of England MPC meeting however, with an unchanged outcome both on policy rates and asset purchases on the cards.

Despite yesterday’s data disappointments UK data has been improving and point to a reasonably good growth outcome in Q3 and a reduced likelihood of further asset purchases by the BoE. Nonetheless, GBP’s gains look overdone, with scope for short covering having diminished. Further pressure is expected against both EUR and GBP in the short term.

Australian jobs data revealed an increase of 9.1k in employment evenly split between full time and part time jobs and a surprise drop in the unemployment rate to 5.6%. The headline increase in employment was below consensus. Moreover, there was a marginal drop in the participation rate which helped to push the unemployment rate lower. On balance, the data will leave the AUD unperturbed, with the AUD/USD likely to remain supported over the short term. AUD/USD looks primed to test resistance around the 0.9530.

Asian currencies are on the back foot in the face of a slightly firmer USD. KRW will be in focus, with the Bank of Korea delivering an unchanged policy outcome but revising lower its growth and inflation forecasts. Against this background KRW appreciation looks overdone and appears to face strong resistance on any breach down to USD/KRW 1070. Nonetheless, downside risks will be limited. Encouragingly Korea has been a major beneficiary of the prospects of a delayed Fed tapering, with the country recording a strong return of equity portfolio flows over recent weeks

Bracing for a world without steroids

The sell off of risk assets in the wake of the Fed’s surprisingly direct FOMC communication continues unabated. Hopes that Fed chief Bernanke would attempt to assuage market concerns about tapering have been blown apart and instead the reality of forthcoming tapering continues to bite leading to higher US yields, weaker stocks and commodities and a firmer USD. In fact the USD appears to have finally re-established its positive relationship with yields and risk aversion.

The situation hasn’t been helped by the fact that data out of China has disappointed while local money market rates had risen sharply this week. Separately Japan’s reform momentum appears to have stalled ahead of Upper House elections as Prime Minister Abe’s third arrow missed target.

In combination these factors mean that markets are bracing for the day that they no longer have steroid injections to keep them going. Instead fundamentals will become important to sustain gains in risk assets. Why should anyone be surprised? US growth is recovering and at some point tapering has to occur. Unfortunately risk assets were just not ready for this revelation.

Ongoing volatility and uncertainty is likely to persist over the coming weeks as markets transition to an environment of Fed tapering, but this will give way to a renewed improvement in risk appetite and lower volatility later in the year.

The USD index continued to rise overnight having corrected around a third of its losses since 22 May. Gains remain broad based with gains registered against major and emerging market currencies. US Treasury yield differentials with other countries continue to widen across the board leaving the USD in strong form (10 year Treasury yield has risen by close to 80 basis points since early May).

Going forward firmer US data, taken together with higher US yields, will continue to drive the USD higher against major currencies, while some improvement in risk appetite as investors become accustomed to the prospects of Fed tapering will allow emerging market currencies to recover some, but not all lost ground against the USD.

Many currencies have become highly sensitive to US yields, with the TRY, NZD and INR the most sensitive over the past three months although notably most Asian currencies are near the top in terms of sensitivities.

Against this background unsurprisingly Asia continues to register capital outflows. All Asian countries have registered capital outflows this month, with total equity outflows of $10.2 billion registered, led by South Korea and Taiwan. Obviously the bigger concern is for deficit countries including India and Indonesia, with their currencies remaining particularly vulnerable to capital outflows.

Recent market volatility has meant that the prospects of Japanese investors stepping up their outflows have diminished over the near term. The latest data released yesterday showed that Japanese investors repatriated capital for a fifth straight week.

It is only a matter of time before outflows pick up as risk appetite improves as US yields move higher. The US 10Y Treasury yield advantage has widened versus Japanese JGBs to around 153bp and I expect this to widen further to around 185bp by the end of 2013. This will be consistent with a renewed slide in the JPY versus USD.

Calmer sentiment

Gains in US stocks overnight will help to calm sentiment. The fact that US equities were able to shake off the 6%+ plunge in the Nikkei yesterday reveals the different perspectives in both markets. US markets were helped by a bigger than expected increase in headline US retail sales in May and a bigger than expected decline in weekly jobless claims.

A WSJ story that Fed Chairman Bernanke would highlight at next week’s Fed FOMC meeting that a “considerable” amount of time would pass before ending QE and raising rates also likely contributed to firmer sentiment while pressurizing Treasury yields lower. Commodities’ markets also showed some sign of stabilization.

The data slate today consists of mostly US releases including May industrial production and June Michigan confidence both of which are likely to record positive outcomes. Markets are likely to digest the data well and after recent bouts of volatility a period of calm ahead of next week’s FOMC meeting will be welcome.

The USD index has suffered a dramatic reversal of fortunes since reaching a high just under 84.5 on 23 May dropping by around 4.3%. Its tumble has taken place despite higher US bond yields and risk aversion, both of which would usually be expected to boost the currency. Fed tapering nervousness has done nothing to support the USD despite prospects of reduced asset purchases.

The USD’s move should not be seen in isolation, however. In the wake of major position adjustments across many asset classes usually strong correlations have broken down. Given recent record long USD positioning over recent weeks the pull back in the USD versus major currencies may have further to run but we suspect that much of the decline has already taken place. Given that the USD appears to be more strongly correlated to equities at present it may find some support from the gain in US stocks overnight.

Assuming that the USD’s declines begin to slow and even reverse the EUR is unlikely to extend its gains much further. The overall backdrop for the EUR is not particularly positive, with growth data remaining weak, albeit less so than in previous months. Additionally there are renewed concerns about Greece due to protests over the shutdown of the state broadcaster highlighting the difficulty in implementing crucial deficit cutting measures.

Meanwhile, European Central Bank Board member Mersch once again highlighted the possibility of utilizing negative deposit rates, which ought to prove to be a negative influence on the EUR, while other members including President Draghi continue to defend the potential use of OMT. EUR/USD will run into strong resistance around 1.3434 and I expect the upside momentum to fade over coming sessions.

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