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%).

 

Euro still looks uglier than the dollar

Currency markets continue to vacillate between US debt ceiling concerns and eurozone peripheral debt worries. Despite a lack of agreement to raise the debt ceiling, with House Republicans failing to back a proposal by House speak Boehner, the USD actually strengthened towards the end of the week as eurozone peripheral issues shifted back into focus.

The resilience of the USD to the lack of progress in raising the debt ceiling is impressive and reveals that the EUR looks even uglier than the USD, in many investors’ eyes.

Much in terms of direction for the week ahead will depend on the magnitude of any increase in the debt ceiling and accompanying budget deficit reduction measures. Assuming that a deal is reached ahead of the August 2 deadline it is not obvious that the USD and risk currencies will enjoy a rally unless the debt ceiling deal is a solid and significant one.

Given the limited market follow through following the recent deal to provide Greece with a second bailout, the EUR remains wholly unable to capitalise on the USD’s woes.

A reminder that all is not rosy was the fact that Moody’s ratings agency placed Spain’s credit ratings on review for possible downgrade while reports that the Spanish parliament will be dissolved on September 26 for early elections on November 20 will hardly help sentiment for the EUR. Compounding the Spanish news doubts that the EFSF bailout fund will be ready to lend to Greece by the next tranche deadline in mid-September and whether Spain and Italy will participate, have grown.

Some key data releases and events will also likely to garner FX market attention, with attention likely to revert to central bank decisions including the Bank of Japan, European Central Bank, Bank of England, Reserve Bank of Australia and US July jobs report. None of the central banks are likely to shift policy rates, however.

The risk for the USD this week is not only that there is disappointing result to the debt ceiling discussions, but also that there is a weak outcome to the US July jobs report. An increase of around 100k in payrolls, with the unemployment rate remaining at 9.2%, will fixate market attention on weak growth and if this increases expectations for a fresh round of Fed asset purchases the USD could be left rather vulnerable.

The RBA is highly unlikely to raise interest rates but the tone of the accompanying statement is unlikely to be dovish. The RBA noted the strong emphasis on the Q2 CPI inflation data and in the event it came in higher than expected, a fact that supports my expectation that the Bank will hike policy rates at least once more by the end of this year.

Markets have largely priced out expectations of a rate cut but there is still scope for a more hawkish shift in Australian interest rate markets, which will give the AUD a boost. However, AUD remains vulnerable to developments in the US and Europe as well as overall risk aversion, and a preferable way to play a positive AUD view in the current environment is via the NZD.

Risk Aversion to remain elevated

It remains a tumultuous time for markets, gripped by a cacophony of concerns ranging from the lack of resolution to the Eurozone debt crisis to the failure to reach agreement on raising the US debt ceiling and associated deficit reduction plans. Mingled among these is the growing evidence that economic growth is turning out weaker than expected. Meanwhile Europe’s crisis appears to be shifting from bad to worse, as reflected in a shift in attention towards the hitherto untouched Italy although Italian concerns have eased lately.

The release of the EU bank stress test results at the end of last week have not helped, with plenty of criticism about their severity and rigour following the failure of only 8 banks out of the 90 tested. Expectations centred on several more banks failing, with much more capital required than the EUR 2.5 billion shortfall revealed in the tests. Answering to this criticism officials note that there has already been a significant amount of capital raised over recent months by banks, but this will be insufficient to stem the growing disbelief over the results.

Attention is still very much focussed on Greece and reaching agreement on a second bailout for the country, with further discussions at the special EU summit on July 21. The contentious issue remains the extent of private sector participation in any debt restructuring. The decision to enhance the flexibility of the EFSF bailout fund to embark on debt buybacks has not helped. Consequently contagion risks to other countries in the Eurozone periphery are at a heightened state. Despite all of this the EUR has shown a degree of resilience, having failed to sustain its recent drop below 1.40 versus USD.

One explanation for the EUR’s ability to avoid a steeper decline is that the situation on the other side of the pond does not look much better. Hints of QE3 in the US and the impasse between Republicans and Democrats on budget deficit cutting measures tied to any increase in the debt ceiling are limiting the USD’s ability to benefit from Europe’s woes. Moreover, more weak data including a drop in the Empire manufacturing survey and a drop in the Michigan consumer sentiment index to a two-year low, have added to the worries about US recovery prospects.

Against this background risk aversion will remain elevated, supporting the likes of the CHF and JPY while the EUR and USD will continue to fight it out for the winner of the ugliest currency contest. Assuming that a deal will eventually be cobbled together to raise the US debt ceiling (albeit with less ambitious deficit cutting measures than initially hoped for) and that the Fed does not embark on QE3, the EUR will emerge as the most ugly currency, but there will be plenty of volatility in the meantime.

Data and events this week include more US Q2 earnings, June housing starts and existing home sales. While housing data are set to increase, the overall shape of the housing market remains very weak. In Europe, July business and investor surveys will be in focus, with a sharp fall in the German ZEW investor confidence survey likely and a further softening in July purchasing managers indices across the eurozone. The German IFO business confidence survey is also likely to decline in July but will still point to healthy growth in the country. In the UK Bank of England MPC minutes will confirm no bias for policy rate changes with a 7-2 vote likely, while June retail sales are likely to bounce back.

Which is the ugliest currency?

The contest of the uglies has once again been set in motion in FX markets as last Friday’s weak US jobs report, which revealed a paltry 18k increase in June payrolls, downward revisions to past months and a rise in the unemployment rate, actually left the USD unperturbed. Europe’s problems outweighed the negative impact of more signs of a weak US economy, leaving the EUR as a bigger loser.

The USD’s resilience was even more impressive considering the drop in US bond yields in the wake of the data. However, news over the weekend that talks over the US budget deficit and debt ceiling broke down as Republicans pulled out of discussions, will leave USD bulls with a sour taste in their mouth.

Should weak jobs recovery dent enthusiasm for the USD? To the extent that it may raise expectations of the need for more Fed asset purchases, it may prove to be an obstacle for the USD. However, there is sufficient reason to look for a rebound in growth in H2 2011 while in any case the Fed has set the hurdle at a high level for more quantitative easing (QE).

Fed Chairman Bernanke’s reaction and outlook will be gleaned from his semi-annual testimony before the House (Wed) although he will likely stick to the script in terms of US recovery hopes for H2. This ought to leave the USD with little to worry about. There will be plenty of other data releases this week to chew on including trade data, retail sales, CPI and PPI inflation and consumer confidence as well as the kick off to the Q2 earnings season.

Fresh concerns in Europe, this time with contagion spreading to Italy left the EUR in bad shape and unable to capitalise on the soft US jobs report. In Italy high debt levels, weak growth, political friction and banking concerns are acting in unison. The fact that there is unlikely to be a final agreement on second Greek bailout package at today’s Eurogroup meeting will act as a further weight on the EUR.

Discussions over debt roll over plans, the role of the private sector and the stance of ratings agencies will likely drag on, suggesting that the EUR will not find any support over coming days and will more likely lose more ground as the week progresses. If these issues were not sufficiently worrisome, the release of EU wide bank stress tests on Friday will fuel more nervousness. Against this background EUR/USD looks vulnerable to a drop to technical support around 1.4102.

The Bank of Japan is the only major central bank to decide on interest rates this week but an expected unchanged policy decision tomorrow is unlikely to lead to any JPY reaction. In fact there appears to be little to move the JPY out of its current tight range at present. USD/JPY continues to be the most correlated currency pair with 2-year bond yield differentials and the fact that the US yield advantage has dropped relative to Japan has led to USD/JPY once again losing the 81.0 handle.

However, as reflected in the CFTC IMM data the speculative market is still holding a sizeable long position in JPY, which could result in a sharp drop in the currency should US yields shift relatively higher, as we expect over coming months. In the short-term USD/JPY is likely to be well supported around 80.01.

Shaking Off The Bad News

Markets managed to shake off the initial shock of the SEC’s fraud case against Goldman Sachs following news that the charge was not approved unanimously, but with a 3-2 vote. This was interpreted by some to imply that there was more of a political rather than economic bias behind the charge, with two Democrats voting for and two Republicans voting against and SEC Chairman Schapiro siding with the Democrats.

Stronger than forecast earnings from Citigroup and a bigger than expected 1.4% jump in US March leading indicators also helped to calm market nerves, with US equities closing higher and the VIX volatility index reversing some of its spike higher. Attention is still firmly fixed on earnings and with 121 S&P 500 companies due to release earnings this week including Apple, Goldman Sachs, Johnson & Johnson and Yahoo today.

Nonetheless, it is difficult to see sentiment improve too much against the background of ongoing worries about Greece as reflected in the renewed widening in Greek debt spreads yesterday. Moreover, the negative economic impact of the spread of volcanic ash from Iceland, and potential for more lawsuits related to CDOs from regulators as well as investors, against banks, will continue to act as a drag on market risk appetite.

Earnings have been positive so far into the season and as seen overnight, this is helping to counter market negatives, giving risk appetite some support. In turn, this will give risk currencies some relief but given the gyrations between positive and negative news it is difficult to see most currencies breaking out of recent ranges.

My overall bias is for positive earnings and data to overcome the negatives this week, leaving the likes of the AUD, NZD and CAD as well Asian currencies firmer. The EUR and GBP are likely to remain the weakest links, with both currencies set to retrace lower and EUR/USD finding plenty of sellers above 1.3500.

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