Firmer JPY and CNY fixings to support Asian FX

The USD has lost steam as US yields appear to have temporarily topped out. The fact that aggregate (minus MXN) USD speculative positioning is marginally below its all time high also points to the risk of position squaring / profit taking on USD longs. However, any downside risks to the USD will be limited.

Consumer confidence data today will highlight the ongoing improvement in sentiment driven by both equity and housing wealth gains. In the debate about early Fed tapering the confidence data will err on the side reducing Fed asset purchases sooner rather than later. Consequently, it seems unlikely that the yields and the USD will drop much further.

Hopes of a calm start to the week were dashed as Japanese equity markets extended their slide and the JPY strengthened. Heightened volatility is frustrating policymaker’s efforts to contain the rise in Japanese bond yields. Although Bank of Japan governor Kuroda noted that Japan could cope with rising interest rates, higher yields could dampen growth at a time when the economy is finally showing signs of life.

Higher JGB yields have led to a narrowing in the US Treasury yield advantage over JGBs, which in turn has helped to push the JPY higher versus USD. Unless the BoJ succeeds in curtailing the rise in yield, USD/JPY is at risk of breaking back below 100.

Like the JPY, the CHF has strengthened in part due to increasing risk aversion. For a change the CHF may garner some direction from domestic news this week, with Q1 GDP, April trade data and the May KoF Swiss Leading Indicator scheduled for release later in the week. The data will likely show that Switzerland is escaping the downdraft from weak Eurozone activity, helped to some extent by the CHF cap.

Encouraging economic news will not imply any change in the CHF cap, however especially given the benign inflation outlook. Higher risk aversion will keep the CHF supported in the near term but any move in EUR/CHF back to 1.24 should be bought into.

The rebound in the JPY and strong CNY fixings have given Asian currencies some support although sideways trading is expected in the near term. Equity capital outflows over recent days in the wake of higher risk aversion suggest some caution, however. South Korea in particular has been a major casualty of equity portfolio outflows this year although a factor that prevented the KRW from strengthening. Our models show PHP and THB as likely outperformers over coming weeks.

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Euro firmer, AUD vulnerable to risk gyrations

A surprise drop in US August consumer confidence which dropped to its lowest since November last year put a dampener on markets and notably the VIX index edged higher. Consequently treasuries rose and equities slipped despite a firmer than expected increase in US house prices in June. The confidence data adds the pressure on Fed Chairman Bernanke to give some indication of a further round of quantitative easing during his speech at Jackson Hole on Friday.

An upward revision to US Q2 GDP and a bounce in July pending home sales today are unlikely to change this perspective although the Fed’s Beige Book will likely show some moderate improvement providing the Fed with useful information.

Separately decent debt auctions in Spain and Italy helped to calm Eurozone market nerves further amid hopes of European Central Bank (ECB) action next week despite the news that Spanish region Catalonia formally asked for EUR 5 billion in funding. As a result the EUR retained a firmer tone.

Contrary to expectations, EUR/USD continued to push higher. Just why the currency is strengthening given the significant event risk in the days and weeks ahead is questionable although in part the move is attributable to an ongoing short squeeze. Hopes of constructive ECB action next week taken together with Fed quantitative easing expectations have helped to put the USD on the back foot, allowing the EUR to take advantage.

Admittedly the drop in Eurozone peripheral bond yields is certainly helpful for the EUR, while my short term quantitative ‘fair value’ estimate for EUR/USD suggests more upside too. Nonetheless, given the risk that so much could go wrong in the weeks ahead I am loathe to get on the bullish EUR bandwagon. While EUR/USD and EUR on the crosses will likely remain firm ahead of Jackson Hole I expect the EUR to struggle to hold onto gains into next week.

AUD has lost ground since around 10 August. This has roughly coincided with a rise in risk aversion over recent weeks. Indeed, AUD maintains a strong correlation with risk aversion and is therefore highly susceptible to swings in risk appetite. Additionally renewed China worries have also dampened the attraction of the AUD given the increasing dependency of Australia’s economy to China both directly through trade and indirectly via commodity prices.

While I remain positive on the AUD over the medium term, the high level of speculative positioning in the currency suggests some vulnerability to profit taking over the short term, with AUD/USD vulnerable to a drop to technical support around 1.0282. Much will depend on news out of China in terms of AUD direction, with Chinese stock market gyrations also providing some influence.

ECB risks, more JPY jawboning, Asian FX supported

Risk assets have given back some of their Draghi inspired gains but expectations of European Central Bank action on Thursday continues to provide a solid underpinning for markets. Although European equities closed higher US equities slipped while the VIX ‘fear gauge’ rose. Ahead of the ECB policy decision attention will be on whether German resistance to a more aggressive ECB stance eases. Given that markets have priced in a positive outcome the risks are asymmetric in the days ahead, with a bigger sell off in risk assets should policy makers disappoint.

One indicator worth highlighting is the Baltic Dry Index which has dropped by over 20% from its high on 9 July and continues to head south, indicating rising global growth risks. Economic data releases including the Eurozone ‘flash’ July Eurozone inflation data, and US July consumer confidence will offer some direction for markets but we suspect that a tone of consolidation will continue ahead of the ECB and Fed meetings and the July US jobs report at the end of the week.

Japan continues to jawbone about the strength of the JPY, with Finance Minister Azumi delivering a further threat of FX intervention. Azumi notes that the advance of the JPY has been one sided, does not reflect fundamentals and that no measures will be ruled out when it comes too FX action when needed. He also hints that any intervention may be supported by other countries. It is doubtful that Azumi is setting the scene for actual intervention although a sustained drop below 78.00 will sharply raise the odds of Japanese official JPY selling.

EUR/USD looks supported above 1.2118 but a drift lower is likely ahead of the ECB meeting. Reports in Der Spiegel that Draghi’s pledge of action has created discord within the ECB while Germany continues to resist action to restart the ECB’s securities market purchase programme. The risk is that Draghi has set the ECB and risk assets up for a fall if agreement cannot be reached ahead of the ECB policy meeting.

Asian currencies look supported going in the near term and its worth noting that equity portfolio flows to the region have pocked up over recent days led by South Korea. The USD will be restrained ahead of the Fed meeting allowing Asian currencies to grind higher. We favour KRW and IDR although gains are likely to be limited ahead of the key central bank policy decisions this week. On that note, a likely unchanged decision from the RBI in India today, may act as further disappointment for the INR.

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