Tough Times for the US Dollar

The US dollar had an awful July, with the USD index dropping by around 5% over the month, its worst monthly performance in 10 years. A range of factors can be cited for USD weakness including an asset allocation shift to assets outside of the US, worsening news on US Covid cases over recent weeks, improved risk appetite, US election concerns, lower real yields and fiscal cliff worries, among other factors.  Gold has been a particularly strong beneficiary of the malaise in the USD and declining real yield yields.  The Fed’s pledge to keep on aggressively supporting the economy and likely strengthening of forward guidance in the months ahead suggest that any increase in US interest rates could be years off.

It is still difficult to see the recent weakness in the USD resulting in a deterioration in its dominant reserve currency status though the longer the factors noted above remain in place, the bigger the danger to longer term confidence in the USD. As a reminder of such risks Fitch ratings downgraded US AAA credit rating to a negative outlook.  I do not expect markets and the USD to be impacted by the move, but it does highlight a worsening in US fundamentals.  While other currencies are still a long away from displacing the USD dominance in FX reserves, financial flows, FX trading and trade, the longer term risks to the USD are clear.

That said, the USD caught a bid at the end of last week resulting in a sharp retreat in the euro (EUR) from heavily overbought technical levels.  It is unlikely to be a coincide that this occurred as US Covid cases showed signs of peaking while cases in many parts of Europe began to accelerate, resulting in delays to opening up or renewed tightening of social distancing measures there.  US stocks have also continued to perform well, despite much discussion of a rotation to value stocks.  Solid earnings from US tech heavyweights solidified their position as leaders of the pack.  It is too early to say that this is the beginning of a USD turnaround, but the currency is heavily oversold in terms of positioning and technicals, which point to room for some respite.

Turning to the week ahead attention will be on July global Purchasing Managers Indices (PMI) data beginning with China’s private sector Caixin PMI (consensus 51.1), and the US ISM survey (consensus 53.6) tomorrow.  Central bank decisions include the Reserve Bank of Australia (Tue), Bank of England (Thu), Reserve Bank of India (Thu) and Bank of Thailand (Wed).  No change is likely from the RBA, BoE and BoT, but expect a 25bp cut from RBI.  At the end of the week two pieces of data will take precedence; US July jobs data and China July trade data.  US-China tensions will come under further scrutiny after President Trump vowed to ban TikTok in the US while pouring cold water on a sale to a third party.

 

Opening Up

Attention is squarely going to be on efforts to open up economies in the days and weeks ahead.  Most US states are opening up to varied degrees while the same is happening across Europe.  The risk of course is that a second or even third wave of Covid-19 emerges for some countries, as is being seen in some parts of Asia, for example Korea where renewed social distancing measures have been put in place after a fresh cluster of cases in clubs and bars there.

However, governments will need to weigh up these risks against the growing economic costs of lockdown, which will by no means be easy.  Even as social distancing and lockdown measures are eased, it will likely be a gradual process, with activity likely to remain under pressure.  This is when the real test for markets will take place.  While markets have clearly been buoyed by unprecedented stimulus measures, especially from the Federal Reserve, which could continue for some time, fiscal injections will run their course over the next couple of months.

As revealed in April US jobs data at the end of last week the costs in terms of increased unemployment has been severe. The US unemployment rate hit a post war high of 14.7% while 20.5 million people lost their jobs.  This news will be echoed globally. Markets were expecting bad news and therefore the reaction was limited, but the data will nonetheless put more pressure on policy makers to keep the stimulus taps open.  Discussions are already in place between US Republican and Democrats over a new package, though disagreements on various issues suggest a deal may not happen soon.

Another spanner in the works is tensions between the US and China.  The US administration has become more vocal on blaming China for the virus, over recent weeks.  This had threatened to undermine the “phase 1” trade deal agreed a few months ago.  However, there were some soothing remarks on this front, with a phone call between senior US and Chinese officials last week, highlighting “good progress” on implementing the deal.  Despite such progress, it may not calm tensions over the cause of the virus, especially ahead of US elections in November and markets are likely to remain nervous in the weeks ahead.

This week there will be more evidence on tap to reveal the economic onslaught of the virus, just as many countries are finally flattening the virus curve itself.   Q1 GDP releases will reveal weakness in several countries.  Chinese activity data including retail sales and industrial production as well as credit metrics will give further evidence of the virus impact and how quickly China is recovering.  If anything, China’s recovery path will likely show the pain ahead for many economies that are easing lockdown measures.  In the US, inflation data and retail sales will garner attention.  In terms of central banks attention will be on the Reserve Bank of New Zealand (RBNZ). While no change in policy rates is likely a step up in the RBNZ’s asset purchases may take place.

 

 

 

 

Risk and carry attraction increasing

The outcome of the EU Summit together with hopes of monetary stimulus has definitely helped to put a floor under risk appetite. Indeed, such monetary stimulus expectations are reflected in the price of gold which continued to rise overnight. Risk assets in general have maintained a positive tone recently and even forward looking indicators of global activity such as the Baltic Dry Index have been trending higher.

Although it is difficult to become too positive given the still very significant downdraft to global growth officials in Europe have bought some time to get their collective house back in order. Whether they will use it wisely is another question entirely. It is difficult to see much of a market move ahead of the ECB Council meeting and US June jobs report this week. Moreover, the US Independence Day holiday will keep trading subdued today.

My Risk Barometer has moved back into ‘risk neutral’ territory following several weeks of remaining in ‘risk hating’ territory. Consequently the backdrop for risk currencies has turned positive. Although FX trading has become more subdued amid summer conditions and a US holiday today as reflected in the drop in implied volatilities, there is a clear sense that investors are increasingly moving into carry trades.

My Yield Appetite Index {YAI) has surged over recent weeks, now at its highest in several months. I remain concerned that markets are addicted to stimulus while underlying economic conditions remain weak as likely revealed in today’s releases of June service sector purchasing managers’ indices in Europe.

Nonetheless, it seems likely according to my risk measures that the current tone of risk / carry attraction will persist for some weeks to come. The currencies that will benefit in an environment of improving risk appetite / yield attraction are the ZAR, MXN, PLN, CAD & NOK by order of magnitude of correlation with our risk barometer.

However, the beneficiaries are by no means limited to these currencies. Almost every currency except the ARS and PHP has a statistically significant correlation with the risk barometer. The only currencies that come under pressure as risk appetite improves are the USD and JPY given their negative correlations.

Currencies with healthy carry such as the AUD, which broke above its 200 day moving average versus USD overnight, will be even bigger beneficiaries as investors pile into carry trades over coming weeks as indicated by the jump in our YAI.

Notably there is plenty of scope to build carry positions as our speculative measure of yield attraction (based on CFTC IMM data) remains relatively low, suggesting that leveraged investors have still not jumped on the carry bandwagon.

Political pressures afflicts the euro

I’m in Dubai today presenting at a client seminar so am a little late on my blog post today. There is definitely lots going on however and all the talk is about politics. The mood is decidedly downbeat following the elections in France and Greece over the weekend. Risk assets have tanked while the USD looks firm except versus JPY. The elections over the weekend clearly dealt a blow to advocates of austerity resulting in a major increase in policy uncertainty.

Following the weaker the forecast US jobs report at the end of last week data over coming days will be less influential on the USD. In general I expect the USD to edge higher, helped by a decidedly more nervous market tone and higher risk aversion. The main interest for FX markets on the data front will be the April NFIB Small Business Optimism survey, March trade data and May Michigan confidence at the end of the week.

Although not a particular driver for the USD, the dip in the NFIB survey in March provoked concerns about the pace of US recovery and potential downturn in growth. This has been echoed in other data, which in turn has kept the door open to more Fed action restraining the USD in the meantime.

The ECB failed to rattle the EUR’s cage following its policy meeting last week although the lack of a dovish tone did help the EUR to rally briefly. We believe the market reacted prematurely and if anything the ECB may be setting the scene for a rate cut in June. Weak data has helped to undermine the EUR and I expect little or no improvement over coming days. Given that Germany has also succumbed to some weakness, the March German industrial production report will be monitored with interest on Tuesday.

The main driver for the EUR over coming days will be politics rather than the ECB or economic data however, with markets digesting the outcomes of the second round of the French Presidential election and Greek elections as well as the poor result for Chancellor Merkel in German state elections. Against this background and facing a bearish technical picture EUR/USD will struggle to recover, with 1.3060 providing a new resistance level.

ECB to Hike, BoJ, BoE & RBA on Hold

The better than expected March US jobs report will likely help to shift the debate further towards the hawkish camp in the Fed. There is little this week to match the potency of payrolls in terms of market moving data this week. Instead attention will focus on a raft of Fed speakers over coming days as well as the minutes of the March 15 FOMC meeting.

This week’s Fed speakers include Lockhart, Evans, Bernanke, Kocherlakota, Plosser and Lacker. Of these only Lockhart and Lacker are non voters. Given the intense focus on recent Fed comments FX markets will be on the lookout for anything that hints a broader Fed support for a quicker hike to interest rates and/or reduction in the Fed’s balance sheet.

In any case the USD may struggle to make much headway ahead of an anticipated European Central Bank (ECB) rate hike of 25 basis point on Thursday. Much will depend on the press statement, however. If the ECB merely validates market expectations of around 75bps of policy rate hikes this year the EUR will struggle to rally.

It may also be possible that once the ECB meeting is out of the way the EUR may finally be susceptible to pressure related to ongoing peripheral tensions. Last week the outcome of the Irish bank stress tests, and political vacuum in Portugal ahead of elections set for June 5 were well absorbed by the EUR but it is questionable whether the dichotomy between widening peripheral bond spreads and the EUR can continue.

The Tankan survey in Japan released today unsurprisingly revealed a deterioration in sentiment. The survey will provide important clues for the Bank of Japan (BoJ) at its meeting on April 6 & 7th. Although a shift in Japan’s ultra easy monetary policy is unlikely whilst strong liquidity provision is set to continue, pressure to do more will likely grow. This will be accentuated by a likely downward revision in the economic outlook by the BoJ.

The JPY will not take much direction from this meeting. Nonetheless, its soft tone may continue helped by foreign securities outflows (particularly out of bonds), with USD/JPY eyeing the 16 December high around 84.51. Speculative positioning as reflected in the CFTC IMM data reveals a sharp deterioration in JPY sentiment as the currency evidence that finally the currency maybe regaining its mantle of funding currency.

It is still too early for the Bank of England to hike rates despite elevated inflation readings and MPC members are likely to wait for the May Quarterly Inflation Report before there is decisive shift in favour of raising policy rates. Even then, members will have to grapple with the fact that economic data remains relatively downbeat as reflected in the weaker than expected March manufacturing purchasing managers index (PMI) data.

Today’s PMI construction data will likely paint a similar picture. The fact that a rate hike is not expected by the market will mean GBP should not suffer in the event of a no change decision by the BoE this week but instead will find more direction from a host of data releases including industrial production. GBP has come under growing pressure against the EUR since mid February and a test of the 25 October high of 0.89415 is on the cards this week.

Finally, congratulations to the Indian cricket team who won a well deserved victory in the Cricket World Cup final over the weekend. The celebrations by Indians around the world will go on for a long while yet.

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