Calm after the storm

After yesterday’s carnage, global equity markets have recovered some of their poise. Whether this is a pause before another wave of pressure or something more sustainable is debatable. It appears that US equities are finally succumbing to a plethora of bad news.  Higher US yields have driven the equity risk premium lower.  Also there’s probably a degree of profit taking ahead of the onset of the Q3 US earnings season.

At the same time valuations have become increasingly stretched.  For example, the S&P 500 price/earnings ratio is around 6% higher than its 5 year average while almost all emerging market price/earnings ratios are well below their 5 year averages.  While strong US growth prospects may justify some or even all of this differential, the gap with emerging markets has widened significantly.

While US President Trump blames an “out of control” US Federal Reserve, it would have been hard for the Fed to do anything else but raise policy rates at its last meeting.  If the Fed didn’t hike at the end of September, bond yields would like have moved even higher than the 3.26% reached on the 10 year US Treasury yield earlier this week as markets would have believed the Fed is falling behind the curve.   However, as US yields rise and the equity risk premium reacts, the opportunity cost of investing in equities rises too.

In the FX world the US dollar could succumb to more pressure if US equities fall further but as we saw yesterday, USD weakness may mainly be expressed versus other major currencies (EUR etc).  Emerging market currencies continue to face too many headwinds including higher US rates and tightening USD liquidity, as well as trade tariffs.  The fact that emerging market growth indicators are slowing, led by China, also does not bode well for EM assets.  Unfortunately that means that emerging market assets will not benefit for the time being from any rout in US assets despite their valuation differences.


Risk rally losing steam

The rally in risk assets is losing its momentum, with US stock markets failing to extend gains following a four day rally while US Treasury yields continued their ascent in the wake of Fed Chairman Yellen’s testimony highlighting no deviation from tapering. Her testimony to the Senate will be delayed today while US data in the form of retail sales is likely to register a soft outcome. Sentiment was boosted overnight by strong Chinese trade data in January and the approval by the US Congress allowing a suspension of the debt limit, a far cry from the major saga that took place last time the debt ceiling was about to be breached.

Additionally Eurozone markets will find some support from comments by European Central Bank board member Coeure who noted that the central banks is “very seriously” considering negative deposit rates. His view may be supported by the release of the ECB monthly bulletin today and Survey of Professional Forecasters (SPF). Coeure’s comments undermined the EUR however, while in contrast sharp upward revisions to growth forecasts by the Bank of England in its Quarterly Inflation Report boosted GBP. Suffice to say, EUR/GBP dropped like a stone and looks set to remain under downward pressure.

“Feral hogs” beware

Bond and equity selling has been sustained as worries both about Federal Reserve tapering and liquidity in China’s banking sector continues to roil markets. Fed comments overnight did little to soothe market angst, with the Fed’s Fisher and Kocherlakota both revealing little concern about the market reaction to prospects of Fed tapering. However, both Fed officials were keen to point out that policy will remain accommodative even after the end of quantitative easing which helped to allay some of the pain on markets in overnight trading.

Reinforcing market volatility is the approach of month and quarter end. Several other Fed speakers will be on tap over coming days while 2, 5 and 7 year Treasury auctions will also be under scrutiny but ahead of the speeches and auctions markets will look to today’s US data releases including May durable goods orders, June consumer confidence and May new home sales for further direction.

EUR/USD failed to get much of lift from the rise in the German IFO business confidence survey in June and looks set to extend declines over coming sessions. Despite its drop from its high around 1.3420 EUR/USD has not been particularly sensitive to higher US yields over recent weeks but this may be changing. As revealed in the latest CFTC IMM report net speculative positioning in EUR/USD became positive for the first time in four months.

Now that the room for EUR short covering has disappeared EUR’s sensitivity to yield is likely to grow. The fact that the 10 year US Treasury yield differential with bunds has widened sharply will be difficult for EUR/USD to ignore, with attendant negative consequences for the currency. The lack of key Eurozone data releases over coming days will leave the EUR/USD increasingly at the mercy of US yield movements.

Another currency having to deal with a relatively thin data slate is GBP. Only the government’s Spending Review, Bank of England Financial Stability Report and second estimate of Q1 GDP are scheduled for release this week but none of these are likely to prove to be market movers. Having been hit by a firmer USD, GBP/USD has fallen well off its recent highs around 1.5752. On the crosses GBP looks a little healthier but is notably failing to make any headway against the EUR.

While the USD has rallied on higher US yields markets are not looking for a similar policy moves in the UK, especially given that some BoE MPC members are still inclined to increase asset purchases. Indeed, the recent rise in UK gilt yields may embolden the doves on the MPC. Although net speculative short GBP positions have not fully evaporated, the room for GBP upside is now very limited, with a firm USD in general set to continue to push GBP lower.

US dollar helped by higher yields

The dichotomy between hard economic data and asset market performance continues but unlike over past weeks at least there was some justification for the rally in equity markets following the stronger than expected US April jobs report. US non farm payrolls rose by 165k while revisions added 114k to previous months and the unemployment rate dropped further to 7.5%.

The data will offer the Fed some comfort perhaps reducing the need to expand further asset purchases in the months ahead. Nonetheless, the jury is still out and following the shift in Fed language at the FOMC meeting last week, in which they opened the door to increasing quantitative easing, it may take more than one, albeit important data release to completely erase expectations of more QE.

Further Fed thoughts on the jobs data as well as the plethora of disappointing data releases over previous weeks could emerge from the Chicago Fed conference this week, with several Fed speakers including Chairman Bernanke scheduled to speak. Given that there is little else on the data front market direction will take it cue from Fed comments.

Aside from central bank meetings in the UK and Australia the data slate is similarly thin elsewhere. No change is expected from both the Band of England and Reserve Bank of Australia but the latter is a much closer call given weaker data both domestically and in China. If the RBA does not move AUD will find some further support after rallying on the back of the jump in copper prices last week although gains will be limited as markets may just push back Australian easing expectations to the next meeting.

In the Eurozone, the final services confidence indices and German industrial data will be on tap and will add more evidence of the weaker economic trajectory and likely restrain the EUR and keep Eurozone core bonds supported. EUR/USD will find little else to give it direction, with higher US yields also likely to help keep any gains in EUR/USD capped, with resistance seen around 1.3220.

Japan has little on the data front too with trade and current account data in focus. The jump in the USD/JPY following the US jobs report will mean that attention will be on whether the 100 level can finally be cracked, with the spike in US 10 year Treasury yields likely keeping the USD supported versus JPY. I suspect that this level will not be breached unless US yields rise further.


The overall tone to markets remains a positive one. Core bonds (Treasuries, bunds) have taken on a bearish tone in the wake of strengthening economic data and have established the usual bullish equities / bearish bonds relationship. Meanwhile volatility measures both in equity and currency markets have dropped to historically low levels.

The USD has been propelled by higher US bond yields but looks vulnerable as US Treasuries consolidate in the short term. Data this week is fairly light, suggesting that direction will be limited as only housing data in the US and purchasing managers’ indices in Europe will be of interest. Overall, the start to the week will see markets in consolidation mood.

The USD index had made up plenty of ground since hitting its lows around 78.095 at the end of February. Higher US bond yields in the wake of strengthening economic data and receding expectations of more Fed money printing have boosted the USD. Nonetheless, US Treasuries appear to be consolidating their losses (ie yields have failed to push higher recently), limiting the ability of the USD to strengthen further.

Data releases in the US this week will be mainly centred on the housing market and are unlikely to be strong enough to warrant a further strengthening in the currency. Much will also depend on gyrations in risk. My Risk Barometer has moved into ‘risk loving’ territory, which plays negatively for the USD versus many high beta currencies. The USD will struggle to make further gains in the short term.

The agreement to furnish Greece with a second bailout gave the EUR no help whatsoever. Instead, higher US Treasury yields relative to bunds dealt the EUR a strong blow and the currency came dangerously close to dropping below the 1.3000 psychologically important level versus USD. Even a narrowing in peripheral bond spreads against the core has failed to give the EUR a lift. Further EUR losses will be limited over coming days but only because US yields have not pushed higher.

Nonetheless, the technical picture has turned bearish and any relief could prove temporary. A mixed batch of data releases including ‘flash’ purchasing managers’ indices which overall will reveal the composite PMI below the 50 boom/bust level for a second month in a row, will not be particularly helpful for the EUR. EUR/USD is likely to be stuck in a 1.2974 – 1.3291 range over coming sessions.

Euro Resilience To Fade

There will at least be a little more liquidity in FX markets today following yesterday’s public holidays in the US and UK. Whether this means that there will be a break out of recent ranges is another matter. Clearly global growth worries as well as eurozone peripheral debt concerns are having an important impact on market dynamics but are also providing conflicting signals.

On the one hand the USD ought to garner support from Europe’s problems but on the other, safe haven demand and growth concerns is bolstering demand for US Treasuries keeping US bond yields at very low levels despite the lack of progress on increasing the US debt ceiling and agreeing on medium to long term deficit reduction.

In the wake of a run of US data disappointments including April durable goods orders, Q1 GDP and weekly jobless claims last week, fears of a loss of momentum in the US economy have intensified. Manufacturing and consumer confidence surveys in the form of the May Chicago PMI and Conference Board consumer confidence survey today will be closely scrutinised to determine whether the ‘soft patch’ in the US economy will persist.

This will have important implications for the USD as worries about growth may feed into expectations that the Fed’s ultra loose monetary policy will be sustained for longer. As it is US 2-year bond yields have dropped to their lowest level this year.

Fortunately for the USD only USD/JPY and USD/CHF have maintained a statistically strong correlation with bond yield differentials although we expect the break in relationship for other currencies to prove temporary. In the case of USD/JPY, yield differentials have narrowed between the US and Japan, a factor playing for JPY appreciation.

Perhaps the fact that unlike the US Japanese data has on balance been beating expectations notwithstanding disappointing April household spending and industrial output data has helped to narrow the yield gap with the US. One explanation is that that worst fears of post earthquake weakness have not been borne out, suggesting that economic expectations have been overly pessimistic. In any case, USD/JPY 80 is still a major line in the sand for the currency pair.

The EUR continues to show impressive resistance, with EUR/USD breaking technical resistance around 1.4345, which opens up a test of 1.4423. Reports that Greece had failed to meet any of its fiscal targets and of harsh conditions set by European officials for further aid have failed to dent the EUR. Whether the market is simply becoming fatigued or complacent will be important to determine if the EUR can gain further.

A report in the WSJ that Germany is considering dropping its push for early rescheduling of Greek debt has given some support to the EUR too. Ongoing discussions this week are unlikely to prove conclusive however, with attention turning to meetings of European officials on 20th and 24th June. I still believe EUR gains will limited, with the break above 1.4345 likely to prove shortlived.

Capital Flowing Out of Europe

When investors’ concerns shift from how low will the EUR go to whether the currency will even exist in its current form, it is blatantly evident that there is a very long way to go to solve the eurozone’s many and varied problems. As many analysts scramble to revise forecasts to catch up with the declining EUR, the question of the long term future of the single currency has become the bigger issue. Although the EUR 750 billion support package was hailed by EU leaders as the means to prevent further damage to the credibility of the EUR, it has failed to prevent a further decline, but instead revealed even deeper splits amongst eurozone countries.

Although the European Central Bank (ECB) confirmed that it bought EUR 16.5 billion in eurozone government bonds in just over a week, with the buying providing major prop to the market, private buyers remain reluctant to renter the market. As a result of the ECB’s sterilised interventions bond markets have stabilised but the EUR is now taking the brunt of the pressure, a reversal of the situation at the beginning of the Greek crisis, when the EUR proved to be far more resilient. Reports that some large institutional investors have exited from Greek and Portuguese debt markets whilst others are positioning for a eurozone without Greece, Portugal and Spain, suggest that the ECB may have taken on more than it has bargained for in its attempts to prop up peripheral eurozone bond markets.

As was evident in the US March Treasury TICS report it appears that a lot of the outflows from Europe are finding their way into US markets. The data revealed that net long-term TIC flows (net US securities purchases by foreign investors) surged to $140.5 billion in March. The bulk of this flow consisted of safe haven buying of US Treasuries ($108.5 billion), although it was notable that securities flows into other asset classes were also strong especially agencies and corporate bonds, which recorded their biggest capital inflow since May 2008. Asian central banks also reversed their net selling of US Treasuries, with China investing the most into Treasuries since September 2009. Anecdotal evidence corroborates this, with central banks in Asia diversifying far less than they were just a few months ago.

This reversal of flows is unlikely to stop anytime soon. It is clear that enhanced austerity measures in the eurozone will result in weaker growth and earnings potential. This will play negatively on the EUR especially given expectations of a superior growth and earnings profile in the US. Evidence of implementation, action and a measure of success on the fiscal front will be necessary to begin the likely long process of turning confidence in the EUR around. This will likely take a long time to be forthcoming. EUR/USD has managed to recover after hitting a low of around 1.2235 but remains vulnerable to further weakness. The big psychological barrier of 1.20 looms followed by the EUR launch rate of around 1.1830.

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