Rocky Road

Despite the rally in US stocks on Friday, led by the technology sector, US stocks have fallen for four straight weeks.  The jury is still out on whether equities and risk assets in general can rally in the face of a host of uncertainties in the weeks ahead including the potential for a contested US election, fading US economic momentum, lack of progress on “Phase 4” US fiscal stimulus and a resurgence in virus cases globally.  What is clear, is that the road ahead is a rocky one, reflected in the fact that equity volatility (VIX) remains elevated and G10 FX options implied volatility around the time of the US election has spiked. 

One of the main beneficiaries of this uncertainty has been the US dollar lately, much to the detriment of precious metals given their strong inverse correlation.  It wasn’t that long ago that most commentators were writing off the USDs prospects and it’s still not clear that its recovery can persist.  The USD has hit its highest level in 2 months but will likely struggle if equities can eke out further gains in the days ahead.  In contrast, gold is trading around its lowest levels in 2 months.  While these trends may persist in the very short term, technical indicators (eg Relative Strength Index) indicate approaching overbought USD and oversold gold levels. 

This week, the main focus will be on the first US Presidential debate on Tuesday and US September jobs report at the end of the week.  While the US jobs report will likely show a relatively strong (when compared to pre-covid levels) increase in hiring (consensus around 900k), the pace of hiring is likely to slow and employment is still likely to be at least 11 million lower compared to February.  The battle for the new US Supreme Court Justice adds another twist, with President Trump announcing the nomination of Amy Coney Barrett and the Senate moving ahead to vote on this nomination this side of the election.  This has changed the dynamics ahead of the election battle, energizing voters on both sides. 

In Asia, China’s September purchasing managers indices (PMIs) and monetary policy decisions in India and Philippines will garner most attention this week.  China’s economy is emerging from the Covid crisis in good shape, helped by resilient exports performance, with medical goods and electronics exports performing particularly well.  This is likely to be reflected in China’s PMIs this week, which are set to remain in expansion territory. Meanwhile US government pressure on Chinese technology companies continues to rise, with the US government reportedly sanctioning China’s biggest chipmaker, SMIC.  This may draw a retaliatory response from China, such as adding US companies to China’s “unreliable entities” list.  

India’s Reserve Bank of India (RBI) monetary policy decision is likely to result in an unchanged outcome on Thursday.  While growth has been hit badly due to Covid-19, inflation has also spiked to well above the RBI’s target, leaving the central bank in a difficult position on policy.  Ultimately the RBI will have to ease monetary policy further, but it is unlikely to do so at its meeting on Thursday.  India’s economy is fast heading for a double-digit plunge in growth this year and unfortunately virus cases remain at very high levels.  The rupee has been resilient, however, and is unlikely to weak much further in the short term, even as the economy softens. 

Waiting for a solution to Europe’s crisis

The boost to sentiment following Germany’s approval of changes to the EFSF bailout fund was brief. Although the outcome of the vote was not particularly surprising political concerns were assuaged by the fact that Chancellor Merkel secured support from within her coalition. Markets were also helped by a bigger than expected drop in weekly US jobless claims but this also failed to provide a lasting impact.

The bottom line is that there is still a huge degree of scepticism on the ability of policymakers to resolve the crisis in the eurozone periphery while growth worries have not receded. Even the approved changed to the EFSF bailout fund are increasingly being seen as old news given the view that it will need deeper changes including ‘leveraging’ it up.

Consequently risk aversion remains at a highly elevated level and is showing no sign of easing. It may be difficult to turn sentiment around as we go into the final quarter of the year, especially as those investors registering profits for the year may want to capitalise on these profits rather than sit through continued volatility in the weeks ahead. Indeed the sharp drop in gold prices over the last couple of weeks even in an environment of elevated risk aversion may reflect this.

Similarly risk assets may struggle to recover over coming weeks unless there is a major improvement in the situation in Europe or in growth data. Markets will go into the end of this week looking ahead to key events next week including an Ecofin meeting at the beginning of next week, a European Central Bank (ECB) meeting and the US September jobs report.

There will be plenty of attention on the Ecofin meeting of European Finance Ministers on Monday especially given that much of the reason for the stability in markets recently is the hope of concrete measures to resolve the crisis in the region. In this respect the scope for disappointment is high, suggesting that the EUR is vulnerable to a further drop.

While the extent of short market positioning at the beginning of week left open some scope for EUR short covering the absence of any good news will mean the impetus for short covering diminishes. Unless the Ecofin meeting delivers on expectations EUR/USD will likely re-test the 26 September low around 1.3363.

Japan FX Measures Underwhelm

Currencies continue to show remarkable stability in the face of elevated risk aversion which has prompted huge volatility in other asset markets. Although FX volatility has risen over recent weeks its rise is nothing compared to the jump in the VIX ‘fear gauge’ equity volatility measure. FX markets are in some form of limbo where there are conflicting forces at play and where there is no obvious currency to play. The lack of clarity in markets suggests that this situation will not change quickly.

The USD (index) is trading at the lower end of its recent ranges and verging on a retest of its July 27 low around 73.421, with the currency perhaps suffering from expectations that Fed Chairman Bernanke will announce a desire to embark on more quantitative easing at Friday’s Jackson Hole symposium. Its losses could quickly reverse as such expectations are quickly dashed.

Indeed, while Bernanke will likely keep all options open any hint at QE3 is unlikely as the Fed maintains a high hurdle before any prospect of further quantitative easing is entertained. One option on the table is ‘sterilised’ large scale asset purchases which would not result in an increase in the size of the Fed’s balance sheet. This would be far less negative for the USD than a fresh round of QE and may even prompt a rally in the currency as markets shift away from the idea of QE3.

The USD will benefit from high risk aversion except against safe havens such as the CHF and JPY. In this respect the USD remains a better bet than the EUR which has failed to garner much benefit from renewed ECB peripheral bond buying. Nonetheless, data yesterday failed to feed into negative EUR sentiment despite mixed manufacturing surveys and a sharp drop in the German ZEW investor confidence survey. EUR/USD remains trapped in a broad 1.42-1.45 range.

News that Moody’s ratings agency has downgraded Japan’s sovereign ratings by one notch to Aa3 is unlikely to have much impact on the JPY. Moody’s left the outlook stable while unlike the US and Europe around 95% of Japanese debt is held domestically, suggesting little FX and JGB impact. USD/JPY continues to garner some influence from yield differentials and given that the US bond yield advantage versus Japan has continued to narrow, USD/JPY continues to face downward pressure.

Japan announced measures to deal with JPY strength including the creation of a $100 billion emergency credit facility. However, the main impact on the JPY could come from increased monitoring of FX transactions with firms having to report on FX positions held by dealers. The statement made no comment on FX intervention and this is where there will be most disappointment for JPY bears. Overall, the actions are somewhat underwhelming and are unlikely to have much impact on the JPY. If anything, the JPY may actually strengthen given the lack of comment on FX intervention. USD/JPY downside could face strong technical support around 75.93, however.

US Ratings Under Threat

The USD succumbed to further pressure overnight as Moody’s Investor Service threatened to place the US Aaa rating on review for downgrade if there is no agreement reached on raising the US debt ceiling. Although the news prompted a rise in US Treasury yields it did little for the USD.

News that the Federal Reserve’s balance sheet expanded to a record $2.772 trillion in the week ending June 1 highlights the ongoing headwinds to the USD from Fed asset purchases. The fact that there is even talk of QE3 in the wake of weak US data suggests that the headwinds will not dissipate quickly.

Direction today will come from the US May jobs report though this is unlikely to deliver any good news for the USD. Forecasts for non-farm payrolls have likely been revised lower to sub 100k compared to the published consensus forecast of 165k following the weaker indications from the May ADP jobs report and ISM data this week. A weak payrolls outcome will only intensify worries about the depth and length of the US ‘soft patch’.

Although market expectations are also likely to have been downwardly revised, something that may cushion the blow to the USD, it will be difficult to get away from the fact that growth in Q2 is weaker than many had thought.

EUR was well supported overnight, boosted by a relatively successful Spanish bond auction yesterday and reports that officials have agreed in principle to a 3-year adjustment plan for Greece covering funding needs to 2013 although there was no confirmation of such an agreement.

As a result, EUR/USD tested 1.45 and looks supported ahead of today’s US payrolls data. EUR’s recovery in general has been impressive but gains above 1.45 are likely to prove more difficult even if an agreement on Greece is close to being achieved.

As usual Japan’s political gyrations are having little impact on the JPY as the currency is instead buffeted by risk aversion swings and yield differentials. In fact USD/JPY has been rather well behaved over recent weeks as indicated by implied options volatility.

Prime Minister Kan’s success in winning a no-confidence motion came at a cost and may provide very little political stability. Kan said will resign as soon as post-earthquake recovery efforts are completed and once he is gone there is likely to be some realignment of existing political parties.

As for the JPY it will remain unscathed by political events. Over the near term USD/JPY is likely to cling to the 81 handle but we maintain our bearish view on the JPY in the medium term under the assumption that there is a sharp widening in US – Japan bond yield differentials.

G7 Intervention Hits Japanese Yen

One could imagine that it was not difficult for Japan to garner G7 support for joint intervention in currency markets given the terrible disaster that has hit the country. Given expectations of huge repatriation flows into Japan and a possible surge in the JPY Japanese and G7 officials want to ensure currency stability and lower volatility. Moreover, as noted in the G7 statement today officials wanted to show their solidarity with Japan, with intervention just one means of showing such support.

Although Japanese Finance Minister Noda stated that officials are not targeting specific levels, the psychologically important level of 80.00 will likely stick out as a key level to defend. Note that the last intervention took place on 15 September 2010 around 83.00 and USD/JPY was trading below this level even before the earthquake struck. The amount of intervention then was around JPY 2.1 trillion and at least this amount was utilised today. The last joint G7 intervention took place in September 2000.

Unlike the one off FX intervention in September 2010, further intervention is likely over coming days and weeks by Japan and the Federal Reserve, Bank of France, Bundesbank, Bank of England, Bank of Canada and other G7 nations. The timing of the move today clearly was aimed at avoiding a further dramatic drop in USD/JPY, with Thursday’s illiquid and stop loss driven drop to around 76.25 adding to the urgency for intervention. USD/JPY will find some resistance around the March high of 83.30, with a break above this level likely to help maintain the upside momentum.

The JPY has become increasingly overvalued over recent years as reflected in a variety of valuation measures. Prior to today’s intervention the JPY was over 40% overvalued against the USD according to the Purchasing Power Parity measure, a much bigger overvaluation than any other Asian and many major currencies. The trade weighted JPY exchange rate has appreciated by around 56% since June 2007. In other words there was plenty of justification for intervention even before the recent post earthquake surge in JPY

Although Japanese exporters had become comfortable with USD/JPY just above the 80 level over recent months, whilst many have significant overseas operations, the reality is that a sustained drop in USD/JPY inflicts significant pain on an economy and many Japanese exporters at a time when export momentum is slowing. Japan’s Cabinet office’s annual survey in March revealed that Japanese companies would remain profitable if USD/JPY is above 86.30. Even at current levels it implies many Japanese companies profits are suffering.

Upward pressure on the JPY will remain in place, suggesting a battle in prospect for the authorities to weaken the currency going forward. Round 1 has gone to the Japanese Ministry of Finance and G7, but there is still a long way to go, with prospects of huge repatriation flows likely to make the task of weakening the JPY a difficult one. The fact that there is joint intervention will ensure some success, however and expect more follow up by other G7 countries today to push the JPY even weaker over the short-term.

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