USD Recovery, Risk Sell-off Likely to Continue

by: Brian Dolan
After consolidating for much of this past week, the USD surged again to finish the week at new recent highs. The gains came in the wake of a disappointing US weekly jobless claims report and a shocking drop in the July Philadelphia Fed Index of local manufacturers, which fell to -7.7 from +5.1 in contrast to forecasts of gain to +7.0. USD strength in the face of weaker US data again illustrates the role of the USD as a safe haven currency. As the US outlook continues to deteriorate it spells bad things for the global growth outlook, undermining confidence and raising risk aversion. On Friday, Bundesbank Pres. Weber added another reminder of the dimming global outlook and latent Eurozone financial sector stress (see more below), sending the EUR sharply lower, but ultimately the USD higher across the board.
Every major asset class is screaming that risk is 'off' and markets are still struggling to play catch up following a sharp reversal just two weeks ago. Major government bonds made new highs/yields new lows as investors continue to seek safety in the most secure investments. Oil prices (WTI) shed nearly 3% as global demand was marked lower and inventories (at least in the US) reached record levels of refined products.
Given what we think is still the initial phase of major markets re-pricing a slower growth outlook, and aided by thinner summer liquidity conditions, we expect recent USD strength to continue, with accompanying declines in commodities and most stock indexes. Our only source of hesitation is that US Treasury yields have dropped to near key 2.50% levels in 10 year notes, and we think that could signal a near-term top for prices/low in yields. While we will continue to watch US rates closely for signs of a base forming, we will still look to re-buy USD on pullbacks, anticipating further gains ahead, especially as there is little reason to expect more positive growth surprises and every reason to plan for further deterioration. Next Friday will see the first revision to 2Q GDP which could see the preliminary 2.4% reading marked down to the 1.5% area. Fed Chairman Bernanke will also speak on the US economic outlook next Friday, and it is difficult to see how he will find much positive to note.
Weber comments soften the euro
The euro softened as ECB Governing Council member and Bundesbank President Axel Weber spoke in Frankfurt Friday, commenting on the ECB’s exit strategy as well as German and Eurozone growth divergences. The comments were viewed as dovish by his standards as he is a known hawk. Weber noted the ‘stellar performance’ by Germany in Q2 pointing to the possibility of 3% growth this year. However, he went on to state that ‘the current momentum is not sustainable’ and that Germany will face ‘weakening momentum ahead, which is in line with the global weakening of momentum’ such as that in the U.S. economy. Weber called on European governments to consolidate budgets and focus on structural reforms at the national level to foster growth to halt the growing divergences between the core and peripheral countries. On the ECB’s exit strategy, he cautioned that it would not be ‘wise to continue with these very long operations’ and that he is firmly of the view to keep full allotment in weekly, monthly, and three-month refinancing operations until after the end of this year. Weber also mentioned that the market is re-pricing sovereign debt in peripheral European countries to find new equilibrium levels that will not be the same as pre-crisis levels. This implies relatively higher sovereign CDS, a trend we have seen in recent weeks.
The comments by the potential-future ECB President sent the euro lower and EUR/USD broke through key technical levels to signal further downside potential. A rising support line that starts from the 2010 lows of June 7 and the 100-day simple moving average was violated on Friday with the pair trading below 1.2750. Thursday’s price action saw a bearish crossover as the daily Tenkan line crossed under the Kijun line. EUR/USD now faces near term support into its 55-day sma and Ichimoku cloud top which come in around 1.2635-1.2665 area. A sustained move below here sees the next significant level of support between 1.2450-1.2500 where the cloud base and 61.8% retracement of the June-August rally comes in. Several failed attempts above 1.2900-1.2930 this past week bring this level in focus as resistance and should cap a move higher in EUR/USD.
Australian election this weekend
The Australian Federal election was held this weekend. Typically, national elections have a minimal effect on the Australian Dollar. However, the closeness of the election, as well as the Minerals Resource Rent Tax (MRRT) is a topic of great debate. Prime Minister Julia Gillard recently compromised with Mining Companies and agreed to a 30% MMRT on coal and iron ore. This tax gained support from two of the three independent parties, while the Liberal-National Party is seeking to repeal the MRRT altogether. The adoption of the tax is considered an AUD-negative, as it may see reduced investment, while the rejection of the tax is mostly considered an AUD-positive.
Of the potential scenarios and outcomes for the AUD, in our opinion the market has slowly positioned for a hung parliament, therefore an outright victory by either major party would likely benefit the Aussie (a gain of 75 to 100 pips).
A hung parliament elevates uncertainty and would be a short term negative for the AUD (a loss of 50 to 75 pips). The longer it takes for a clear result for any new government, the more negative it's likely to be for AUD (loss of 75 to 100 pips). However, the negative impact could be relatively short-lived because minority parties have previously indicated they’re willing to work with either party to establish a coalition government.
JPY strength may demand government action
USD/JPY tested 15-year lows this week in the 84.70/80 area and so far it has managed to hold. In recent weeks, we have cautioned about the increasing potential for some form of official intervention to limit further JPY gains, whether it be renewed unconventional easing from the BOJ, market intervention from the MOF, or additional fiscal stimulus measures from the government. A much anticipated meeting between PM Kan and BOJ chief Shirakawa was postponed at the end of the week, suggesting there is still no immediate consensus on who should act and what measures might be adopted. In the meantime, semi-official buying interest appears to be stemming the decline in USD/JPY and we would expect that to continue until a larger policy response is agreed on. We are also mindful of a one-way mentality that has settled into currency markets, where the only way for the JPY is higher. Additionally, we would note a potential 'descending wedge' pattern in spot USD/JPY and think the environment is ripe for an unexpected rebound in USD/JPY, likely in response to some new QE policy initiative. A sharp correction higher in USD/JPY would also fit with our expectations of a stronger USD overall, and we would be reluctant to hold USD/JPY shorts for much past the 86.50 area.
Key data and events to watch next week
US data kicks off the week ahead with July Existing Home Sales and the August Richmond Fed Manufacturing Index on Tuesday. Wednesday sees July Durable Goods Orders and July New Homes Sales followed by Initial Jobless Claims on Thursday. The weekly data session comes to a close on Friday with Q2 Personal Consumption and the much anticipated Q2 GDP Second Estimate. Also of note Friday is Fed Chairman Bernanke’s speech on the ‘The Economic Outlook and the Federal Reserve’s Policy Response’ at the Kansas City branch’s annual symposium in Jackson Hole.
Euro-zone data starts off Monday with the August Composite, Manufacturing, and Services PMI followed by August EZ Consumer Confidence. Tuesday sees June Industrial New Orders and Thursday wraps up the week with the July EZ M3 annual growth rate. Monday begins a busy week of German data with August Manufacturing and Services PMI and Final Q2 GDP to follow on Tuesday. Wednesday sees August IFO Business Climate Index and Friday wraps up with August Consumer Price Index.
UK data sees BBA July mortgage lending data on Monday. There's no further UK data until Thursday's CBI retail distributive trades survey for August. Friday sees the first revision of Q2 GDP and private consumption.
Data out of Tokyo kicks off with July Merchandise Trade Balance on Tuesday. Wednesday sees July Jobless Rate and Job-to-Applicant Ratio. Thursday wraps up the data session with August Tokyo CPI and August Nationwide CPI. Although a light week of Japanese data, significant event risk lies ahead with rumors of FX intervention and an unconfirmed but possible meeting on Monday between BOJ Governor Shirakawa and Prime Minister Kan.
The only significant data release out of Canada is June Retail Sales on Tuesday but will also see Bank of Canada’s Murray speak on Canada’s inflation target in Kingston.
A light calendar down under begins with Q2 Construction Work Done on Tuesday and wraps up Wednesday with Q2 Private Capital Expenditure. Of particular note is the Saturday August 21st Australian federal election.
Data out of China sees July Leading Index released sometime between August 22nd and 26th.
Disclosure: No Positions