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The unwinding of the recent risk-on plays continues today, sparked by three factors. First, another month with the Chinese PMI (HSBC flash) below the 50 boom/bust level at 47.8 (up marginally from the previous 47.6), allows anxiety to continue to run high about the kind of landing the world's second largest economy is having. Second, the euro zone flash PMI was disappointing. Third, the well received Spanish 3- and 10-year bond auctions today are seen as delaying what is now thought of as nearly inevitable formal request for aid, and this appears to be weighing on Spanish bond prices.

While we have generally been anticipating the dollar to bottom, we are not yet convinced this is it. So far the bounce is marginal at best, barely approaching the minimum technical retracements. We identified the Canadian dollar and the Australian dollar as the most vulnerable, We remain impressed with the resilience of the British pound, which is trading at pixel time about a quarter of a cent below last week's closing price. The UK retail sales and CBI industrial trends were in line with expectations today or slightly stronger, but did not seem to prompt much of a market reaction.

The euro area flash PMI is poor and the details even worse. The continued weak data can only raise expectations that with the OMT waiting for a formal request (hello, Mr. Rajoy?), the ECB will turn its attention to the transmission mechanism, and deliver another cut in the refi rate to 50 bp from 75 bp. The euro area September flash composite came in at 45.9 from 46.3 in August. The German data looked better with the manufacturing PMI risen to 47.3, a six-month high and the service PMI bounced back above 50 to 50.6 from 48.3.

While there is no doubt that the German economy remains generally resilient, the details were soft including new business and staffing levels. France's report, on the other hand, was simply dreadful. The flash manufacturing PMI fell to a 3.5-year low of 42.6 from 46.0. The service PMI fell to a 4-month low of 46.1 from 49.2. The details were even worse, with a decline in employment and business expectations.

The euro, which was already trading heavily, though within last Friday's trading range, broke down. Yesterday it briefly dipped through the $1.30 level, and while it finished the North American session above there, it did close below its 5-day moving average for the first time since August 30.

A break of the $1.2900-20 area would strengthen ideas that important top is in place. The price action is broadly consistent with what we saw following the announcement of QE2 back in November 2010, where the dollar weakened initially and then recovered smartly.

The yen weakened after the BOJ's extension of its QE back in April, but we argued at the time and still think it offers the better explanation, that the yen's drop then was partly a function of the risk-on that followed the second LTRO. Even if the objective of the BOJ's moves yesterday were not directed simply at the yen's strength, Japanese officials must be disappointed with the market reaction. The dollar is back to the lower end of its range near JPY78 after having traded above JPY79 yesterday, albeit briefly.

If the risk-off forces gain the upper hand here, the yen may strengthen further, not just against the dollar, but against the euro and other crosses as well. Japan did report a slightly smaller than expected trade deficit for the month of August, but on a seasonally adjusted basis was worse than expected and about a quarter larger than the July deficit. Of particular note, exports fell 5.8% on a year-over-year basis, the third consecutive decline. Lower oil prices helped imports decline the most in 2.5 years (-5.4%).

Exports to China and the EU are off a little more than 28% on a year-over-year basis. Exports to the US are up 10.3%. The data increases the risk that the Japanese economy is contracting here in the July-September quarter. Separately, note that Japan's flow of funds report showed that foreign holdings of JGBs reached a record high in Q2 and, at JPY8 trillion, account for 8.7% of the outstanding JGBs.

Source: Unwinding Of Risk-On Continues