A Hard Look At Global Currency

After falling to a fresh two-year low of 1.2235 at the start of the Asian trading session, the euro clawed back into positive territory to end the day slightly higher against the U.S. dollar. It was a quiet day in terms of volatility in currencies but the rebound in the EUR/USD is at odds with the further sell-off in equities and the rise in Spanish and Italian bond yields. It appears that even though European Finance Ministers met today to talk about Spain's bank bailout program and to hash out the details on some of the decisions made at the EU Summit, euro traders have completely taken their eyes off European bond yields. In our opinion, this is a dangerous mistake because rising borrowing costs is the source of Europe's problems. Spanish 10-year bond yields are within 2bp of 7% while Italian bond yields are within 12bp of its record high of 6.18%. The recent interest-rate cut by the ECB should have driven all European bond yields lower and while German yields responded accordingly, the move by the ECB did not bring much relief to the countries that need it the most.
 
More trouble is in store for Spain if yields do not decline. No one can afford the consequences of a Spain sovereign bailout, which is why today's discussions at the meeting of Eurozone finance ministers centered on the possibility of granting Spain an extra year to meet its deficit targets if the country commits to further austerity measures. Last week Spanish Prime Minister Rajoy hinted at a third round of austerity that could involve cuts in government spending and a higher value added tax. These steps will certainly be politically unpopular and could trigger more protests, but is needed to avoid a full sovereign bailout. EU Finance Ministers are expected to make an announcement Tuesday that includes relaxing Spain's 2012 deficit target to 6.3% instead of 5.3% of GDP. In terms of Spain's bank bailout, in return for the EUR 100 billion in aid, the Spanish government has agreed to create a "bad bank" to house all the toxic assets and to force the banks to raise their core tier-1 capital of healthy assets to 9%. While all of this is good news for Spain's fiscal finances and reduces the risk of a full sovereign bailout, the rise in Spanish bonds yields tell us investors are not impressed. A memorandum of understanding is expected to be signed before the end of the Finance Ministers' meeting followed by a loan agreement on July 20th. If Spanish bond yields refuse to budge from now until then, the "rumors" of a new emergency summit could become a reality. With European officials so sensitive to Spanish and Italian yields, ignoring the recent increase could turn out to be a big mistake.The lack of major Eurozone economic reports on the calendar tomorrow means that the euro area Finance Ministers meeting will remain the market's number one focus.

USD: Definitely No Recession According To Fed President Williams
The U.S. dollar either held steady or traded slightly lower against all of the major currencies. Friday's softer nonfarm payrolls report still has the market divided on the possibility of QE3. With no major U.S. economic releases until Wednesday, there is very little for the dollar to key off of outside of risk appetite. According to Federal Reserve President Williams who is a voting member of the FOMC this year, growth "is a little weaker than we thought and more stimulus could be needed if the economy meets his (pessimistic) forecast."  While he "definitely" doesn't expect a recession, the "June jobs report was one signal of loss of momentum" in the U.S. economy. As a result, Williams favors varying bond purchases as the economy changes because he believes that buying mortgage-backed securities is more effective at this point than buying Treasuries. He also repeated the Fed's pledge that they " stand ready to do what is necessary to attain our goals of maximum employment and price stability." As one of the more moderate members of the FOMC, Williams dovish monetary policy stance certainly adds to the argument that QE3 is on the table. The NFIB Small Business Optimism index, the IBD/TIPP Economic Optimism index and the JOLTS job openings report are the only pieces of U.S. data on the calendar Tuesday. We always like to watch the IBD reading of consumer confidence because it can be a reliable leading indicator for the more closely watched University of Michigan Consumer Confidence index scheduled for release on Friday.
 
GBP Shrugs Off Dovish Comments From Posen
Like the euro, the British pound ended the North American trading session slightly higher against the U.S. dollar. While there was no U.K. economic reports released this morning, Bank of England monetary policy committee member Adam Posen's pessimistic comments about the U.K. economy and banking system suggests that he has continued to favor easy monetary policy. According to Posen, the lack of demand poses big problems for the U.K. economy and the banking sector "isn't working well."  He believes that the BoE "got it right by not overreacting to inflation."  Posen has long been one of the most dovish members of the central bank and, for this reason, his pessimistic comments reveal nothing new about the BoE's overall view on monetary policy. In all likelihood, Posen will favor continued easing but the sentiment of his more neutral counterparts will be far more important. Unfortunately we won't know further details until the BoE releases the minutes from this meeting a few weeks from now. The next 24 hours will be busier for sterling with house prices, sales, industrial production and trade balance scheduled for release.
 
AUD: All About China
The Canadian dollar ended the day unchanged against the greenback while the Australian and New Zealand dollars trended lower. A few pieces of ancillary economic reports were released from the commodity-producing countries but they had very little effect on their currencies. The same was true for commodity prices, which ended the day slightly higher. For commodity currencies, the big focus this week is Chinese data. We will learn a lot about how the Chinese economy is performing this week and will get a sense of how deep the slowdown has been in the Chinese economy.  Last night, we learned that inflationary pressures in China eased in the month of June. This should not be a big surprise because it is consistent with the decline in global inflationary pressures that has been caused by weaker demand and lower commodity prices. Nonetheless, it is worth mentioning that consumer price growth fell to a 2-year low while producer prices extended deeper into negative territory. The decline in price pressures reflects a decline in demand and provides a bit of explanation for why the People's Bank of China surprised the market with a rate cut last week. Now the focus will be on Chinese trade numbers. While the nation's surplus is expected to grow, the level of export growth will be most important. If exports slow significantly, then we have the case for another rate cut from the PBoC this year. Commodity-producing countries live and die by demand from China and for Australia, which will release business confidence numbers this evening. The pace of growth in their number one trading partner will be extremely important because what is bad for China will be bad for Australia and New Zealand.
 
JPY: Data Points To Renewed Weakness In Japan
The Japanese Yen weakened against the British pound, euro and Swiss Franc and remained flat against the U.S., Canadian, Australian and New Zealand dollars. Japan released its data for machine orders, current account and trade balance overnight. Machine orders plunged the most since 2001, falling 14.8%. Current account numbers were also very disappointing with the deficit at its highest levels since May 1985. The country's trade position has weakened materially due to the rising energy imports after last year's earthquake. Prime Minister Yoshihiko Noda approved the restart of nuclear plants, which resumed last week, to avoid power shortages and rolling blackouts this summer as the use of electricity increases this time of year. The trade balance also showed a higher deficit of 848.2 billion from 463.9 billion. This deterioration in trade contradicts with the Bank of Japan's decision to raise its economic assessment for all 9 regions for the first time since 2009 last week. It cited improvements in consumer spending and higher consumer demand as they repair damages from last year's earthquake. Most regions noted that their economies were experiencing moderate recovery, although some were experiencing pauses with some signs of pick up. BoJ Governor Masaaki Shirakawa said last week that the economy is improving and pledged to set the appropriate policy as the bank agreed on powerful monetary easing. The bank will review its forecast for growth and inflation for 2012 and 2013 at its next meeting on Thursday, July 12. It will be interesting to see how BoJ will adapt to the nation's deficit and trade balance. The Ministry of Finance is returning from its hiatus after many members of the Democratic Party of Japan resigned in revolt to Noda's tax consumption bill being passed through the lower half of Parliament. Noda's administration and the Ministry may be increasingly cautious about yen appreciation. Data expected for Tuesday include consumer confidence and the tertiary industry index.