Dollar Slips While Bond Market Rally Continues

The dollar is trading a little below levels seen in late North American session yesterday, but that is after it initially extended its gains in Asia. The news stream is light, and unlike yesterday, there is no US economic data outside of the MBA's mortgage application report.

Despite the minor dollar setback today, the uptrend remains intact. There still is a strong bias toward buying dollar dips. The euro has not been able to move back into last week's ranges. At the end of last week, it made a low of $1.3221, according to Bloomberg. Sterling broke below $1.66 on August 21 and attempts to resurface it have been stymied for the past several sessions. Against the yen, the dollar rose to almost JPY104.20 at the end of last week and continues to knock against it now. Support is pegged in the JPY103.50-75 area.

The dollar-bloc is faring a bit better. The US Dollar has been probing resistance near CAD1.10 over the last several sessions, and it reversed lower yesterday. Today the greenback has been pushed below CAD1.09 for the first time in five sessions. Canada reports Q2 GDP at the end of the week, and the consensus expectation appears to have crept up to 2.7% after a 1.2% pace in Q1. The Bank of Canada meets on September 3. Its rhetoric is expected to recognize the reduction of the downside risks of inflation and the better growth domestically as well as its dominant trading partner.

The Australian Dollar is trading in narrow ranges, but firmly so. Dips below $0.9300 have been bought in recent days. Last week it was turned back from its 100-day moving average, but approaching it again (~$0.9342).

Here in August, there are only three major currencies that have gained against the dollar. The Norwegian krone is the strongest, up 1.8%. It has been bolstered by economic data that has squashed any lingering ideas that the Norges Bank needs to cut interest rates. The other two currencies that have appreciated are the Australian dollar (0.4%) and now the Canadian dollar (0.1%).

The New Zealand dollar is off 1.5% this month, and that reflects the almost 0.5% gain today. Today's upticks have been sparked by the news from Fonterra that it is leaving the 2014/2015 payout to farmers unchanged at NZ$6.00 per kg of milk.. There has been strong downward pressure on milk prices, and many had expected a further decline.

Some observers are linking the yen's weakness to the dollar-blocs strength. Eureka: It must be an expression of carry trade strategies. We are less sanguine. First, we suspect that to the extent that there are significant flows, it is more about momentum than carry. Second, we think that focusing on the yen as a funding currency distracts us from what is more important development: the use of the euro (and to a lesser extent, the Swiss franc) as a funding currency.

Moreover, the key driver now is not about the yen and the aggressive BOJ policy, but about the prospects that the ECB can take additional measures next week. Draghi's comments at Jackson Hole last week, and expectations that this week' preliminary CPI data will show a further decline, has spurred speculation that the ECB will not wait for the TLTROs, or the impact of the June rate cuts to be fully transmitted, before taking fresh action. A larger than expected decline Geman import prices, reported today, only add to the deflationary worries. Some observers are even playing up the risk of the initiation of the long-awaited ABS purchase scheme.

The rally in the European bonds is arguably the most significant development in the capital markets. Benchmark 10-Year bond yields are making new record lows today, but consider the magnitude of the move this week. Italy, Spain and Portugal have seen their yields fall 20, 28 and 23 basis points respectively.

The 10-Year German bund yield has fallen almost 7 bp to near 90 bp. German yields are negative going out four years. This is stark. Not even Switzerland is close to this. As we have noted, the Swiss 10-Year yield has fallen below Japan's. Only Switzerland's 2-Year generic yield is below zero. Despite the turmoil in French politics, the French premium over Germany has narrowed 6 bp this week. The premium has shrunk to almost its lowest level in four years. And this, even though the French budget deficit is likely to overshoot its relaxed target.