FX Markets Are Exhausted

Over the past month we have seen some extensive moves in the financial markets. The dollar index rose to its highest level in more than 2 years, the S&P 500 hit a record high and U.S. 10 year Treasuries dropped to their lowest level in over a year.

When we have moves as strong as the ones that we have seen in recent weeks, exhaustion will eventually set in and that is what we saw yesterday during the U.S. session. While currencies, equities and bonds all reacted in a way that is consistent with profit taking, the comments from Fed President and FOMC voter Rosengren had an impact on some markets and not others.

No major U.S. economic reports were released yesterday so the focus was Rosengren. As one of the more dovish members of the central bank, his comment that a modest reduction in asset purchases may make sense in a few months time represents a notable shift in view that suggests he would support tapering bond purchases in September. While he added that the decision would hinge upon further improvements in the labor market and the overall economy, he also indicated that he expects a recovery over the next few months.

As these views are consistent with recent comments from Bernanke and Dudley, the consensus is clearly building for an adjustment in monetary policy. The Fed isn’t in a rush to act, but September is the perfect time because Bernanke has a press conference scheduled that would give him the opportunity to manage expectations and explain their decision. The dollar should have rallied in response and it did, but the gains were modest. Equities reacted appropriately by selling off, bond yields did not rise – a sign that exhaustion overshadowed the Fed’s comments.

The second release of first quarter U.S. GDP is expected later today, but no revisions are anticipated. This leaves the focus on jobless claims and pending home sales. Economists are not looking for significant changes but claims can be volatile. There was only one piece of U.S. data released yesterday and that was the International Council of Shopping Centers’ weekly chain store sales report, which found spending dropped 0.9% in the week of May 25th after rising 0.2% the prior week.

For USD/JPY 100.65 is support and for the EUR/USD, 1.30 is resistance.

EUR Immune to Weaker German Data and OECD Forecasts

The euro traded higher against the U.S. dollar yesterday but the rally stalled below 1.30. Considering the steep slide in European equities and the larger than expected increase in German unemployment, the euro should be trading much lower. However dollar weakness has driven all of the major currencies higher and continued profit taking should lend additional support to the euro.

Still, in the grand scheme of things, the rise in German unemployment and the OECD’s grim forecast leaves the ECB in a position to ease and while the bar may be high, they may not be shy about publicizing their options. The OECD called on the European Central Bank to cut their deposit rate and consider Quantitative Easing. They believe that the central bank’s OMT program has achieved a lot but more needs to be done.

The agency cut their global growth forecasts to 1.2% this year from a prior forecast of 1.4%. Their concern centers on the high level of unemployment in Europe and the negative impact of continued fiscal reform.

As such, they expect the Eurozone economy to contract by 0.6% this year and expand by 1.1% in 2014. In contrast, U.S. GDP growth is expected to increase 1.9% in 2013 and 2.8% next year. Eurozone confidence numbers are scheduled for release today and based on the uptick in the IFO and PMIs, there is scope for an upside surprise.

Meanwhile, the Swiss franc was the biggest mover yesterday, falling more than 1.5% against the U.S. dollar and over 0.8% against the EUR. According to UBS, consumption increased in the month of April. First quarter GDP numbers are scheduled for release today and we are skeptical about whether the gains in the Swissie can be sustained considering that retail sales and trade activity weakened in the first 3 months of the year.

JPY Soars on USD/JPY Unwind, MoF Data on Tap

The unwind of USD/JPY long positions drove the Japanese yen higher against all of the major currencies. The lack of big moves overnight in the Nikkei and JGB tell us that U.S. and not Japanese fundamentals are behind the sell-off in USD/JPY.

That may change however, as Japanese investors respond to the decline in U.S. stocks and domestic data. The Nikkei was unchanged but futures are pointing to a significantly lower open today that could drag USD/JPY to 2 week lows.

The next focus will be on the Ministry of Finance’s weekly flow of funds report. Last week’s report showed Japanese investors selling more than 800 billion yen worth of foreign bonds which offset all of the buying seen over the past few weeks. If this week’s report shows additional selling, USD/JPY will be in trouble because purchases of foreign bonds are essential for a continued rally in USD/JPY. Eventually, it will become hard for Japanese investors to ignore the 2% yield offered by U.S. 10 year Treasuries but we may have to wait longer for demand to respond.

Yesterday’s Japanese economic reports were mixed. While consumer spending increased 0.7% in April, sales at large retailers dropped 2.3%. BoJ Governor Kuroda did not make any market moving comments but an unnamed senior BoJ official was quoted saying that the central bank is prepared to increase the frequency of JGB purchases which could be an option if yields rise excessively.

CAD – No Surprises from BoC, Slight Optimism on Economy

The Canadian, Australian and New Zealand dollars rebounded against the greenback yesterday but not before the AUD sank to fresh 19 month lows. Even after yesterday’s recovery, both the CAD and AUD remain in a downtrend.

NZD is trying to bottom but after the RBNZ’s comments, we think further losses are likely. RBNZ Governor Wheeler said the central bank has been trying to dampen spikes in the exchange rate, which they feel is overvalued and they are prepared to scale up currency activities if necessary. This threat to intervene should cap gains in the NZD in the near term.

Meanwhile, the Bank of Canada left interest rates unchanged yesterday at 1%. This was the final Canadian monetary policy meeting for Mark Carney and as such, the forward-looking statement was virtually untouched. The BoC felt that:

“...with continued slack in the Canadian economy, the muted outlook for inflation, and the constructive evolution of imbalances in the household sector, the considerable monetary stimulus currently in place will likely remain appropriate for a period of time, after which some modest withdrawal will likely be required, consistent with the 2 per cent inflation target.”

On the economy, they said: “recent economic indicators suggest that growth in the first quarter was stronger that the Bank projected in April” which is consistent with the rebound in the labor market and the improvements in the U.S. economy. The AUD also shrugged off slower leading indicator growth. Building approvals are scheduled for release today, followed by Canadian current account figures later on Thursday. Neither of these reports are expected to be big market movers for the AUD and CAD which will most likely trade on U.S. dollar appetite.

GBP – Shrugs Off Dovish MPC Comments and Weaker Data

While the British pound held steady against the EUR, it traded higher versus the greenback. Sterling completely ignored the steep decline in the CBI reported sales index and the dovish comments from Bank of England policymaker Bean and extended higher on dollar weakness.

According to the Confederation of British Industry, retail sales dropped the most in 16 months as their retail trade index sank from -1 to -11. Economists had actually hoped for an improvement but slowing demand for food and drink caused the index to drop for the sixth straight month.

The inherent problem is weak wage growth and high energy costs and until the labor market improves, consumption may have a tough time recovering. The CBI index is not a closely watched measure but it has a relatively good correlation with the government’s official retail sales report. The latest deterioration is extremely worrisome as it suggests that spending continued to weaken, which if continued would weigh on second quarter GDP growth.

The comments from MPC member Charles Bean suggest that he shares our concerns. He said exports have been disappointing and high debt levels act as a drag on growth. He also felt that monetary policy can be a backstop for stability which suggests that he supports additional easing.