So far this summer the U.S. dollar has shown some broad based strength and is currently clinging to some gains made in the last week against most other majors. USD strength isn’t because of love for the USD, but rather because of bad data elsewhere and the resulting implications around of the timing a Fed rate hike. The U.S. 2-year government bond has been relatively steady even as central banks show signs of policy divergence from their highly accommodative monetary stance, but biases are evolving in different directions. If you are confused, you are not alone. As Market News wrote, “Anyone who claims to know what is going on is lying.” Illustrating the very short sighted nature of most FX trading and commentary, Market News went on to point out, “Price action [In the FX Market] is based on the latest flow and not necessarily on any well thought-out plan or strategy.” I fully agree, and this is a topic that deserves much more discussion. Another time…
Back to the US Dollar, in order for it to benefit in a more lasting way from the positive payrolls bombshell of last week, one thing needs to happen: the yield differential has to rise further to favor the dollar. According to Bloomberg, “The extra yield that 10-year Treasuries offer over their Group-of-Seven counterparts expanded one basis point to 74 basis points, the most since April 2010.” A good start, but this isn’t enough. There needs to be an unmistakable and stable premium, possible as much as 1.5-2.5%, to underpin the dollar. This is not going to happen quickly, but it will happen as the Fed starts to move.
The June payrolls increased 288,000 and May was revised up to 224,000. Both figures were more than forecast, and both were the best since 2006. U.S. job gains in the last 6-months are over 1.39 million.
The unemployment rate is down to 6.1%, the lowest since Sept 2008, which is a level the Fed had not expected until closer to year-end. This is all positive, even though the economy isn’t producing high numbers of high quality jobs and the labor force participation rate is anemic. Nevertheless, the bottom line is that the accelerated rate of jobs buoys well for the economy’s strength.
Yesterday the Fed affirmed ending tapering in October and said “Most participants viewed this as a technical issue with no substantive macroeconomic consequences and no consequences for the eventual decision about the timing of the first increase in the federal funds rate.”
Russia / Emerging Markets
As the market’s attention has turned to data, crises in the emerging market are off the tier 1 currency market radar.
The Ukrainian situation is now in a full-out civil war. Ukraine government has re-captured Slovyansk and the rebels are backing into the last big eastern stronghold of Donetsk. As we predicted, Russia is keeping its hand off, to the deep disappointment of the rebels Putin has yet to be heard from. Bloomberg reports “Russia’s ruble gained 0.5 % against the dollar. Ukraine’s hryvnia strengthened 0.4%. Ukraine’s army has had the big-gest victories of a three-month campaign over the past few days, retaking the towns of Slovyansk and Kramatorsk.
As tensions in Iraq have captured less western attention, the Central Bank of Turkey (CBT) cut the weekly repo rate (policy rate) by 75 basis points to 8.75% in June 24th. The overnight corridor remained unchanged at 8.00-12.00%. In the policy statement, the CBT mentioned its goal was to keep a flat yield curve until there be sizeable progress in the inflation outlook. The Turkey’s inflation advanced to 9.66% in May with improvement foreseen from June. Given the tensions in Iraq and higher oil prices, do not rule out surprise deterioration in the TRY through the coming months. That said, the position below, which was highlighted on 6/17 commentary, currently has a 1.04 % net gain.
The US-China Strategic Dialogue opened today, although most everything has been discussed beforehand. The BOC raised the reference rate by 1 point and the yuan was engineered to a 3-month high. A series of weak numbers may open the window for stimulus, whether through directed programs or a rate cut/reserve cut. Government announced that a new agenda will include ‘domestic’ financial reforms (Is that a hint?), and yuan reforms: Banks can apply their own renminbi rate to transactions according to supply and demand, although the official reference rate and 3% band will still apply to interbank trades.
The European Central Bank president said a program is in hand for 1 trillion euros ($1.4 trillion) for banks to build incentives to spur lending. The measure will allow banks to borrow cheaply from the ECB even without increasing credit supply. The EUR has corrected from lows in June to reached highs in July. Regardless of data or proposals, the EUR’s downward trend may be coming to an end. However, if worries about Draghi’s dovishness and the effectiveness of his institutional proposals may grow, the EUR will fall back again. Implied volatility is extremely low. Exercise caution writing options.
Due to a delay in some bond payments by a Spanish bank, Espiritu Santo, peripheral European yields have risen. The resulting change in sentiment took the Italian and Spanish 10-year yields to 2.84% (up 3 bps) to 2.71% (3 bps) respectively. Note: the German Bunds are unchanged at 1.25%.
Australian dollar (AUD)
After the release of some soft trade data, the Australian dollar weakened among the major currencies. The central bank repeated that a high Australian dollar offers less assistance to balancing growth, while noting that growth is expected to be a little below trend in the year ahead. RBA Gov Stevens called the AUD “overvalued by most measures.” Nevertheless, technicals point to continue short term AUD strength.
Great British Pound (GBP)
The pound is mildly higher after continued releases of sturdy data. Growth and labor market strength continue to improve, and although there has been some softening in the sentiment surveys, they have remained strong. A rapid deceleration in the housing market would pose a risk, but it doesn’t seem likely as prices have eased but are still up 8.8% in Q2. BOE appear to have become more hawkish. Policy discussions around timing of hikes. Technicals show GBP testing resistance.
Canadian Dollar (CAD)
The central bank remains concerned about low inflation amid weaker-than expect growth. Where have we heard this before? Strength in the U.S. economy should support Canada and benign, or brushed aside, geopolitical concerns are positive for the commodity currencies. With inflation near the Bank of Canada’s near term target rate and a robust housing market, the likelihood of greater dovishness from the central bank is limited. Additionally, technicals are slightly positive. Expect very moderate CAD strength. Implied volatility is slightly higher.
Japanese Yen (JPY)
Core machinery orders (a leading indicator) tanked 19.5, which is the worst 1-month drop since in 1987. Considering all we’ve seen in Japan since 1987, the speaks volumes. Some are worried about the role of the sales tax hike and the credibility of Abenomics. Oddly, it was the JPY that rallied on the news.
Mexican Peso (MXN)
Monetary policy should remain on hold for now, while successful implementation of structural reforms should result in increased economic activity. Speculative FX positioning shows an increase in peso longs, while the technical outlook is mixed. The central bank gave the economy another dose of stimulus by cutting the policy rate to a record low after a sluggish start to the year. Look for a recovery and gradual strengthening in the peso.
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