Dollar and Yen Rally, Euro Bears Brunt

Highlights

• The US dollar is broadly higher, alongside the Japanese yen, amid heightened anxiety over the possible stalling of the global economic recovery and the fragility of the banking system.  The euro has borne the brunt of the adjustment.  Not only has the euro fallen below its 20-day moving average against the euro for the first time in a couple of weeks, but the it has fallen to its lowest level against the yen since late 2001 and has slumped to levels not seen since late 08 against sterling, while continuing to make new record lows against the Swiss franc.   Sterling has been knocked back after meeting a wall of offers above $1.51, but remains fairly resilient, maintaining a foothold above $1.50.
• Global equity markets are experiencing steep declines today.  The MSCI Asia-Pacific Index fell 1.6%, with Chinese shares seeing the largest sell-off and sending the Shanghai Composite to its lowest level in 14 months.  News that the April leading economic indicator, compiled by the US Conference Board, was revised from 1.7% to 0.3% due to a calculation error weighed on sentiment.  In addition the recent decline in Chinese equities made for a difficult environment to launch the last IPO of a major Chinese bank and reports suggest that the Agriculture Bank has had to cut its price.    European bourses are off 2-3%.  The global slowdown story is taking a toll on basic materials, industrials and oil and gas.  Financials are also outpacing the overall market to the downside.    Steep losses are expected in the US markets in the early going.
• Safe haven demand has pushed the US 2-year note to a new record low yield, driven the 10-year yield below 3% and the 30-year bond yield below 4%.  In Europe core bonds markets, like Germany, France and Netherlands, and to UK gilts are also seeing strong safe haven demand.   However, peripheral bond markets are doing worse and spreads are widening out.   Credit default swaps appear to be leading the bond market itself.  Five year Spanish CDS is posting a new record high, but all the peripheral countries, including Ireland are pressure on credit-default swaps.

Currency Markets

The market has been well aware that last year’s massive 442 bln euro 12-month repo operation by the ECB, which accounts for a little more than half of ECB’s outstanding 870 bln euro of liquidity, was set to expire this week, however the situation is getting a bit more acute.  There has been underlying concern that banks in the periphery of Europe are particularly vulnerable because they have come to depend on ECB funding.  Banks from the periphery of Europe appear to have taken about 45% of the 12-month funds.  The ECB will offer unlimited 3-month funds and a special 6-day operation as well.  However, this will shorter the maturity profile which forces the banks to have to keep coming back to the market or try to secure long-term financing, which in current market conditions is particularly difficult.  Market talk suggest that demand for the 3-month facility could reach 200-250 bln euros.  Where would the rest of the funds come from?   Some suspect that some of the 304 bln euros that banks have deposited with the ECB will used.  Banks also seem to be trying to raise some funding in the market and Euribor continues to creep higher.  Ironically, the ECB is wrestling with both its credit easing strategy of buying sovereign bonds, of which it bought 4 bln euros worth last week, the same as the previous week, which is the lowest so far in the program’s seven week history, but also trying to exit its long term refinancing operation.  The unwinding is the market’s immediate focus.

As the second quarter has wound down, the fear that the global economic recovery is losing momentum has resurfaced.  That story today finds a foothold in Asia.  The Conference Board’s revised its measure of China’s LEI from 1.7% to 0.3%, which is the smallest gain this year.  It plays on fears that the world’s fastest growing economy is set to slow.    Japanese data was simply dreadful.  First, the unemployment rate unexpectedly rose in May to 5.2% from 5.1% in April.  The consensus had expected decline to 5.0%.  May’s industrial output had been expected to be flat after the 1.3% gain in April, but instead declined by 0.1%.  The most disappointing report, however, was overall household spending which fell 0.7% on a year-over-year basis in May.  The consensus had expected a 0.3%-0.5% increase.  Yet the market had some inkling as the recent report showed retail sales plunged 2%, their biggest drop since early 2005.  While deflationary forces are generally recognized in Japan, it does not simply imply falling goods prices, but wages as well.  Japanese wages are off 2.4% year-over-year and this seems to also depress consumption.

The US financial regulatory bill that had been approved by key House and Senate committees at the end of last week and encouraged risk-on activity before the weekend has had a setback.  The death of a key US Democrat Senator jeopardizes the finely balanced politics.  Essentially 60 votes are needed to overcome attempts to block the bill.    A Democrats successor will likely be appointed by the Democrat governor of Virginia, but it may not be until next week.  In the meantime the opposition is not standing still.  Some Senators that initially support the bill, like Massachusetts Senator Brown, is reportedly considering voting no.  In addition to Brown, there are three other key Republican Senators, the two from Maine and Grassley from Iowa.   On the Democrat side, pressure may build on Cantwell from Washington and Feingold from Wisconsin.  They both oppose the bill on the grounds that it is not sufficiently strong.   The bottom line here is that the bill is less certain than it was before the weekend and that uncertainty cannot be good for investors.

While the decline in dollar-yen may frustrate Japanese exporters, it is the euro’s slide that poses the greater financial challenge.  Many Japanese exporters had internal budget level of around JPY95 for the dollar.  The dollar is about 6.5% weaker.   In contrast Japanese corporates had assumed the euro would be in the JPY120-JPY125 area. The euro is 10-15% below this.  Contacts suggest that hedges may have offered some protection over the past three months, but many are set to expire at the end of this month or early July.  The new hedges can be established but at much lower rates.  However, new internal rates will likely be adopted and this may add to the pressure on the euro at the start of Q3.   There is increased talk of the euro falling toward JPY100, though note that as the euro posted its record low against the yen early Q4 2000 near JPY89.

Upcoming Economic Releases
The US reports S&P/Case-Shiller home prices at 9:00 EST/13:00 GMT.   A third consecutive monthly year-over-year rise is expected for the 20 large metropolitan areas.  The Conference Board’s Consumer Confidence is out at 10:00 EST/14:00 GMT.