Dollar Losses Continue After Weak US Data

Highlights

US dollar was mostly weaker vs. the majors, up modestly only vs. AUD and CAD as the euro made another new high for the cycle near 1.2950. By ending the day at the highs, further euro gains look likely in Asia today. The yen and Swiss franc were mostly firmer as risk appetite eased after more weak US data reported (PPI, Empire manufacturing and Philly Fed surveys) on top of weak China data for June. Dollar losses look likely to continue near-term, while CAD and MXN are most at risk from weak US growth (see below). EM FX was mostly firmer, but we highlight risks for the weaker EM credits in our EMFX Weekly as risk appetite remains very choppy. Biggest gainers on the day vs. USD were CZK, EUR, RON, GBP, and HUF, while biggest losers vs. USD were ZAR, CAD, MXN, UAH, and CLP. Turkey central bank left rates steady at 7%, as expected.

US equity markets ended mixed after earlier weakness, as DJIA, S&P, and NASDAQ ended down 0.1%, up 0.3%, and flat, respectively. European markets were lower, with Euro Stoxx 50 down 1.3%. Asian equities are likely to open down today as Asian ADRs were lower during N. American trading Thursday. Nikkei futures point to a down Japan open, and the stronger yen should hurt Japan exporters.

US bond market was mixed, as 2- and 10-year yields were flat and down 6 bp, respectively. European bond markets were mixed too, as 10-year yields in UK, France, and Germany were down 2 bp, flat, and flat, respectively. Greek 10-year yields rose 4 bp, Portugal fell 4 bp, Ireland rose 2 bp, Italy rose 1 bp, and Spain fell 11 bp. Spain outperformed after strong sale of EUR3 bln 15-year bonds, though Spain had to pay higher rates than the last auction in April.

Currency Markets

The 0.1% rise in US industrial output in June seems to defy expectations for the first decline since mid-2009, but the headline is deceiving. Manufacturing, the key component actually fell 0.4%. The headline was flattered by a 2.7% jump in utility output. Utility output also jumped 5.4% in May. Manufacturing output was hurt by the cuts in auto output. The 1.9% decline appears to be a correction to the 5.6% jump in May. Excluding auto and parts, manufacturing output was still off 0.3%. The real weight on manufacturing was from consumer goods production. It fell 0.6%, led by a 1.7% decline in the output of appliances, furniture and carpeting. The output of business equipment rose 0.9% following a 1.4% rise in May. Computers and semiconductors output was the strongest. Looking forward, utility output might remain firm in July and the high unemployment and weakness consumption does not auger well for improved consumer goods output. In turn, this implies risk to business investment too and so July industrial output may be weak as well.

Japan Ministry of Finance publishes portfolio flows on a weekly basis. The latest data shows the general continuation of recent trends. Japanese investors continue to buy foreign bonds and stocks. Over the past nine week, Japanese investors have purchased roughly $87 bln of foreign bonds and $15 bln of foreign equities. Foreign investors have sold a little less than $20 bln of Japanese shares and sold a smidgen of Japanese bonds. The net portfolio flows out of Japan have been dominated by Japanese investors themselves. On the other hand, non-commercials (speculators) in the IMM currency futures have been buying yen. Since early May they have swung from a substantial short position (65.6k contracts, ball park value $9 bln) to a long position (37.9k contracts, ball park value $5.2 bln). Since early May, the yen has been easily the strongest major currency, rising almost 7.3% against the US dollar and more than 10% against the euro and nearly 12% against the Australian dollar. The BOJ has not intervened in the foreign exchange market for several years. That alone would suggest that the bar is high. The strength of the yen is not desirable for country that anticipates to still be in the grip of deflation throughout the remainder of the year. However, BOJ intervention remains unlikely. The market has been very orderly and intervention is not a tool that can be deployed simply because an official does not like the price action. Implied volatility has fallen from 16.5% in late May to about 11.25% yesterday. The premium the market pays for yen calls over yen puts, which may illustrate a skew in the market views and positions, is not extreme. Implied volatility may increase if the dollar continues to approach the multi-year low set late last year near JPY84.80, but alone that may also prove insufficient to get spur official action. That said, given the changing political landscape in Japan, a combination of a strong yen and deflationary pressures could increase the pressure on the BOJ to take additional measures, such as increasing its JGB purchases, which currently stand at JPY1.8 trillion a month.

Mexico central bank meets July 16, and is expected to keep rates steady at 4.5%. The Mexican economy is recovering, but was clearly lagging many of its regional counterparts even before this latest batch of weak US data. Mexico policy-makers will thus be wary of tightening policy anytime soon. We note that the peso underperformed within EM for most of 2009, outperformed in Q4 09 and Q1 10, and then went back to underperforming in Q2 10 and is in the middle of the pack so far in Q3. We think underperformance will continue; while MXN offers decent yields, the growth and fundamental backdrop is not as compelling as in other regional economies. President Calderon just shuffled his cabinet in response to rising drug-related violence, naming his fourth Interior Minister in as many years. Interior Minister is responsible for security matters, as well as handling negotiations between political parties in order to pass legislation. So the regular replacement of this post reflects Calderon’s dissatisfaction with the legislative agenda as well as the deteriorating internal security situation. Calderon also named a new Economy Minister, who joins new Finance Minister Cordero (named back in Dec). Looking ahead, the yield trajectory is not so good for MXN, with local analysts pegging March 2011 as the likely start of the tightening cycle. By that time, Chile, Colombia, Peru, and especially Brazil will all have hiked rates considerably. Indeed, Chile is expected to hike rates 50 bp today to 1.5%, with analysts looking for a year-end rate of 3.0%, mid-2011 rate of 4.25%, and end-2011 rate of 5.5%. After weak US data today, CAD is the worst performing G10 currency on the day while MXN is the third worst in the EM space. If US growth concerns remain in play, we believe the peso will continue to be hurt disproportionately within EM. USD/MXN made a marginal new low for the July drop at 12.6533 today but has had trouble getting through that area over the past three days. If USD/MXN closes above 12.7519 (Weds high), it will be an outside up day and could signal a possible reversal. If so, levels to look out for are 12.853, 12.9150, and 12.9765 (retracement levels of the July drop in USD/MXN). While EM currencies have been doing well so far in Q3, rising concerns about US and China growth could lead to a bout of profit-taking.

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