Dollar Remains Vulnerable After Weak US Jobs Data

Highlights

US dollar was mostly firmer vs. the majors in the aftermath of weak US jobs data, but lost ground to EUR and GBP.  While we still think the US outshines the euro zone from a fundamental standpoint, the break of 1.25 last week points to further losses ahead for the dollar as the correction continues.  Yen and Swiss franc were largely softer, while EM FX was mostly firmer despite what should have been a strong risk off backdrop.  Biggest gainers on the day vs. USD were RON, BRL, TRY, CLP, and SEK, while biggest losers vs. USD were MXN, INR, CHF, NZD, and CAD.  India hiked 25 bp unexpectedly (see below).  EM sentiment will be boosted this week after IMF gave new $14.9 bln standby loan to Ukraine, while also disbursing $1.15 bln loan tranche to Romania.   ECB, BOE, and RBA meetings this week offer some event risk, though no policy changes are expected.       

US equity markets were lower, as DJIA, S&P, and NASDAQ ended down 0.5%, 0.5%, and 0.5%, respectively.  European markets were higher, with Euro Stoxx 50 up 0.15%.  Asian equities likely to open flat today as Asian ADRs were flat during N. American trading Friday.  Nikkei futures point to down Japan open.

US bond market was mixed, as 2- and 10-year yields were flat and up 3 bp, respectively.  European bond markets mixed, as 10-year yields in UK, France, and Germany were up 4 bp, down 2 bp, and up 2 bp, respectively.  Greek 10-year yields fell 6 bp, Portugal fell 21 bp, Italy fell 6 bp, and Spain fell 4 bp.  Portugal pledged to meet 3% of GDP budget deficit by 2012 vs. 2013 as previously planned.  Sentiment on the periphery improved last week on bond sales. 

Currency Markets

When China first announced on 19 June that it was going to reintroduce flexibility into its exchange rate mechanism, we advised caution, warning that it may take some time for China’s intentions to be clarified.    The market’s euphoric response was quickly unwound as it became clear that China’s position is more nuanced than it may have first seemed.  The flexibility that the US (and others) call for means the primary source of rigidity that prevents the yuan from appreciating, namely the hand of the government, should be removed.  What Chinese officials mean by flexibility is greater two way movement in relatively narrow bands.  However, now two weeks after the new policy was announced, China’s intentions are clearer.  It will accept some currency appreciation as well as greater two way movement.  Ironically, though it looks like the market is over correcting its initially euphoria and now appear to be pricing China cheaply.  Currently indicative prices for the 1-month NDF implies small yuan depreciation over the next month.  The 12-month NDF implies about a 1.5% appreciation.  Over the past two weeks, the dollar has slipped 0.8% against the yuan.  This pace of 0.4% a week cannot be expected to be sustained for the year or even for a quarter.  Over the next month, some modest appreciation is likely, even if 0.2% a week on average seems reasonable and is not priced in. Over the next 12 months, we suspect 3-5% appreciation is likely.  Back in the July 05-July 08 period of yuan appreciation, China allowed the yuan to appreciate on average about 7% a year against the dollar.  This was during a different set of macro economic conditions, including better growth prospects in its biggest export market, Europe.  During that previous 3-year yuan appreciation phase, the dollar was generally weak.

Polish zloty was the worse EMEA currency performer, down 10.5% and 5.5% against the US dollar and versus the euro respectively, but we remain of the view that the zloty is actually amongst the most appealing currencies in the region.  Updated central bank forecasts only reinforce this view, as it has revised its economic growth profile to the upside for this year (to 3.2% from 3.1%), next year (to 4.6% from 2.9%) and for 2012 (to 3.7% from 3.1%). The Polish economy is less export-orientated than some of the other CEE economies – see exports/GDP ratio at 33% in Poland, versus 60% in the Czech Republic and 63% in Hungary (2009 data) – so any disappointment on the euro zone economic front will prove less damaging for Poland than for its neighbors. The inflation profile has been revised higher for 2010 (to 2.5% from 1.8%) and for 2011 (to 2.7% from 2.4%) but the 2012 inflation forecast has been revised down to 2.9% from 3.5%. Note that the bank’s inflation target is at 2.5% and the new central bank Governor Belka has expressed a slightly more hawkish message of late. He has also hinted that a more volatile zloty could have an upward effect on inflation.  This means that i) while some central banks in the EMEA zone were still considering the merits of a rate cut not so long ago, it is only a matter of time before monetary tightening is discussed in Poland and ii) like in Romania and Hungary, central bank FX intervention risks should not be totally underestimated.  The fundamental case for a stronger zloty remains compelling and those not willing to have outright exposure against the majors given a still risk averse world should contemplate playing the bull zloty trade on the intra-EMEA crosses. The long zloty trade was an overcrowded trade late last year, but this has changed. On the crosses, there is nice carry on long PLN/CZK positions (see Czech rates at 0.7%, versus 3.5% for Polish rates). We identify good entry levels at 6.1640 and 6.14 (this year’s low), with near-term resistance at 6.42 (June high). This year’s high of 6.6596 is a reasonable longer-term objective for zloty bulls.  Note that market favorite centre-right Civic Platform candidate Komorowski appears to have the presidential election and should give further ammunition to zloty bulls on Monday.

Reserve Bank of India hiked rates 25 bp in an intra-meeting move.  Reverse repo rate is now 4% and the repo rate is now 5.5%.  The hike itself was not surprising, but the timing was since the regular RBI meeting is only weeks away on July 27.  This move suggests that it will move again then as well.  Similar move was seen earlier this year, when the RBI hiked 25 bp intra-meeting in March and then followed it up with another 25 bp hike at its April meeting.  RBI has also raise commercial bank reserve requirements intra-meeting this year, and more hikes there could be seen.  Why now?  Inflation has stabilized, but remains at very elevated levels.  In May, industrial CPI rose 13.9% y/y while rural CPI rose 13.7% y/y.  On the wholesale side, WPI rose 10.2% y/y in May and is still accelerating.  The government just hiked gas and diesel prices in June, so look for all the inflation measures to move higher in the coming releases.  GDP growth is surging, up 8.6% y/y in Q1 vs. 6.5% y/y in Q4, and so further tightening is warranted.  Despite the prospects of strong growth and higher interest rates, INR was the second worst Asian EM currency in Q2, behind only KRW.  We remain nervous about the global backdrop, and so INR underperformance is seen continuing.  So far in Q3, we are seeing a bit of divergence in EM FX, with most of Eastern Europe gaining against the dollar.  Laggards in Q3 are MXN, INR, KRW, ZAR, PHP, and TWD (all down vs. USD).  Level to look for ahead is 46.92, the 62% retracement of the May-June drop in USD/INR.  Break would target the May high of 47.745.

Upcoming Economic Releases

Asia: Indonesia central bank meeting; Taiwan CPI, reserves; Singapore PMI Europe/EMEA: Turkey CPI; Swiss, euro zone retail sales Americas: No US data; Brazil FIPE inflation; Mexico consumer confidence.  No US speakers of note.