BBH CurrencyView: FX Drivers Aiding Greenback

Highlights
The US dollar is trading with a firmer bias across the board.  The main driver appears to be a reassessment of the likely outcome of today’s FOMC meeting as many Fed-watchers play down the likelihood of renewed asset purchases and this has been sufficient to force some weak shorts (dollars) to cover.  In addition, a disappointing French industrial output report (June -1.7% month-over-month vs consensus of -0.3%) and widening sovereign spreads in Europe has weighed on the euro.  Weak UK BRC retail sales and the first decline in RICS house prices undermined sterling and better trade balance failed to repair the damage after yesterday’s failure at $1.60.  The BOJ as widely expected left rates unchanged and refrained from taking new measures to combat deflation. 

Profit-taking is the theme in global equity markets today, despite the 0.5% rise in the S&P 500 yesterday.   The MSCI Asia-Pacific Index fell 1%, led by a 2.9% decline in the Shanghai Index.  News that urban property prices rose at their slowest pace in six-months (10.3% year-over-year) weighed on that sector and may have contributed to the 1.50% drop in Hong Kong as well, stopping the six day advancing streak.   Most bourses in Europe were off 0.6%-1.0% near midday in London.   The Dow Jones Stoxx 600 is succumbing to profit-taking after reaching new 15-week highs yesterday.  Basic materials, industrials and financials are leading broad decline, with only the health care sector posting gains.    US shares are not immune with early indications pointing to 0.5%-0.8% opening losses. 

The retreat in stocks is not spurring demand for most bond markets.  Japanese 10-year yield rose 3 bp following the failure of the BOJ to increase its rinban operations for which there was some speculation.  European bond yields are rising and sovereign spreads are widening.  The premiums Ireland and Portugal pay over Germany, for example, are their widest since 2-3 weeks.    Their 10-year yields are up 13 and 8 bp respectively.  Greek 10-year bond yields are also 13 bp higher today.  Spain and Italy are experiencing a 5-6 bp backing up in yield.  German 10-year yield is up a modest 2 bp.   In comparison, US yields are flat to slightly lower ahead of the $34 bln 3-year note auction later today. 

Currency Markets
The focus in North America today will be the FOMC meeting.  Since the end of last week, there has been some re-thinking about the outcome of today’s meeting.  In particular, many Fed-watchers are playing down the likelihood that the Fed renews its asset purchases.  It was one of three steps that Fed chief Bernanke suggested (in late July) as possible ways the Fed could provide more support for the economy.  The other two were to reinforce its guidance about the protracted period rates for which rates will remain low.  The other was to lower the interest rate paid on excess reserves.  Some recognition that the recent string of data has been weaker than expected, coupled with a commitment to do more if necessary may be the most likely outcome.  This re-consideration may be encouraging some paring back of short dollar positions.

There appears to be another force at play as well.  In our understanding of the euro’s appreciation, we have highlighted more than others, the shifting spread of short-term interest rate differentials and to illustrate our point, have focused on the Us-Germany 2-year note.   In late May it was in the US favor by almost 34 bp and it proceeded to tumble to a little more than 25 bp in Germany’s favor by the end of July.  It has stabilized, albeit in a choppy fashion and this is coinciding with some great stability in the euro-dollar exchange rate, even though it did make a new 3-month high in response to the disappointing US jobs data.  The dollar has recouped last Friday’s decline in full (against the euro, sterling and Swiss franc).  The expiry of the ECB’s 12-month long-term repo operation at the end of June and the net drain of liquidity (as well as stronger than expected economic news) pushed up short-term euro money market rates, which ECB Trichet had characterized as “normal”.  Well, that adjustment period has begun easing and Eonia, the Euro Overnight Index Average is near its lowest level since the 12-month repo rolled off (near 33 bp from 55 bp in early July).  Today ends a maintenance reserve period at the ECB.  European banks have been building their overnight deposits at the ECB in anticipation.  Monday night, for example, there were 172 bln euros on overnight deposit with the central bank.  The ECB in effect drained liquidity today in its regular refi operations.  There were about 204 bln euros of repos maturing today and the ECB replaced them with about 193 bln euros (153.7 bln euros in the weekly 7-day operation and 39.1 bln in a 28-day operation).  On top of that, it conducted a “fine-tuning operation” to drain liquidity as well.  
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After nearly stagnating in Q1, Europe’s economy appeared to accelerate in Q2 and appears off to a good start in Q3 (according to the ISM data and Trichet’s assessment).  Nevertheless, among many participants is the expectation that the European economies will slow again under the “triple tightening” in the form of fiscal and monetary policy and currency strength.  Today France reported a 1.7% decline in June’s industrial output, nearly offsetting in full May’s 1.9% rise.  The market consensus was for around a 0.1% decline.  The UK reported a softening of the BRC sales (0.5% year-over-year vs 1.2% previously), perhaps as the World Cup spur faded.  RICS reported the first decline in house prices in a year for the month of July today.  There is some thought that in its Quarterly Inflation report tomorrow, the BOE may cut its growth forecasts.  One of the early tells that the dollar’s decline was tiring, we suggested, lay in how the market responded to fundamental news.  In recent weeks, the market appeared to have simply shrugged off poor euro zone data and generally ignored positive US data.  The shifting rate differential story and the price action in response to disappointing European data are flashing cautionary signals to dollar bears. 

China and the UK reported trade figures today.  Both were better than expected.  China reported its biggest trade surplus since Jan last year of $28.7 bln.  In July imports actually fell 0.4% and this weighed on those countries that rely on exports to China.  China’s exports rose almost 6% on the month and this may have been exaggerated by Chinese companies trying to beat the end of the an export subsidy scheme.  As if to send a clear message that the larger trade surplus will not lead to renewed pressure on the yuan, the PBOC fixed it lower.   The UK reported a GBP 7.4 trade shortfall, its smallest deficit since Feb.  Sterling’s depreciation over the last couple of years has not appeared to help exports and one month a trend does not make, but exports rose 4.3% on the month and about 6.5% quarter-over-quarter.  With imports rising a more modest 1%, there is new hope that the external account can begin contributing positively to UK growth.

Upcoming Economic Releases
The US reports Q2 productivity and unit labor costs at 8:30 EST/12:30 GMT.  These are derived from the Q2 GDP estimate and tend not to be market moved.  June wholesale inventories are released at 10:00 EST/14:00 GMT and this will help fine tune expectations for Q2 GDP revisions.