Rising Risk Aversion Favors JPY, USD, and CHF

From the BBH Currency Strategy Team.

Highlights
The US dollar is stronger vs. the majors as risk aversion carries over and intensifies.  EUR/USD is making new lows for this move but is finding some support around 1.26 for now.  We expect further losses for the single currency, and break of 1.26 would target the next retracement level around 1.2430.  The yen is firmer across the board, benefiting from risk off trading as well as lessened concerns about FX intervention.  USD/JPY traded at its lowest level since June 1995, while Swiss franc is mostly stronger but lagging a bit and so EUR/CHF has yet to hit our target of 1.3070.  EM currencies are largely softer, which is to be expected in this negative trading environment.  Only gainer vs. USD so far today is JPY, while biggest losers are HUF, PHP, AUD, NOK, and CAD.  US data out today could add to the negative sentiment, as housing data has really surprised to the downside in recent months.  Recent technical damage despite stronger than expected euro zone orders data (see below) points to further EUR losses in the coming days.  Canada reports retail sales today, but CAD along with Mexico is expected to underperform near-term due to close ties with the US.             

Asian equities were lower, with the MSCI Asia-Pacific Index posting a 0.7% drop after rising 0.1% Monday.  China and Malaysia outperformed and rose on the day, while Hong Kong, Philippines, and India underperformed on the day.  Nikkei 225 posted a 1.3% drop, with the strong yen continuing to weigh on Japan’s economic outlook.  European bourses are trading lower so far today.  US shares are likely to come under pressure too as futures trading points to down opens for the major US indices. 

Core bond markets are higher in the wake of the recent rise in risk aversion.  Peripheral spreads to Germany have widened today, more as a result of Germany 10-year yield falling 5 bp to a record low 2.23% than rising yields in the periphery.  The Greek-German spread has widened 5 bp to +867 bp.  Portugal, Ireland, Spain, and Italy 10-year spreads are wider to varying degrees, with Portugal up the most (8 bp).  US Treasuries have continued to gain on the flight to quality trade, with 10- and 30-year yields 4 bp lower on the day.  

Currency Markets
Gloom and doom have taken hold of the markets, and so the usual suspects (USD, JPY, and CHF) are benefiting.  While economic prospects in the major countries appear to be on the slide, the yen continues to benefit, and the announcement yesterday that the Japanese PM and Bank of Japan chief had not discussed intervention is also lessening any objections to drive the yen higher for the moment.  More official jawboning was heard today by Japan officials, but given the boilerplate nature of those comments, they did little to dissuade markets from taking the yen higher.  USD/JPY touched a low of 84.16 overnight and in territory not seen since July 1995.  EUR/JPY is trading at levels not seen since 2001, and even stronger than expected euro zone data did little to bolster the single currency, despite new industrial orders jumping 2.5% m/m in June vs. 1.5% expected and an upwardly revised gain of 4.1% (was 3.8%) in May.

Euro sentiment wasn’t helped after Olli Rehn, EU commissioner for economic and monetary affairs, said that any slowdown in Asia would have a “serious negative impact on economic growth in Europe” while Nobel laureate Joseph Stiglitz warned of a double dip risk in Europe, adding to negative sentiment. Stiglitz also touched on the theme of deficit-cutting in Europe as a big risk to growth, something Moody’s highlighted in its comments yesterday.  Sterling came under pressure after Martin Weale of the MPC was quoted saying the UK faces a ‘real risk’ of a second recession and that the possibility of another financial crisis ‘can’t be regarded as trivial.’ In the Times of London interview he admitted he was comfortable with current policy. The BOE cut its growth forecast for 2012 in its most recent inflation report earlier this month to 3%, down from 3.5% in May and Weale’s words reinforce the sense gained from the minutes of last MPC policy meeting that there is no indication of the Bank moving towards an exit strategy. Cable’s break through 1.5475 opened the way up to test support at 1.5325, and with the trend remaining bearish.  Indeed, sterling underperformed the euro for a change today, with EUR/GBP rising for the first time in 5 days.  Weale’s comments may keep sterling on its back foot for now, as recent market optimism regarding sterling is getting beat up a bit in this risk off environment.

EM currencies have taken it on the chin this week, and today EMEA is again underperforming.  As the EM region with the weakest fundamentals, we would expect EMEA currencies to continue underperforming as the risk off trading mentality looks likely to persist into the fall.  In this environment, we continue to highlight cross-EM plays that favor countries with strong fundamentals over weak.  Defensive plays would suggest favoring Asia and Latin America over EMEA.  But there are plays within each EM region as well.  For instance, yesterday we recommended long PLN/HUF and long ILS/CZK positions.  Both have moved today in our favor and we expect that to continue.  We believe one by-product of the deteriorating economic sentiment is that EM policy-makers will pare back their tightening biases.  Central banks that were thought to start hiking in Q4 are likely to push that back into 2011 given the uncertain environment.  That includes Poland, which meets today and is expected to keep rates steady at 3.5%.  While the economy has held up well during the crisis, officials have been fairly dovish as CPI rose a lower than expected 2.0% y/y in July vs. 2.3% y/y in June, the fourth straight month that it has been below the midpoint of the central bank’s target range of 1.5-3.5%.  There was no meeting in July, but we note that minutes from the June 30 meeting showed heightened concerns about the external environment and the impact on the zloty exchange rate.  Earlier today, Poland reported weaker than expected retail sales.  Yesterday, both Hungary and Israel kept rates on hold.  Today, South African GDP growth was reported to have slowed to a weaker than expected 3.2% annualized rate in Q2 from 4.6% in Q1, and we cannot rule out further easing by the SARB if the economic backdrop deteriorates.  Next SARB meeting is September 8/9.  HUF and ZAR are amongst the worst performers this week, and the combination of weak growth profiles and poor fundamentals are likely to see these two currencies remain under pressure.

Upcoming Economic Releases
At 8:30 EST/12:30 GMT, Canada reports retail sales for June, which are expected to rise 0.4% m/m (0.1% ex-autos).  Only US data releases scheduled today are due out at 10:00 EST/14:00 GMT, with July existing home sales expected to drop -13% m/m and Richmond Fed manufacturing index expected to fall to 8 from 16 in July.  At 10:00 EST/14:00 GMT also, Mexico reports July trade and mid-August CPI.  Poland central bank announces policy decision today (no time scheduled) and is expected to keep rates steady at 3.5%.  At 8:45 EST/12:45 GMT, Fed’s Evans speaks in Indianapolis.