Dollar on its Back Foot

Highlights

The US dollar remains on its back foot. The main driver remains the contrast between the likely trajectory of Fed policy in contrast to the ECB. Moody’s 1-notch downgrade of Spanish credit rating and news that Anglo-Irish needs another 6.4 bln euros on top of the 22.9 bln already injected, and possibly another 5 bln on top of that (in a stress case) has been shrugged off and the market has focused on news that European banks are relying less on ECB financing, strengthening the case for the exit that some officials indicated earlier this week. Better than expected Nationwide house prices, month-end demand, no deterioration in the Q3 BOE credit condition assessment has seen sterling lead the charge today and is moving above the $1.59 level for the first time in seven weeks. The dollar continues to edge toward the levels that were seen when the BOJ intervened. The low seen on Sept 14-15 was about JPY82.90 and today’s low thus far has been JPY83.16.

Asian stocks fell as worries about faltering global growth were exacerbated by the poor data from Japan and the Irish news. The MSCI Asia Pacific index had its biggest decline in three weeks, dropping 0.9%, while Japan’s Nikkei led declines among the benchmarks in the region with a 2% decline. Yet Chinese stocks rose on speculation measures to quell real-estate prices may eventually remove uncertainty over asset bubbles. The Shanghai and the Shenzhen were both up over 1.5%. Outside China, banks were the largest declining group in the regional index. In Europe, the Stoxx Europe 600 declined by 0.2% on concerns over the cost of bailing out European banks as Spain had its credit rating cut and Ireland’s Allied Irish Banks will need to raise an additional €5.4B.

Despite the news of Spain’s rating downgrade and the withdrawal of €92B from the liquidity system, European bond yields are declining. Greece and Ireland’s 10-year yields, for example, are down 16bps and 14bps. Although, the Irish 2-year yield was up 14 bps as concerns about Allied Irish weighed on the market. In addition, Japanese bonds finally dropped back after a strong six-day advance. 10-year JGB yields added 2 basis points to 0.93%. Treasuries gained ahead of the Chicago PMI data and Fed chairman Bernanke’s testimony before the Senate Banking Committee. The 2-year was unchanged at 0.43%, but the 10- and 30-year yields fell 3 bps to 2.47% and 3.65% respectively. And finally, as expected Taiwan hiked rates to 1.5%.

Currency Markets

The euro was already recovering from the bout of profit-taking in Asia that had seen a low recorded just ahead of support pegged at $1.3550, when news that the European banks borrowed considerably less from the ECB than anticipated and this sent the euro to $1.3675. Recall that 225 bln euro refi operations were maturing today. These included the rump of the 12-month and 6-month facilities which no longer exist. The ECB offered 3-month funding yesterday. European banks took 104 bln, which was obviously on the light side, but dealers did not want to draw any hard and fast conclusions ahead of today’s 6-day funding made available today. However, banks only wanted to borrow 29.4 bln euros, a little more than half of what a Reuter’s poll suggested was likely. The combined 135 bln euro in the two days means that there is 90 bln euro less liquidity sloshing around the banking system. This will reinforce official perceptions that the banking system in general in Europe is healing and sufficiently so that it can continue to proceed with a further exit of some of its crisis measures. Turning our attention to Japan, an unexpected decline in Industrial Production added to the gloom about the economy’s prospects, reinforcing speculation that the BoJ will unveil new measures to help stimulate growth early next week. Yet by midday in Europe the yen is up by nearly 0.5% versus the greenback. Moreover, industrial output dropped 0.3% from July, the third straight monthly decline. It was expected to rise by 1.1%. From a year ago, production climbed 15.4%, below the 16.9% expected.

Irish officials should be pleased. The government announcement about the cost of financial support was greeted with a strong bond rally that has seen the Irish 10-year yield fall 13 bp, fully recouping what it has lost in the past five sessions. On top of the 22.9 bln euros already provided to Anglo-Irish Bank, the government says another 6.4 bln euros is needed. On top of that, it under new stress conditions, an additional 5 bln may be needed and the sum is fairly close to the S&P warning that 35 bln euros may be needed. In addition, the government projected Allied Irish banks would need an additional 3 bln euro and Irish Nationwide may need 2.7 bln euros. The market is acting as if these figures mean that Ireland may not need to tap the EFSF. However, the rally in Irish bonds may also have been boosted by Finance Minister Lenihan’s confirmation that because of market conditions, i.e., high yields being demanded, Ireland not hold is scheduled bond auctions in Oct and Nov. Fitch immediately warned that Ireland’s debt rating is not secure. Meanwhile, as well telegraphed, Moody’s cut Spain’s sovereign rating from AAA to Aa1 and is now in line with Fitch and one notch above S&P. There might be some relief that Moody’s move was only one notch and the outlook was seen as stable. The gain today in Spanish bonds has also been enough to offset the weakness seen over the past five days.

The Australian dollar is has appreciated almost 9% this month against the dollar, but is struggling a bit today. The hawkish comments of by the RBA had spurred a shift in the pendulum of expectations toward a rate hike next week. In addition to the firm commodity prices and the favorable PMIs from China had helped spur the buying. However, disappointing building approval data earlier today (-4.7% in Aug vs expectations of a flat report coupled with a sharp downward revision in July from 2.3% to 0.1%) have prompted second thoughts by market participants. The market now appears to be seeing it as a closer to a 50/50 call rather than 70% likely as recently as yesterday.

Late last night, the Senate confirmed two of the three Federal Reserve candidates, Yellen and Raskin (former as vice chairman and the latter as governor). This is important because it they are seen as centrist to dovish and are seen as part of the emerging consensus to provide more support for the economy. As we noted at the time, the FOMC had been operating on the light side with only 4 of the 7 governors in position. The hawkish wing of the Fed is clearly coming from some of the regional Fed presidents. Because of a technical glitch the confirmation process of Diamond for the third nominee, it may have to begin over, which at this late date mean it is unlikely to happen before the Nov 2-3 FOMC meeting.

Upcoming Economic Releases

At 8:30 EST/ 12:30 GMT the US reports 2Q GDP. Additionally, weekly Initial Jobless Claims are expected to decrease 5k from the previous month, while Continuing claims are expected to fall to 4473. Chicago’s PMI for the month of September is expected to drop to 55.5 from 56.7 in August. And finally, at 8:30 EST / 12: GMT Canada reports July m/m GDP numbers. Consensus is for a 0.1% fall.