Dollar Soft on Interest Rate Spreads


The US dollar remains soft, but the downside momentum seen in recent days appears to be ebbing as new catalysts are awaited. The dollar’s slide is not over and bounces are expected to be shallow and short-lived. The main catalyst continues to current interest rate differentials and their likely trajectory. The contrast was underscored yesterday as the ECB’s Stark indicated the ECB was still planning an exit from unconventional provisions while the risk of renewed measures by the US and the UK run high. The dollar slipped further against the yen and has now given up roughly two-thirds of the intervention gains, even though the poor outlook for December contained in the Tankan Survey underscores the likelihood that the BOJ responds with additional measures as early as next week. The dollar is softer against most emerging market currencies.

Despite an early rally fuelled by the strong China manufacturing PMI, China stocks fell as developers will issue new measures to avert a property bubble. Although, other Asian stocks – including Japan, India, Philippines and Hong Kong – rose as mining stocks climbed on metal prices, following a strong PMI number from China and over speculation the BoJ will intervene to bolster economic growth. Overall, the MSCI Asia Pacific Index is up 0.89%. In Europe stocks were flat with the Stoxx Europe 600 down 0.13% by midday trading in London. In addition, the drop in European stocks was led by consumers and financials.

Japanese bonds climbed for the sixth day as the Tankan added to speculation about further measures from the Bank of Japan next week. The yield on the 10-year JGB dropped 4 basis points to 0.915%. That’s a drop of 14 bps since Sept 17. In Europe, the Irish 10-year yield was up marginally by 4 bps followed by a 4 bps gain in Portugal as German bonds were flat. US bonds were little changed. And finally, the US sells $29 billion of seven year debt today.

Currency Markets

The divergent paths between the ECB on one hand and the Fed, BOE and BOJ on the other hand are very stark. The ECB seems determined to reduce the extraordinary liquidity provisions as they expire at the end of the year. In contrast, the market seems to be acting as if new bond purchases by the Federal Reserve are a done deal. Japan is moving to provide additional monetary and fiscal support. Despite the immediate retort by the BOE’s dissenting hawk Sentance, fellow-member Posen’s comments suggest a dovish consensus may be emerging at the MPC for additional measures, though it might not be quite there yet. The ECB is the outlier and although in the short-term this is favoring the euro, this may not lay the basis for a sustained rally. The less supportive monetary conditions coupled with tighter fiscal policy will mean that the region is unlikely to generate the growth needed to stabilize debt ratios. So once again the old formula by which the dollar is punished in the short-run for pro-growth policies and later rewarded still seems to be operative.

The prospects for new asset purchases in the US are overwhelming the continued stress in Ireland and Portugal as a driver in the foreign exchange market. The Irish and Portuguese economies are roughly the same size and about 1/3 smaller than Greece. If the problems are contained there, then the European fire wall has worked. Italy’s 7.9 bln euro bond sale today went off without a hit, (slightly higher bid-cover than the last auctions) even though there is heightened political uncertainty ahead of the confidence vote later today. Spain is experiencing its first general strike in eight years. Speculation continues to run high that Moody’s will soon cut Spain’s triple-A rating. That rating agency has had them on credit watch since late June. A one-notch cut would bring it to where Fitch has been. S&P has Spain a notch lower than that. Most seem to be looking for Moody’s to bring Spain down to Fitch’s level, but a two-step move cannot be entirely ruled out. As the rating agencies often lag behind the markets, and in this case Moody’s is truly lagging, the market impact may not be significant. There used to be talk about a multi-speed Europe and there appears to be one emerging, but not quite the way it was initially envisioned. It is fragmented. There is Greece with its separate EU/IMF package. There is Ireland and Portugal, where the wolf seems to be knocking on the door. There is Italy and Spain, which strains but still fairly well contained. There is Belgium and Austria where some pressure is beginning to be evident. As noted here yesterday, after Portugal and Ireland, Belgium bonds are the third worst performing euro zone bond market this month. The budget pressures in the region are likely to get worse as higher interest rates means higher debt servicing costs, which means more savings are necessary.

Japan’s Tankan index of confidence among large manufacturers increased in the third quarter, but it was the smallest gain since the beginning of 2009 when the economy was making its way out from the effects of the financial crisis. The overall index rose to 8 from 1 in Q2, compared with a 15 point gain in June, and significantly the component predicting next quarter’s result – a measure of confidence in future prospects – has the index dropping to -1. Much of that decline in the outlook component can be put down to concern about recent JPY appreciation. The Tankan revealed the pessimism that Japanese companies feel about the future. In fact, the market seems to have taken the report as a harbinger further easing. But according to the manufactures survey they envision an average USD/JPY rate of 89.66. This is not a big drop from the previous figure of 90 yet it suggests that manufactures are bit optimistic about the exchange rate. Overall, this implies that the corporates are un-hedged and have failed to realize the changing developments in the currency market which may leave them exposed to sharp profit adjustments down the road.

The US House of Representatives are expected to vote on the bill that seeks to make it harder for the Commerce Department to reject corporations seeking countervailing duties on Chinese goods because of the undervalued yuan. This may make headlines but it remains aimed primarily at a domestic audience ahead of the midterm election. Although contacts reported that the Senate was unlikely to take up the measure before their recess early next month, the champion of the bill there, NY Senator Schumer, let confirmed this may saying he would push for the bill after the election. China seems to be responding on two channels. One is they have let the yuan appreciate at a faster pace recently. The reference rate was set today at CNY.66936, the lowest for the dollar since July 2005. The 12-month NDF’s now imply a 2% pace of appreciation. It has appreciated 1.85% this month.

Upcoming Economic Releases

There are no major events numbers reported from the US but in Canada at 8:30 EST / 12:30 GMT Industrial Product Prices are reported for August. An increase of 0.2% is expected after a 0.1% rise in July. A number of regional Fed presidents are on tap for today. Kocherlakota speaks in London at 10:15 EST / 14:15 GMT, followed by Plosser and then Rosengren in New York, of whom only the latter is a voting member of the FOMC.

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