Dollar Bounce – Not the Real Thing

Highlights
The US dollar is broadly higher as the correction seen before the weekend was extended through the Asian session.  In Europe, the greenback’s gains have been pared, but it remains above last Friday’s high against the major currencies.  The exception is the yen, against which the dollar has been confined to roughly JPY81.00-JPY81.50.    The dollar’s bounce looks to be more a function of market positioning and a bout of profit-taking more than a fundamental-driven development.  While we anticipate the dollar making low in the first half of Q4, as the Fed’s QE and the normalization of euro zone money market conditions are discounted,  this dollar bounce is not being confirmed by interest rate developments and we are suspicious of its sustainability. 

Asian stocks dropped back, led by a 1.7% drop in the Taiwanese Index, after BHP Billiton and Rio Tinto abandoned plans for a join iron-ore venture. The MSCI Asia Pacific index dropped 0.7% after last week completing its seventh weekly advance, the strongest run since 2006.  China’s stocks fell for the first time in eight days, led by material and agriculture producers, on concern this past months rally may run out of steam.  The Nikkei was flat, falling by 0.02%, led by nearly a 1% loss in telecommunications, despite a 2.5% gain in utilities.  In Europe stocks were little changed.  The Stoxx Europe 600 Index rose by 0.1% by mid afternoon.  Meanwhile, UK stocks pared losses, as shares of Man Group Plc and Lloyds Banking Group Plc offset a retreat in mining companies.  In effect, basic materials were down 1.5%, despite the strong rise in technology. 

Bond markets were mixed to higher. Japanese debt was steady, with 10-year JGBs yielding 0.865%.  10-year German bund yields slipped 1bp to 2.370%. Most eurozone spreads continue to narrow on a reversal of intra-eurozone safe haven flows and hawkish ECB comments, which confirm that the ECB is not in the mood for further QE. Trichet overnight confirmed that rates are appropriate but also rejected Weber’s call for an end to the bond purchase program.  2-year US treasuries were flat, yielding 0.359, while the 10-year dropped by 2 bps to 2.538.

Currency Markets

We now know that speculators at the IMM began lightening up on their long currency positions in the week that ended last Tuesday.  While the euro and sterling made new highs on Friday last week, this was not matched by the Swiss franc and Australian and Canadian dollars.  Some observers are highlighting in Bernanke’s pre-weekend speech the recognition that a further substantial expansion of the Fed’s balance sheet could erode confidence in the Fed’s ability to enact a credible exit strategy.   Yet there seems to be little recognition of this in the US debt market where US yields are lower.   One of the key fundamental factors that we have argued encapsulates the various forces at work that are driving the dollar lower has been short-term interest rate differentials and the US 2-year yield is holding just above last week’s low just below 35 bps.  Meanwhile, short-term euro zone rates are rising.  Three month Euribor has now reached the ECB’s main interest rate (1.0%) for the first time in 15-months today.  This is seen as largely reflecting the ECB’s exit strategy, encouraging banks to reduce their reliance on special liquidity provisions.    The US-German 2-year spread is at 50 bp today, which favors Europe the most since late last year.  Ideas that a rift in the ECB has undermined the euro are likely an exaggeration.  It is well known the BBK’s Weber and Stark did not support the ECB buying sovereign bonds.  Clearly a majority did and does.  Weber is in the minority, but pressed his case at the end of last week.  While this spur talk about the significance that Weber is seen as a lead candidate to replace Trichet (terms expires in the end of Oct 2011).  If anything Weber’s hawkishness, one would have expected, would be euro positive on first blush. 

In Japan the demand for services fell for the first time in three months in August, adding to signs of a weakening recovery.  The August tertiary index slipped -0.2% m/m seasonally adjusted to 1.8% y/y from 2.2% in July. This only partly retraced the July bounce of 1.0% m/m SA, when it reached its highest seasonally adjusted level in 20 months, though still having come back only about half way following its plunge to record -8.0% y/y in March 2009. The tertiary index data remains on the gradual upward trajectory that left Q2 1.2% y/y after Q1 0.8% y/y for the first y/y rise in 2 years, after annual average -5.2% y/y in 2009. Along with earlier report of industrial output -0.5% m/m SA, this would point to August all-industry index -0.2% m/m to 3.3% y/y from 3.5% in July, after 2.5% in January was the first y/y increase in two years.  Indeed, the report and other data emanating from Japan support the prime ministers case for compiling a second economic package as the yen approaches a record high against the dollar.  In fact, despite a broad-based dollar rally overnight and this afternoon in Europe, the dollar continues to weaken versus the yen. 

Bundesbank says Germany may grow more than 3% this year. The Bundesbank has lifted its growth forecast to 3% in August, and now says growth may even be stronger. The central bank said in its monthly bulletin that "foreign orders may have eased somewhat, but still-strong export expectations suggest manufacturers can increase production further in autumn". The Bundesbank also said the budget deficit may be less than expected this year and should drop below the 3% limit next year. We agree that German growth is likely to come in above 3%, which will help to contain the budget deficit as tax revenues are rising among lower than expected Social Security spending.

Rightmove October U.K. house prices rose 3.1% m/m and 2.9% y/y, an unexpected rebound from the 1.1% m/m decline in the previous month. London sellers raised asking prices by 5%, the most in six months. This is in stark contrast to reports from Halifax for example, which showed house prices plunged by the most since at least 1983 in September. Rightmove questioned, however, if the increase in asking prices will be a successful tactic in the current climate and many feel that the housing market is heading for a double dip. U.K. spending cut negotiations are complete,according to the Chancellor of the Exchequer George Osborne. Osborne said yesterday that only a few details are left to be ironed out with Prime Minister Cameron. He added that the £72 bln worth in cuts over four years include steps to deprive persistent welfare cheats of benefits, to cut child benefits for higher earning families and to put pressure on banks to pay more tax.  And finally, there will also be a reduction in military spending of around 7-8%, less than the 10% the Treasury was seeking, according to Bloomberg quoting an unnamed person involved with the discussion.

Upcoming Economic Releases

At 9:00 EST/ 13:00 GMT the US reports the Aug TIC flows.  Though there is no survey data for this measure, the quarterly moving average is around $58 bln which is slightly below last month’s report of $61 bln.  Followed by September industrial production numbers, which are expected to remain unchanged at 0.2% from August.  In  Canada, the int’l securities transactions are expected to increase to CA$6 bln from CA$5.4 bln in August.