Dollar Mostly Lower As Shorts Get Re-established

Highlights
The US dollar is mostly lower as shorts get re-established after yesterday’s squeeze.  The contrast between The ECB’s continued commitment to an exit strategy, leading to firmer euro zone interest rates, while the FOMC minutes underscore the Fed’s willingness to ease further was brought into stark relief yesterday, cutting short what had appeared to be the beginnings of a corrective phase for the dollar.   At the same time, the combination of strong Chinese reserves figures ($2.65 trillion  vs $2.45 trillion at the end of June) and the commitment not to raise interest rates this year means that the world’s three biggest economies will continue to be a source of liquidity and this is encouraging flows into equities, commodities and emerging markets.  In the foreign exchange market this is reflected in the relative under-performance of the yen and Swiss franc. 

Asian stocks rose, sending the MSCI Asia Pacific Index up 0.7% overnight, as reports from China, Japan and Australia showed the economic recovery is strengthening.  The Nikkei was up marginally by 0.1%, led by gains in energy and basic materials after the strong machinery report revived optimism about the Japan inventory cycle.  And yet the Topix was down by 0.1% led by a drop in financials, which was down nearly 1.5%.  In Europe stocks advanced after the minutes from the Federal Reserve showed policy makers are prepared to buy more government debt and as Intel forecast sales topped analyst estimates.  The Stoxx 600 was led by a gain in materials and tech stocks, following the Intel estimates. 

In Asia, Japan’s 10-year government bond yields were up 2bps after this morning’s report, highlighting the strength of Japanese machine orders.  In addition, yields were up in Australia and South Korea as the positive economic data eased concerns about the strength of the Asian region.  This afternoon in Europe Germany sold an additional €5bln 10-year bonds with an average yield of 2.29%.  In addition, the UK sold £1,200 mln at 4.25% with a tenor of 2027 and an average yield of 3.6%.

Currency Markets

The US dollar’s heavy tone is not simply a function of the prospects that the Fed will soon begin a new round of long-term asset purchases, but it also the contrast with Europe.  It is not just that US rates are easing, but that European rates are rising too.  Three-month Euribor is up for the 12^th consecutive day, for example.  The BBK’s Weber, who is tipped as the most likely to replace Trichet at the helm of the ECB in a year, was exceptionally hawkish yesterday, warning that the ECB could lift rates before all its emergency facilities had ended.  It is well known that he opposed the ECB’s sovereign debt purchases and yesterday called for their termination.  Shortly after Weber’s comments, the FOMC minutes removed any lingering uncertainty that the Fed was poised to resume its Treasury purchases.  Perhaps even more important, as this had been largely discounted, was that there were extensive discussions on other measures to boost inflation expectations. 

While the diverging paths undermine the dollar, there seems to be a misconception related to the transmission mechanism.   There has been much talk that the dollars the Fed is about to “print” to finance their Treasury purchases are being sold and are flowing into emerging market countries and hence the number of emerging market countries intervening in the foreign exchange market or putting on capital controls to slow the inflows.  However, this simplification misses several key points.  The Fed will purchase Treasuries by crediting the bank’s accounts.  Bank have been keeping the vast majority of these funds at the Federal Reserve—neither lending it out nor buying much in the way of securities—and getting paid 25 bp to do so.    No doubt money is flowing to developing countries.  The cyclical component is fueled by the expected relative risk adjusted returns in emerging markets vs the developed markets.   This may be responding to the same forces that are making continued QE necessary in Japan, and to be resumed in the US, and possibly in the UK.   However, there also appears to be a structural element as American, Europeans and Japanese investors appear to be embracing emerging markets as a permanent part of portfolio diversification. 

In Japan, August machinery orders data, core machinery orders (private sector, excluding orders for ships and from electric power companies) were up 10.1% m-o-m and 8.7% y/y.  The m/m Machine orders, in fact, were much stronger than the market consensus forecast of a 3.9% decline.  Factory orders rose 10.1% from July, the largest increase since December.  Demand in emerging nations is prompting companies to increase, which is again a favorable sign of economic growth in emerging Asia. Meanwhile, there were some large orders from the steel sector, core machinery orders in August would very likely have expanded even if this impact was stripped out, sustaining the trend in recovery.  And despite the surging yen, this report is a sign that a recovery in earnings may encourage companies to spend on plant and equipment. 

In Britain, the labor force survey (LFS) measure of the unemployment rate surprised widespread expectations for an unchanged reading by falling to 7.7%.  The market consensus was for a rise of 7.8%. Indeed, this improvement in the unemployment rate continues to be driven by moderate employment growth, up 178k on the quarter, although the unemployment would have risen if it excluded 16 to 17 year olds.  Jobless claims ticked up again in September by 5.3 and the August increase was revised up by 1.5k to 3.8k.  This compared to a consensus rise of 4.5K.  In addition, average earnings, excluding bonuses, were stronger than expected, posting a 2% annual rise in the three months ending in August, up from 1.6% in the three months ending in July and topping forecasts for a 1.7% rise.  Recent economic data shows that the recovery may be weakening and coupled with recent housing weakness and yesterdays very weak consumer confidence numbers a case for further quantitative easing may become necessary.  Overall, the UK’s Treasury predicts the loss of half a million jobs in the public sector by April 2015 due to government budget. which may need to be balanced with necessary cuts in monetary policy.

Upcoming Economic Releases
At 8:30 EST/ 12:30 GMT the US reports September’s import prices, which are part of this week’s series of price reports.  The consensus is for an m/m drop of -0.2% from 0.6% the previous month.  In addition, y/y prices are expected to decline to 3.8% from 4.1% in August.  This afternoon at 16:10 EST/ 20:10 GMT Bernanke discusses business innovation followed by a speech by Lacker at 19:45 EST.