Dollar Trades Heavier After PBOC’s Rate Hike

Highlights
The US dollar is trading heavier today as Asia and Europe sold into the strong gains scored in North America yesterday following yesterday’s surprise Chinese rate hike.  Of the majors, the euro and Australian dollar are leading the move, but given the magnitude of yesterday’s losses, these gains today are modest.   The dollar’s pullback after Asia initially managed to marginally extend yesterday’s gains, but has left short-term technical indicators over-extended.  The price action in recent days has been exceptionally choppy and the underlying direction is not as clear as it had been in recent weeks.  Today’s North American session could be pivotal. If North American participants take advantage of the foreign currency bounce to cut stale positions, it would point to a deeper correction of the dollar’s precipitous decline. 

Asian stocks mostly lost ground, as materials firms and property firms lost ground after the China decision. Chinese benchmarks themselves opened sharply lower as you’d expect, but rebounded into positive territory, led by insurers. The MSCI Asia Pacific index fell 0.4%, its fourth straight losing session.  Japan’s Nikkei fell 1.6%, led by a drop in energy and materials which each fell by more than 2%.  In Europe stocks fluctuated, following yesterday’s decline in the benchmark Stoxx Europe 600 Index, which was the largest in two weeks, though the benchmark index was up 0.1% by the mid afternoon session in London, led by a rise in health care stocks. 

Bonds were little changed but the cost of protecting (CDS price) Asia-Pacific bond from default increased after investors were surprised by China’s surprise rate hike decision.  Japanese bonds edged lower, with the 10-year JGB yield up 1 basis point to 0.885%. 20-year debt also slipped ahead of the sale of 1.1 trillion yen ($13.4bln) of 20-year securities tomorrow.   German government bond yields dropped as falling shares boosted demand for the safe haven assets. The yield on the 10-year, for example, was down 1 bps, meanwhile the 10-year yield on Irish debt climbed by 7bp followed by a 2 bps increase on Portuguese debt.   And finally, Portugal’s debt agency has raised a total of €760 mln through a 12-month Treasury bill auction that is due to expire in October 2011 and was issued at an average yield of 2.886%.

Currency Markets

The choppy price action in the foreign exchange market is frustrating short-term operators, but our assessment of the medium term drivers remains largely intact.  We have argued that the combination of the strong prospects of QEII in the US coupled with the normalization of European interest rates would undermine the dollar and carry the euro and sterling to $1.40 and $1.60 respectively.   The move was more rapid that we expected.   Indeed the speed of the move has prompted different responses from market participants.  Some chase the market higher and we have seen several large investment houses revise lower their dollar forecast.  While this may be the appropriate strategy for short-term momentum players, we have been reluctant to advise medium and long term investors to project the trends far into the future.   The market has gone a long way toward discounting QEII in the US and now with 3-month Euribor at the ECB’s refi rate (1%) for the first time in more than a year, the key driver we identified is losing its power.  Sentiment reached extreme readings and market positioning also seemed stretched.   While the choppy price action in recent days seems to be largely a function of market positioning, we anticipated a more durable dollar bounce after the monetary and fiscal uncertainty is lifted after the election and FOMC meeting next month.   For the near-term, our bias is for the dollar’s upside correction to continue, provided the euro holds below $1.3875 and the Australian dollar holds below $0.9830, to cite the lead currencies. 

The BoE Minutes from the October meeting, as expected, showed a three-way split with seven members voting for unchanged policy, while Posen and Sentance were the outliers.  In particular, Andrew Sentence voted for a 25bps rate hike and Adam Posen voted for an extension of QE by £50 bln to £250bln.  Most of the MPC said it was ready to act in either direction, highlighting both downside and upside risk to inflation.  And yet some of the MPC members felt that chances of more stimulus being needed has increased in recent months.  U.K. September public sector net borrowing came in worse than expected, following weak August numbers. Net borrowing was £15.6 bln, higher than the market consensus of £14.5 bln. Overall, September data highlight that U.K. public sector net borrowing remains high, though budget tightening measures are likely to bring down the borrowing need next year. However, focus is now on the Comprehensive Spending Review later today.  In subsequent trading sterling was mostly flat, reaching an intraday low of 1.5651 to the greenback, although sterling weakened much more against the euro.  That said, the chances of another round of QE are small but still probable and the outlook for UK growth and inflation will be paramount.  On the whole, the MPC minutes and spending figures is a clear negative for sterling and based on this morning’s price action may be best augmented through a long EUR/GBP trade.  At these levels the trades looks a bit crowded but look for entry around the 0.86 range. 

Following the surprise move by the PBOC yesterday the greenback was largely up against most currencies except the yen. Of late, the price action in USD/JPY has befuddled as the yen continues to surge against the dollar.  The old script of risk-on/risk-off does not sufficiently explain the price action since the adjusted-correlation of the USD/JPY has broken down and is now largely insignificant.  With risk sentiment no longer the main driver of USD/JPY what could be the catalyst for the recent strength.  The main driver appears to be the interest rate spreads of the dollar-yen at the 2-year and 10-year tenors.  In fact, over the past month the US 10-year Treasury yield has dropped 22 bps while 10-year Japanese yield dropped 17 bps.  And more importantly year-to-date, the 10-year yield on USTs dropped 136 bps, while the yield on JGBs for the same tenor dropped only 40 bps.  This reduces the allure of dollar denominated bonds and has been the key driver for currencies since the breakdown of the risk-on/risk-off paradigm from the summer.  Expect the yen to continue to rally as long as US treasuries continue to fall which is largely expected until the full details of QEII emerge. 

Upcoming Economic Releases

At 7:30 EST / 12:30 GMT the UK is expected to release the comprehensive spending review (CSR).  At 8:30 EST / 13:30 GMT Canada will publish the m/m wholesale sales for the month of August followed by BoC Policy Report.  And at 14:00 EST the Fed releases its Beige Book.