Dollar Enjoys a Broad Correction

Highlights
The US dollar is enjoying a broad correction against most of the major and emerging market currencies.  The Japanese yen is one of the of the few exceptions and it is largely sidelined with the greenback confined in a narrow range on either side of ¥82.  Japanese officials continue to brandish the threat of intervention.  The market had struggled to maintain the downside momentum on the greenback, despite the disappointing jobs data before the weekend, heightened expectations of new long-term asset purchases by the Fed, and continued rise in short-term euro zone rates (3-month Euribor at a new 14-month high today).  As we had noted at the end of last week, bearish sentiment toward the dollar had become extreme and the market had gone a long way toward discounting the dollar’s negatives.

Japanese stocks fell, with the Nikkei 225 Stock Average dropping by 2% the most in a month.  The drop was led by a plunge of 5.5% by the consumer services, particularly the auto industry as the yen continued its strength vis-a-vis the dollar.  Overall, the MSCI Asia Pacific Index was down nearly 2%, although Chinese shares were up as a rally for commodity producers and and automakers improved earnings prospects in those sectors.  And finally, in Asia Hong Kong’s stock index fell, ending six days of gains, as developers and banks dropped after China raised reserve requirements for a handful of lenders.  In fact, on the Hang Seng about three stocks dropped for every two that gained, led by a drop in telecommunications.  In Europe, the STOXX Europe 600 was nearly 2% in the mid-afternoon session led by a plunge in oil & gas, utilities and basic materials.  In addition, German stocks dropped led by a loss in utilities and basic materials as most base commodities were down on the day. 

Japan’s 10-year bond yield was unchanged; although the 10-year bond futures rose for the second day on speculation the yen’s strength will accelerate a decline in domestic prices and prompt the BOJ to ease monetary conditions further.  Additionally in Asia, Thailand’s baht weakened after the government said it will impose a tax on domestic bonds purchased by overseas investors.  This is the government’s latest effort to stem flows of hot money and weaken the surging currency.  In Europe, yields on the 10-year Gilts dropped by nearly 5 bps as weak housing data stoked speculation that the BOE will resume buying securities to avert another recession.  And Greek borrowing costs declined at a sale of bills today after the International Monetary Fund said it may give the nation more time to repay loans and China disclosed plans to buy bonds.  In fact, Greece issues €1.17 bln of six-month Treasury bills today at a yield of 4.54%, compared with 4.82% at a previous sale last month.  Yet German 10-year yield was down 5bps as the weak equity performance spurred demand for safe assets. 

Currency Markets

The US dollar’s downside momentum stalled at the end of last week.  The euro first tested the $1.40 level and sterling flirted with $1.60 last Thursday and since then, the market has struggled as bearish sentiment ran into profit-taking.  The euro has been sold to a five day low, and this could be the first time since Sept 9-10 that the euro is declining for two consecutive sessions.  The euro has come so far so quickly (11% advance from Sept 10 to Oct 7) that it is difficult to place much confidence in nearby technical supports.  The $1.3750 area may be interesting, but the near-term risk may extent toward $1.3650-80.  Perhaps market participants may be better served by focusing on levels the euro needs to see on the upside to stabilize the tone and that now looks to be around $1.3860.  While the price action looks largely corrective in nature, there may also be a fundamental development at work.  In our dollar narrative, we have placed emphasis on the dramatic swing of short-term interest rate differentials against the US.  While the pressure emanating from the prospects of QEII have been discussed at length, at the same time we recognized that the ECB was moving along its exit strategy and the reduction of liquidity had helped lift short-term money market rates in the euro zone.  The ECB took a step today that might help ease this pressure.  In a technical move, it dramatically increased its estimate of its “benchmark allocation”, which is the amount of funds it projects that banks needed to normal operations, from 81.5 bln euros last week to 195 bln euros today.  This would then reduce the amount of funds that officials regard as “excessive” which would be drained.  This in turn could help take pressure off euro zone money market rates.  However, it is also the end of the one month reserve management period for the ECB and this could be distorting conditions. To avoid some of the “noise” in the very short end of the curve, we have focused on the 2-year spread between the US and Germany.  It has widened considerably in recent weeks in Germany’s favor, but it has stabilized in recent days.  These interest rate developments suggest that there may be something more at work here than just a technical short squeeze lifting the dollar.

Thailand has become the latest emerging market country to take action to slow capital inflows.  As hinted yesterday, Thailand’s cabinet approved today to impose the 15% tax on interest income paid to foreign investors that domestic investors subject to. Previously, foreign investors were exempt for income earned from government or quasi-government bonds.  Reports indicate that foreign investors have bought a little more than $1 bln in Thai bonds this month after buying nearly $5 bln in Q3.  Foreign investors have also stepped up their purchases of Thai equities.  Data from the stock exchange indicates that of the $1.61 bln worth of Thai shares foreigners bought in the Jan-Sept period, almost $1.2 bln was bought last month alone. As is the case with many countries experimenting with measures to slow down capital inflows, Thailand is also looking at ways to encourage capital outflows.  Reports indicate the government will take measures to accelerate its foreign spending in Q4.  The Thai baht is among the strongest emerging Asian currencies, gaining about 11.3% against the dollar and bucked the regional trend today to post a minor gain against the recovering dollar.   

UK CPI was in line with consensus as the y/y rate remained unchanged and the m/m dropped to zero from 0.5%.  The RPI, however, surprised to the upside, increasing by 0.4% m/m and bringing the inflation rate down to 4.6% from 4.7%. Overnight, the RIC’s house price index declined to -36% from -32% – in line with market expectations. The decline reflects a high level of new instructions coming on to the market at a time when new buyer enquiries have been declining. These data have weighed on the GBP amid speculation that the probability of further QE is increasing.  Indeed, the MPC’s view has been that above-target inflation is temporary and inflation expectations will be tempered by a large output gap, thereby making tomorrow’s jobs report that much more important. 

Upcoming Economic Releases
At 10:00 EST / 14:00 the US reports the IBD/TIPP Economic Optimism results.  Market consensus is for a small drop to 44.5 from 45.3 the previous month.  Meanwhile, Mexico reports its industrial production figures at the same time. Market consensus is for a small uptick to 6.2% from 5.4%.  Fed’s Hoenig to speak at 11:45 EST followed by the ECB’s Weber and Trichet at 12:00 and 12:20 EST.  Finally, FOMC minutes released at 14:00 EST.