In Europe confusion prevailed
As once again countries there failed
To work out the rules
For bank-closing tools
Which were to have just been unveiled

On the whole, the dollar continues to gain, with only a few minor currencies able to rally as we begin the week.  The notable stories over the weekend were the failure by the EU to come up with a bank resolution mechanism to sever the connection between weak banks and the their national debt problems and the ongoing tightness of Chinese money markets, where the PBoC is trying to rein in ultra loose credit without causing a bank failure or two.

Let’s look at the EU situation to start.  One of the key problems driving the Euro area crisis has been the fact that the peripheral nation’s sovereign debt has largely been held by domestic banks, so Spanish banks own Spain’s debt and Italian banks own Italy’s debt, etc.  That’s all fine and well until the nation’s creditworthiness is called into question.  At that point, the holders of that debt (the banks) are also under the gun.   Given the incestuous relationship between bank and country, problems get multiplied as the viability of the banks is called into question alongside the viability of the nation.  The EU has been trying to address this issue for two years, and last year they ‘agreed’ to a resolution mechanism in one of their meetings with the details to be worked out later.  The idea was that there would be a pan-European entity (under the auspices of the ECB) which would be funded by the members of the Eurozone and would be able to directly recapitalize failing banks.  This would prevent the individual countries from having to take on more debt to save their banks, thus preserving their own creditworthiness.  This all sounded great in principal.  Alas, at the meeting this weekend to hammer out the details, they could not agree on a formula for allocating risk.  In other words, the nations that have to fund this idea (Germany, Austria, Finland and the Netherlands) are not keen to have their taxpayers own bank shares in places like Spain and Italy.  Of course the Spanish and Italians are very keen for others to take that risk.  While it would not be a surprise that, eventually,  European leaders took on this risk despite what could happen to their citizens, it would be a surprise if it were to occur before the German elections in September, as that would open Chancellor Merkel to substantial attacks from her opponents.   And so, despite assurances that they will resolve this issue at yet another meeting this Thursday, I doubt they will reach anything other than a weak compromise with no commitments by the players who matter, although they will describe it as the solution to all their problems.  This is simply another facet of my underlying bearishness on the single currency, the inherent structural flaws in its design.  And while the euro has edged lower overnight, it remains relatively well bid, at least compared to most other European currencies.

I believe the euro’s relative bid is a result of continued unwinding of trades where investors had used the euro as a funding currency to purchase emerging market currencies and assets.  This is exactly analogous to the yen’s behavior in the wake of the financial crisis in 2008.  Back then, the yen was the key funding currency (remember, only they had zero interest rates at the time) and so short-term investors borrowed yen and used the funds to buy other assets.  This was the carry trade, and it was established in very large size.  When things went south after the Lehman bankruptcy, these positions were liquidated very quickly, which resulted in lots of yen buying, and a much stronger yen¹.  I think we are seeing the same thing happen in the euro, although not to the same extent, as the euro had been a popular funding currency for many emerging market trades.  As those trades get unwound, the investor needs to buy euros to repay the funding.  Hence, the euro’s resilience in the face of USD strength elsewhere.  German data was benign, with IFO as expected at 105.9, and I believe all eyes remain on the Fed for now.  I maintain my view that the euro will continue lower over time.

Now, quickly, on to China.  The PBoC is trying to hold the line against the massive real estate speculation that has been occurring in the country, as well as limit the shadow banking system.  However they don’t have the same array of tools to adjust policy that we see in the developed world.  In addition, as there is no semblance of independence, it is widely expected that they will implement whatever policy the government chooses, rather than simply address the monetary concerns in country.  As such, recent gyrations in the short term funding market have been extreme.  A combination of increased demand for funds because of maturing debt and savings withdrawals because of the recent Chinese holidays forced many banks to pay up to fund themselves driving the overnight and 7-day repo rates to records late last week.  While those rates have since fallen, they remain well above recent averages and continue to exhibit a real tightness in markets.  It is becoming clear that the Chinese government is prepared to accept slower growth in order to prevent the inflation of a significant real estate bubble, and that does not bode well for the many exporting nations who rely on China as a key market.  So Chinese monetary foibles are displayed via a much weaker AUD and NZD, both of which count China as their number one export destination.  So too, KRW, MYR and, in fact, the rest of the Asian currency world.  The weakness across all these currencies has further to run.

There is no significant US data today, so we will look at data tomorrow.  Futures are pointing lower and Treasuries are continuing their rout.  (3% in the 10 years anyone?)  I see no reason for those trends to change, nor for the dollar to show any weakness in the near term.  Receivables hedgers, the pressure is continuing and will do so for the rest of the summer at least.

Good luck
adf

1 – This was the genesis of the idea that the yen was a safe haven.  The fact that the yen rallied alongside the dollar as investors fled their carry trades has been confused into a causality.  People weren’t buying yen because they felt it was safe, they were buying yen because they had to repay their debts.  However, the correlation was extremely high, and so many believed the story.  To be clear, yen is NOT a safe haven!

The boys in the Fed are now fighting
Which could make things much more exciting
Bernanke explained
QE could be drained
Then Bullard had words that were biting

The Chairman’s speech was premature
Since right now we just can’t be sure
Of how the US
Will meet with success
Which our buying bonds did ensure

As we walk in to the final day of what has been a pretty dramatic week with respect to market movement, the headline that jumps out to me is the comments from St Louis Fed President Bullard that the Chairman’s remarks were “inappropriately timed”.  This is the Fed’s dirty laundry out in the open and it has been sufficient to roil markets.  One of the things Bernanke has been doing while Fed Chairman has been his effort to bring transparency to the Fed process.  And while I am fully in favor of transparency, I understand that one of its consequences is that there will be more volatility resultant from that transparency.  The question is, does Ben?  After all, think about how markets work.  Traders and investors take the information they have, analyze it and establish their views, then take a position accordingly.  We all know that there are both bulls and bears in any given market, so there are always going to be different views.  But what transparency adds to the situation is that as internal dissent within the Fed becomes clear, it can serve to undermine the perception of the Fed having conviction in its actions.  Any sign of weakness in a central bank, especially the Fed, is an open invitation for markets to test that weakness.  And so now we have dissention in the ranks of the FOMC being played out in the open.  There is more volatility to come.

Yesterday’s FX movements were pretty impressive overall, with multiple currencies falling more than 2% vs. the dollar.  The overnight session has seen a bit of a rebound in the yen, but actually we have seen a continuation in the other major currencies.  The euro has suffered following the news that in Greece (remember them?) the coalition government has been weakened after its decision to close the national radio and television broadcaster, ERT, and fire 2700 government employees.  While this is a condition of the Troika bailout funding, the manner in which this occurred has not gone down well with the smallest member of the coalition.  This has also served to focus attention on questions about Greece’s ability to fund itself for the next year and called into question whether the IMF will continue adding money to the pot.  Euro weakness seems likely the future, although I don’t foresee a collapse, rather a steady decline.  The pound is softer despite better than expected budget numbers, with its deficit much smaller than expected.  However, the impetus from the ending QE story remains the key driver here.

In emerging markets, the PBoC finally injected some cash into the system last night.  This helped ease the growing credit crunch there and overnight rates fell by 442 bps.  It appears that the Chinese are still trying to figure out the best way to manage monetary policy in an economy that is growing at a much slower pace than in the past.  While the CNY is not likely to become extremely volatile any time soon, the impact on other Asian currencies is almost certainly going to be large.  The combination of the Fed changes and the PBoC squeeze has resulted sharp declines in all Asian currencies during the past week, led by INR, but pretty much across the board.  Funds continue to flow out of emerging market economies, both equity and fixed income, and this process is just getting started.  Asian central banks have been actively intervening to prevent a collapse in their currencies, but the weakening trend is going to continue as long as the Fed story remains.  Right now, most of these countries are fine, as they were actively selling their currencies during the past two years to prevent excessive strength, but history shows that defending a weakening currency is a much more difficult process, and if this pressure keeps up, we could start to see other macro policy changes that have real economic impacts, rather than simple FX intervention.  This is simply more of the fallout from Chairman Ben’s transparency initiative.

Finally in Brazil, the protests that I mentioned earlier this week are growing, with more than 1 million people taking to the streets around the country yesterday.  While Sao Paolo has rolled back the bus fare hikes that started it all, it has not been sufficient to end the protests.  Last night resulted in the first casualty in the situation, but I fear there will be more before it is over.  The question is: will President Rousseff be able to address the concerns, which seem to center on corruption in the government?  It is always difficult for a government to look inward and address its own foibles, and I don’t see any reason to believe that this situation will be different.  So to me, these protests are likely to continue for a while, possibly right up until the World Cup, and the BRL probably has further to fall.  I wrote that there was only a 20% chance of a more substantial decline in the Real, to beyond 2.50, but as I read more about what is happening on the ground there, I fear that probability is growing.  I think it is up to a 1/3 probability of a significant decline and those odds are likely to grow.  If you are a receivables hedger in BRL, be very careful.   Things could get ugly in a hurry.

Good luck and good weekend
Adf

Bernanke is getting cold feet
Bond buying he may soon complete
So it’s no surprise
That bond yields did rise
And stocks beat a hasty retreat

In case anyone doubted that the reason equity markets around the world have performed as well as they have over the past two years was directly attributed to the massive liquidity infusion by central banks, those doubts have been erased.  The entire idea behind QE has always been to force investors out of bonds and into riskier assets.  (The underlying premise was that banks would lend the money out to business for expansion, but that’s not really what happened).  Now that Bernanke has intimated conditions may soon lead to the end of QE, it was inevitable that this is how things would play out in the markets.  It doesn’t seem to matter that every time a policy change is made by a central bank, especially the inflection from easing to tightening or vice versa, markets respond with significant volatility.  Central bankers just don’t seem to get it.  The reason for this disconnect between market behavior and central bank desires is that central bankers are traditionally academicians, with little or no market experience, and quite frankly, they simply don’t understand how markets respond to news.  Traders don’t wait around for the eventual changes in the economy to materialize; they adjust their positions at the first hint of a change.  Trading too early is generally a much better error than trading too late.  And this is also why markets tend to trade far beyond any sense of fundamentals.  So if we don’t get some further ‘clarification’ from other Fed members soon, notably Yellen or Dudley, that there is no imminent change in the pace of QE, this market condition can extend quite a bit further.  Higher US yields, lower US stock prices and a rallying US dollar, just like yesterday, will be the norm.  That has been my underlying belief for several months, and I see no reason to change that view.  (Of course if we do get that clarification, look for even more volatility as markets reverse course to some extent.)

Let’s look briefly at just how far things have moved in the past two days:

These are quite substantial movements for a 2-day period, and this increase in volatility is likely to be seen far more frequently as the transition from infinite monetary ease to ‘normal’ monetary policy proceeds.  The market is going to be highly sensitive to comments from all central bankers.  But it is also going to be highly sensitive to US data, because Chairman Ben has made it clear that data is the key.  If growth achieves their forecasts (which have been raised to 3.0-3.5% for 2014), they are going to stop buying bonds and let them start rolling off.

Today’s US data upcoming is as follows:

I think that the first 3 have the opportunity to move markets.  Indications of a better labor market are key, but if the Philly Fed follows the Empire Mfg number, which was much better than expected, and the Housing market continues to show strength, traders are going to be abandoning bonds pretty aggressively.  In fact, in these transitional periods, cash is the best thing to hold, and my guess is that is where we will see investors heading.

Data overseas had limited impact on the FX markets as all eyes remain on Bernanke, but the picture in most places remains bleak.  China’s HSBC PMI data was much weaker than expected at 48.3, and tightening monetary conditions continue to plague the markets there.  Adding this to the Fed change has helped AUD to be the worst performer in the G10 space.  My earlier estimates of 0.90 may be too timid.

In Europe the PMI data for German Mfg was disappointing at 48.7, but its services data was better than expected at 51.3.  In the EU as a whole, the PMI Composite was modestly better than expected at 48.9, still indicating extremely low growth, but edging toward a positive outlook.

The only truly positive story remains the UK, where Retail Sales were up a much better than expected 2.1% in May, continuing the improving economic data there.  It should be no surprise that the pound has been the best performer of all European currencies over the past sessions, as its macro story remains the best of the bunch.

For today the market is likely to continue with its volatile ways.  I believe the trend for dollar strength will underlie most movements, especially in the emerging markets, but I am reluctant to believe that another 2% is in the cards for the rest of the day.  But over the next several weeks, there is ample time for a much stronger dollar.  Do not be looking for other central bankers to stop the USD strength, but do not be surprised if in the emerging market space we see interventions to try to moderate the volatility.  For all you payables hedgers, your time is going to come in the not too distant future, and quite frankly, another layer of hedges after recent moves would not be a bad idea.

Good luck
Adf

The G8 confirmed what we knew
The eight of them haven’t a clue
Seems most people think
Their policies stink
And waste time is all that they do

They talked about taxes and trade
But progress was sadly delayed
All details remain
Completely arcane
While photo ops cap the charade

Today is Fed day, with the FOMC’s 6-weekly meeting ending and any policy changes to be announced this afternoon.  We also get a press conference from Chairman Ben at 2:15 pm, although I would be surprised if there is any new information forthcoming.  He must still be licking his wounds from his comments about tapering bond purchases back in May.  After all, since then, 10 year Treasury yields have risen by 25bps, and equities fell more than 5%, although they have since regained about half those losses.  So while all eyes today will be on the Fed, I would be very surprised to see anything even remotely new in the statement or press conference.

Finishing up the G8 meeting, our illustrious leaders spent a small fortune to meet in Northern Ireland, discuss a range of topics and decide nothing.  It was a standard performance I would argue.  In fact, it is not clear to me that the G8, or G20, or G(anything) has shown any value in the last decade.  Perhaps halting these biannual meetings would be an effective way to reduce each government’s expenditures, photo ops be damned!

Looking at the FX markets today, there has not been a great deal of activity overnight with the euro remaining in a 27 pip range, the pound showing a bit more life with a 65 pip range and the yen the most dramatic of the big three with a 83 pip range.  That said, none of them have moved very far from yesterday’s closing levels as they await the Fed comments.  Overnight we saw strong data from Japan, with Department Store Sales surging by 5.1% nationwide and the Trade Deficit expanding by a less than expected 12.6% to ¥993 billion.  While export volumes fell, the yen value of those exports rose by more than 10%.  This was attributed to the weaker yen, and has helped reinforce the idea that Abenomics is doing its job.  The market response to the data was one of immediate yen strength, halting the recent decline in the currency.  But there has been limited follow through as there are several stories this morning of how major hedge funds remain committed to the yen weakening trade.  I am in complete agreement with the hedge funds, and continue to believe current levels remain attractive for yen receivables hedgers.  Once the Upper House election is over, look for the next wave of yen weakness.

The euro story is virtually non-existent today, with no economic data, no comments of note and no expectations of change in the market.  Any movement will be entirely dependent on the Fed.  And the pound, which has rallied steadily over the past month appears to have reached the end of this move.  While it did edge through the levels I thought would cap things, there seems to be no momentum to the trade higher and it feels like it is setting up to head back to the 1.52 level in the next week or two.  The BOE minutes were a non-event, with outgoing Governor King outvoted 6-3 again in his attempt to increase the asset purchase program.  And finally, in the UK, tonight is the Mansion House speech, where Governor King lays out his views of the economy.  It has oftentimes in the past resulted in both market movement and government action, but with King about to step down, my sense is it will have a limited impact.  Incoming Governor Carney is the one that markets will now focus upon.

In emerging markets, a story I have not been discussing directly is Brazil, where protests have been gathering pace over the past two weeks.  It seems that the people of Brazil have become upset with the general level of corruption, the lack of opportunity and the rising inflation that is eating into their living standards.  The catalyst was a rise in the bus fare by 20 cents in Sao Paolo, but it has spread around the country and forced the government to respond, not only to the protestors directly, but to the issues that they have raised.  During this period, BRL has fallen some 5%, and it is down more than 9% in the last month.  Can this continue?  My experience in emerging markets tells me that there is a chance, maybe 20%, that it can extend dramatically.  While the highest likelihood is that the BRL will settle back between 2.00 and 2.10 over the summer, do not rule out a move to 2.50 or beyond.  While this may be unwelcome news, the thing about emerging markets is that the risk comes not so much from the underlying economy, but rather from the lack of market liquidity that is found in developed markets.  And lack of liquidity can produce quite dramatic results.  Pay close attention to this story if you have exposures in country.

Good luck
Adf

There once was a banker named Ben
When asked he said, never again
Would he take a role
That’s taken its toll
On quite a long list of good men

Now markets are somewhat concerned
The next chairman might not have learned
The lessons that showed
Why growth really slowed
Soon they’ll wish that Ben had returned

It seems to be official now, Chairman Bernanke will not be returning to the Fed when his term ends on January 31, 2014.  President Obama made it clear in an interview that Ben was ready to move on.  So what does this mean for markets in general and FX markets in particular?  I think we are likely to see an uptick in the level of nervousness across the board in markets.  Despite the controversy he courted, market response to Bernanke’s unprecedented monetary policies has been pretty impressive overall.  Concerns over newly inflating asset bubbles are growing, but for most people, who simply hold equities in their portfolios, the rally that has taken place over the past 4 years has been a welcome relief from so much of the overall economic anxiety that has accompanied life since the onset of the Financial Crisis in September, 2008.  During that same period, the dollar has been anything but stable, rallying sharply in 2010, falling sharply through 2011 and edging back higher since then.  I think the biggest uncertainty for market players is that whether or not they agreed with Bernanke’s policies, they grew to understand his behavior and were able to trade accordingly.  But with a prospective new Chairman coming on board, aside from all the speculation about who it will be, there will be the matter of learning a new communication style as well as determining if the new Chairman’s policy ideas are seen as positive for markets.  This is another factor that will, at the margin, increase volatility for the rest of the year.

As to the FX markets overnight, the dollar has had a better session than yesterday, rallying against most currencies, notably the JPY and AUD in the developed space, and the ZAR and INR in the emerging space.

The session started with worse than expected Japanese IP data, a rise of only 0.9% in April, and the initiation of weakness in the yen.  Moving on to Europe, EU auto sales fell to their lowest level in 20 years!  Both these items were sufficient to help boost the dollar in the G10 space.  The euro was able to shake off its early weakness after a combination of better than expected German ZEW figures (38.5 vs. 38.1 expected) and comments from Signor Draghi, repeating that they ECB will do “whatever it takes” to keep the euro in one piece, and that other nonstandard measures, whether negative deposit rates or further liquidity injections are all possible.  The euro reacted positively to these things and is the only currency in the developed space higher this morning.

Meanwhile, UK inflation data was released at a higher than expected 2.7% in May, up from 2.4% in April and higher than the 2.6% forecasts.  Inflation in the UK remains stubbornly above the 2.0% target and seems to be a hindrance to the BOE in its efforts to support the UK economy further.  Remember, Mark Carney will be taking over as the new BOE governor on July 1, and all eyes will be on him to see if there will be more stimulus coming regardless of the inflation situation.  At any rate, the pound is softer this morning, down from recent highs at 1.57, and I continue to believe it is a better sale than buy at these levels.

Perhaps more importantly, data on Chinese home prices continues to show they are rising sharply and are creating concerns that the PBoC will not be able to support the broad economy while inflation is so prevalent.  It was the latter story that helped undermine so many of the Asian currencies, including the AUD.  If China is embarking on a period of slowing growth and rising prices, then all those nations that rely on exports to China as a key part of their growth strategies, a.k.a. the rest of Asia, are going to find themselves in significant difficulty and their currencies are going to suffer for that as well.  Remember, one of the reasons that Asian currencies had performed so well over the past several years was the idea that most of these nations were growing rapidly, albeit in the shadow of China, but that they had learned their lessons from the Asian crisis in 1997-98 and fixed their fiscal issues.  This resulted in a combination of strong underlying fundamentals and rapid growth, drawing in lots of investment.  While their fiscal situations remain in good stead, the potential slowdown in growth is going to have very negative repercussions.  We continue to see investment funds flow out of the area and I see no reason for that to abate in the near future.  This large scale exiting of financial investments will certainly weigh on these currencies.  India seems in particular difficulty, with inflation still above target and growth below target.  Last night’s 1.5% decline was precipitated by a widening of the trade deficit, which has simply been adding to their problems.  We also saw significant weakness in ZAR (soft commodity prices combined with ongoing local labor strife) BRL (weaker Chinese growth restricting its exports) and HUF(declining bond yields discouraging investors).

Yesterday’s Empire Mfg number was much better than expected, and today we see Housing Data (Housing Starts exp 950K, Building Permits exp 975K) as well as CPI (exp 0.2% headline and core).  This is the area of the US economy that has performed best of late, and more strong numbers should translate into both higher yields and a stronger dollar.  I like the dollar from here, especially against the pound in the short term, but receivables hedgers need to be on their toes.

Good luck
Adf

The G8 is meeting this week
Bernanke, as well, gets to speak
Will either present
A good argument
That havoc they no more will wreak?

Bernanke will “want to emphasize that a tapering of asset purchases is not a tightening of policy and isn’t necessarily irreversible,” said Michael Feroli, a former researcher with the Fed board in Washington and chief U.S. economist for JPMorgan.

I had to start with the comment I read this morning, which I think highlights why economists have a reputation for being out of touch with reality.  If asset purchases by the Fed constitute their Quantitative Easing policy, designed expressly to loosen monetary policy despite interest rates at zero percent, then how can tapering asset purchases, the opposite of executing them, not be policy tightening?  It is this type of muddled speaking and messaging that leads to market volatility.  As an investor, my concern is that either the Chairman doesn’t understand what the word ‘taper’ means, which I doubt; or that he is afraid to describe what he believes the Fed will need to do going forward.  It is the latter concern that will continue to drive markets for the time being.

So after several weeks of pretty significant volatility across all markets, the G3 central bankers are starting to figure out that market participants will not simply do exactly what is needed on the back of verbal cues.  In fact, Bernanke, Draghi and Kuroda need to enact policies very clearly and carefully, a level of precision that has always been difficult to achieve in the monetary policy realm, and one made even more difficult because of the unprecedented situation in which they each find themselves each having previously committed to, and enacted, extreme policy measures.  Once again, I will remind you all that as the current set of policies gets unwound, markets will remain quite volatile.

So let’s look at the markets this morning.  The dollar is mixed, with the yen weakening a bit, the Aussie rallying a bit, and emerging markets all over the map.  Equity markets are feeling better, with the Nikkei regaining 2.75%, Europe largely higher by more than 1% and US futures pointing to a higher opening.  Bond prices are mixed as well, with Treasury yields edging lower, but yields in Europe mixed and JGB yields higher.  In essence, we have no trends on which to hang our hat this morning, with each currency and product trading to its own internal issues.  In many ways, I feel this is the healthiest thing for markets, if traders and investors react based on data and news for each product.  But that is the hardest for any analysis to capture because of the disparate stories that exist.

The likeliest market movers this week are, in order, the FOMC meeting and press conference on Wednesday, any one of a number of pieces of US data to be released, and finally the G8 making some meaningful comments.

Here is the week’s data:

I would expect that the Housing data have the best chance of driving a market move, if it misses in either direction.  And what of the G8?  It is hard to believe that given PM Cameron’s stated focus on Trade, Transparency and Taxes, that they will be saying things that impact FX markets greatly.  The Fed, on the other hand, will have much to say about where things go later in the week, and I will discuss that tomorrow.  For today, unless the Empire number is a big miss, the markets appear to be taking a breather from the recent market volatility.  On the surface, I still think the euro has difficulty rallying from these levels, the yen has ample opportunity to decline sharply by the end of the summer, and the pound has seen about all the good news it can handle.

Good luck
Adf

The Chairman is having some trouble
Deflating his massive bond bubble
His stated intent
Is to circumvent
The market collapsing in rubble

The consequences of the recent market volatility are that it is very difficult to figure out what’s next.  In the past three sessions we have gone from concern over the end of the world to an all clear signal.  Yesterday started with serious concern as the Nikkei had tumbled further overnight and European markets were roiled.  US data was certainly better than expected, with Initial Claims falling and, more importantly, Retail Sales showing more strength than expected, but it seems that it was a Fed planted article in the WSJ by Jon Hilsenrath that was able to turn sentiment.  In it, he explained that any Fed reduction of QE would be verrrrrry gradual and anyway, even when they finally stop buying, there will still be no raising of short term rates for a long time thereafter.   In fact, this morning there seemed to be more articles discussing the concerns over falling inflation in the US, or at least falling inflation expectations, than on anything else.  And that would imply increasing the monthly purchases, not cutting them back.  What I do know is that the Fed finds itself in a very uncomfortable position.  It has followed a policy that has not directly addressed its targets (which in fairness are not directly addressable), but which has led to a significant distortion in price signals in asset markets.  And any attempt to unwind this policy is going to result in very severe market responses.  This, my friends, is why market volatility is high, and why it is likely to remain so for a while yet.  The Fed is not done in its attempts to force the market to respond as it sees fit, and that process is inherently volatile.

So what does this mean for the FX markets?  My thoughts go as follows:

1)   EUR – This remains capped by virtue of its internal flaws, which are playing out every day.  There remains no reconciliation over the need for a unified fiscal policy to complement the single currency and unified monetary policy.  Throughout history, nations in trouble like Spain, Greece, etc have always been able to devalue their currency, suffer early consequences but simultaneously realign their labor productivity with global competitors and get their economies growing again.  But this arrangement doesn’t allow for that, and so the tension of the German led core vs. the peripheral weak links is going to prevent substantive strength here.  Despite trading at 1.33, I continue to believe we will see 1.25 before 1.35.

2)   JPY – The recent strength in the yen is a consequence of the market correcting its massive move since last fall.  The Abe – Kuroda plan of doubling the money supply is still going to have the desired effect of weakening the currency.  To me, this remains a timing situation, with the Upper House election on July 21 a key date.  Once that is past, and assuming Abe gains a strong majority there, as currently forecast by the polls, the Japanese will take the next steps toward aggressive fiscal policy and double down on their monetary policy actions leading to a much weaker yen.  If you add in the idea that US rates are likely to move higher over the summer, it simply adds to the case for USDJPY to trade back above 100 before Labor Day, and still achieve my 110 target by year end.

3)   GBP – The pound has seen less activity lately for two reasons, I believe.  First, it has run into pretty strong resistance at the 1.56ish level, and needs another catalyst to take any further steps higher, and second, with so much ongoing in the euro and yen, traders’ propensity to be active in the pound, which is much less liquid than the big two, is diminished.  There is no story crying out for a significant move here, and I don’t foresee one upcoming.  While the recent trend has been higher, and the UK economy continues to perform modestly better, I expect that we are more likely to drift back toward 1.54 in the next weeks than rally further.  When Mark Carney chairs his first MPC meeting in July, we can look for some fireworks.

4)   Commodity currencies – Aussie continues to underperform on the weakness in commodity prices and the uninspiring Chinese economic picture.  Growth forecasts in China continue to be downgraded, and monetary policy there seems to be tightening, which will lead to still weaker growth.  (Last night the Chinese Finance Ministry had a 9-month bill auction with bids for less than 2/3 of the planned amount signaling there is a lack of available liquidity in the economy.)  If Chinese GDP doesn’t pick up, Aussie has further to decline.  CAD on the other hand has performed pretty well during the past month as it benefits from the better than expected US data that has been showing up.  While we have been trading between 1.00/1.04 for the past six months, it appears that we are going to test parity again, implying further modest CAD strength.

5)   EMG – For the past several years these currencies were traded en bloc as almost a single unit.  Yield seekers were willing to buy into virtually any market if the nominal returns were high, regardless of the fundamentals underlying things.  But these days, we have seen a pretty steady outflow of funds from these markets, with another $6.8 billion leaving EMG funds last week.  These currencies are having to live on their own merits, which some can do much better than others.  MXN has rebounded smartly from its weakest point on Tuesday, as has ZAR, while both BRL and INR have lagged that rebound a bit.  During periods of increased volatility like we are seeing currently, history shows that these currencies will underperform.  I see no reason for that to change.  Eventually, investment will flow back to these nations and the currencies will strengthen again, but for now, a trend toward volatile weakness seems the most likely outcome.

Good luck
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Like stones in water
The Nikkei sinks lower yet
What now Abe-san?

Japan continues to lead the market, at least with regards to generating stories about why volatility is increasing.  Another awful night for the Nikkei, down 6.4%, has led to a more than 1% rally in the yen, an increase in yen implied volatility to its highest point in more than 2 years, and a general increase in fear that the world’s central banks may have run out of tools to manage markets as they see fit.  Perhaps it is a good thing if they stop trying to micromanage the global economy and focus only on managing inflation, but I doubt any central banker in existence can do that.

So we have a combination of two key factors driving markets right now; first the Fed and the question of whether they will begin to ‘taper’ their purchases in the near future; and second, Japan and whether PM Abe has the ability to capture control of the Upper House of the Diet and use that increase in political strength to launch the stimulus and efficiency drive he has discussed.  Right now the market is basically clueless on both subjects, although I would contend that most pundits would say both things will happen, eventually.  But in life, timing is everything, and just what the timing of these actions will be is the wildcard.  Think about it, we are discussing the Fed reducing its stimulus at the same time the World Bank (along with every other global institution) is cutting its forecast for global growth.  Last night they lopped another 0.2% from their 2013 forecast, down to 2.2%.  We have seen reductions in forecasts for Chinese growth, Eurozone growth and US growth.  Emerging market economies have seen substantial outflows from both their bond and equity markets and EMG currencies have fallen sharply over the past three weeks.  Is this really the best time for Berdudlen to cut back?

And what about Japan?  Equities there have fallen more than 20% from their recent peak on May 23, which many define as a bear market.  Of course it is a bit ridiculous in my mind to say that a 3-week correction to a 6-month trend is actually a bear market.  It is a correction, one that is both necessary and likely healthy for the longer term prospects for Japanese stocks.  But it is painful.  And you must remember that the FX market is notorious for its extremely short term thinking.  So despite the prospect of things improving significantly after the election on July 21, FX traders are in full-scale panic mode.

Let’s recap currency movements vs. the USD since that Nikkei peak:

Emerging market currencies have suffered, but more against the yen than the dollar.  This remains very much a yen story for now.  The latest data shows that Japanese money managers have been liquidating both foreign bond and equity positions, down a combined $6.4 billion last week.  One of the key drivers in my view of a weaker yen was the likely outflow of Japanese investment.  It can be no surprise that the reduction in that outflow is resulting in a stronger yen.  But the question you need to ask is, will this continue?  I firmly believe that while the current market volatility can be harrowing, the underlying story remains one where Abe and Kuroda will push their agenda more aggressively within months, and that the yen will suffer at that time.  So yen receivables hedgers, don’t miss this opportunity.  The yen is not going back to 88 or even 90, it will find a base in the near future.

As to emerging markets, I continue to believe that current levels offer hedging opportunities for payables hedgers.

Later this morning we will see US Retail Sales (exp 0.4%, 0.3% ex autos) and Initial Claims (346K).  Are they likely to move the FX markets?  I don’t think the market is paying much attention to this data right now.  For this session, equities will be the key driver (SPU’s are down 6 points as I write), but really, I expect to hear some comments from Fed officials soon, as they cannot seem to allow markets to simply trade without imparting their ‘wisdom’.  And we all know that if the stock market rallies irrationally, that is the benefit of Fed wisdom, but if it falls, it is evil short sellers and speculators profiting at your expense!

Good luck
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That very poor nation called Greece
Continues to shrink, to decrease
Their state asset sales
Have largely been fails
Perhaps they can offer a lease!

Markets are rebounding this morning from yesterday’s poor performance with a bit less fear in the air.  Of course, this only means that market volatility continues to rise overall.  The dollar has fallen against most currencies this morning, led by AUD and NZD, which have recouped yesterday’s losses.  Although why that is the case remains unclear.

In the G3 space, the euro is little changed this morning despite the twin Greek blows of the MSCI dropping the Greek stock market from developed to emerging market status, and the failure of Greece to garner any bids for Depa SA, its national gas monopoly, as part of its asset sale program.  But the FX markets seem to be able to ignore the Greeks for now, or at least drew solace from the fact that IP in the Eurozone overall rose an unexpected 0.4% in May, much better than the expected flat reading.  With equity markets rebounding and bond markets not actually declining this morning, that seems to be enough to encourage euro holders to stand pat.

In the UK we saw a better than expected employment report, with employment rising by 24K, but no change in the Unemployment rate, still at 7.8%.  However, the body of evidence from England continues to show improvement in the economy and the pound continues to benefit, up another 0.5% this morning to 1.5650 or so.  If you recall, this is the level I expected to reach, but am not looking for any further appreciation of note.  I guess the accuracy of that forecast will be determined shortly.

The yen continues to strengthen moderately vs. yesterday’s close, although compared to where it was when I wrote yesterday morning, it is actually a bit weaker.  There was virtually no news from Japan overnight, and the Nikkei, while closing slightly lower, showed less overall volatility than we have been seeing lately.  With no comments from any talking heads, the market has been left to its own devices, which for now means no significant movements.

In the US, we have another marginal data day, with just the Monthly Budget statement (exp -$136.5 Billion) which is rarely, if ever, an FX market mover.  More importantly, the Treasury auctions $21 billion in 10yr notes today (and $13 billion in 30 yrs tomorrow).  The results of this are likely to have the biggest impact on the FX world, but they won’t be known until early this afternoon.  As such, my gut tells me that the FX market is likely to be fairly dull this morning at least.  The caveat here is if we get some comments from Fed or other central bank members.

Right now, all eyes are on the Fed as market participants try to discern whether there will be a change in policy very soon, or just sometime during the rest of the year.  I maintain that no matter how much discussion there is, when the Fed does actually move, volatility will increase, treasuries will sell off sharply and equities will probably sell off aggressively as well.  Is that a story for today?  Almost certainly not.  But it is the background noise that won’t go away, kind of like the Cicada invasion that continues to hum in the background of everyone in the Northeast right now.

Good luck
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Amidst hopes and fears
Kuroda remained sanguine
No changes were made

The FX markets are a mixed bag this morning, with the yen reacting to the lack of BOJ activity by rallying sharply, but Aussie and Kiwi having both fallen almost as sharply.

The yen story by now is well-worn, with the market hoping for (although no analysts were expecting) further action by the BOJ to help moderate the recent JGB volatility.  There were calls for increased purchases of ETF’s or a tenor  extension of credit lines that banks use to fund themselves.  However, despite a sixth consecutive month of upgrading their economic assessment, the BOJ made no policy changes.  The Nikkei gave up some of yesterday’s gains and the yen recouped all of yesterday’s losses.  Is this the end for the yen move?  Not the one that calls for a much weaker yen.  At this point, my belief is that there is little desire to do much ahead of the Upper House elections in July, after which PM Abe should command a much more powerful position and will be able to launch his third arrow a bit more accurately.  Until then, I expect that we will see more range games, with 100 remaining hard to breach, but solid support at 94-95.  Longer term, nothing has changed in my view for the yen to trade to, and through, 110, but for now, not so much.  The only caveat to this range trade is the US Treasury market.  If we see 10 year yields start to break out to 2.50% or beyond, which seems feasible to me, I think Japanese investors will start to become more aggressive in their international portfolios, taking advantage of the better yield environment.  And that will lead to a weaker yen regardless of any further BOJ activity.

As to AUD and NZD, I think we can look to their classification as commodity currencies for a rationale as to their declines overnight.  Looking at the screen, pretty much every commodity is lower with the exception of Sugar and Soybeans, both of which are barely higher and neither of which is a critical component of the export baskets for the two nations.  CAD, too, is softer, although not as aggressively, and emerging market currencies, like ZAR and MXN are much weaker.  This price action doesn’t seem to be love for the dollar, rather it appears to delineate a discomfort in holding assets in this space.  What has been the key driver in the strength of these currencies, both EMG and commodity over the past two years?  The hunt for yield!  It has helped that most of these countries were in better fiscal shape, and that most were showing better macroeconomic performance than the US and Europe, but in general, investors were just responding to the combined efforts of the Fed, BOE, ECB and BOJ, who drove interest rates to zero throughout the US, Europe and Japan.  However, recent price action in the interest rate space has been quite a change in these countries.  Bond prices are falling as investors get concerned that 1.5% to 2.0% may not be a sufficient return for 10 years, while short term traders try to prepare for the eventual exit of many of these extraordinary monetary policy measures.  So can we be that surprised that there is a shift from EMG or commodity currencies to the G3?  I think not.  The key to remember with emerging market currencies is that despite improvements in many markets, they do not have the underlying liquidity that is available in the G3.  So when investors are leaving en masse, the movements in these currencies can be quite exaggerated relative to what you might see in the euro or pound or yen.  For those of you who are payables hedgers in this space, we are likely to see some pretty good opportunities going forward.  MXN at 13.50-14.00, or BRL at 2.20, or INR at 59.00 can all be terrific levels to lock in low expense ratios.  And remember, in almost every case the points will be favorable as well.

Finally, looking at the US story today, the data is virtually nil, just Wholesale Inventories (exp 0.2%), and SPU’s are lower by about 1% so pointing to a weak opening.  European bourses have fallen across the board, so it is starting to look like a classic ‘risk-off’ day.  To me, bond prices are the key, giving us the best indicator of market sentiment, so as long as Treasuries continue to soften, look for the dollar to perform well, even against the yen.

Good luck
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