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Dollar Correction Likely To Continue

Highlights

The US dollar is generally consolidating this week’s losses in quiet and largely uneventful turnover.  The shallowness of dollar bounces warns that the downside correction is not complete.    Given the structural arguments that the euro bears drew upon to fuel the single currency’s 13%+ decline between mid-April and earlier this month, the risk seems to be that participants may anticipate the end of the correction prematurely.  We suspect that the onus is now on the dollar bulls, though the market is still asymmetrically positioned.  The correction should be assumed to be intact until proven otherwise. 

Global equities are mixed.  Although the MSCI Asia-Pacific Index edged 0.2% higher and Korea reported net foreign purchases for the sixth consecutive session, the real story was the declines.  China’s Shanghai Composite slumped 1.8%, its biggest decline in three-weeks.  Weakness was broad based, but especially pronounced in health care (-5.7%) and technology (-4.8%).   The Nikkei was fractionally lower, but financials under performed (-1.5%).   European bourses are higher and, of note, following yesterday’s Spanish bond auction, financials in the Dow Jones Stoxx 600 is the strongest sector, rising 1% compared with the overall benchmark up about 0.3%. 

Spain and Italian bonds yields have fallen 5-9 bp as near-term sentiment has been boosted by yesterday’s auction results and suggests that the both country’s banks’ stress tests produced favorable results.  On the week, the Spain-German 10-year spread is about 9 bp wider, while Italy’s is 19 bp tighter.   Ireland’s premium is 32 bp wider.  Portugal is 38 bp wider and Greece is 111 bp wider.  It would not be surprising to learn at the start of next week that the ECB reduced its bond purchases. 

Currency Markets

One of the most important takeaways from this week’s activity is that arguably long overdue dollar correction is becoming convincing.  What had begun as choppy consolidation has morphed into an outright correction.    The euro is having its best week in nearly a year, gaining a bit more than 2% against the greenback over the past five days.  There have been several factors that have encouraged the position adjusting, which had been widely recognized as extreme in the first place.  As we have pointed out, the news stream has generally improved for Europe and even when the news turned less favorable, the die had been cast, and momentum traders were being forced to the sidelines.  Although Spain had to pay up for it, the fact that its long dated bonds were absorbed relatively smoothly by the market helped strengthen the euro’s recovery.  At the same time, the economic news stream from the US has generally disappointed, beginning with the employment data and running through the retail sales and Philly Fed survey.  Indications from the options market would also suggest the correction has more room to run.  Today 3-month implied volatility has slipped to 13.5%, the lowest since mid-May and also appears headed lower.  At the same time, the premium investors are paying for euro puts over euro calls has fallen to its lowest level since early May and a further decline also looks likely.   

The Swiss franc appeared to lead the euro and the SNB’s upwardly revised forecasts for growth and inflation, signaling the end to the deflation risks (and therefore QE) helped the franc gain 3.6% against the dollar.  For the record, the euro was pushed to new record lows against the Swiss franc today, taking out the previous record low set last week by a few ticks before snapping back. 

Sterling traded at a five week high against the dollar; helped by less than expected public finances in May.  The public sector net cash requirement came in at GBP12 bln.  The consensus was for GBP20.5 bln and the April figure was revised down slightly.  The same pattern was seen in the public sector net borrowing.  It came in at GBP16 bln, somewhat less than expected and April’s borrowing also was revised lower.   There have also been a number of M&A stories in recent days that may be helping underpin sterling as well.  Sterling flirted with its 50-day moving average today near $1.4865, but has since pulled back.   Provided the $1.4750-70 support holds, there is potential to $1.50 in the coming days. 

Japan’s macro-fundamental picture has improved in recent days.  Recent economic data has prompted the government to rise higher its economic assessment for the first time in 3-months.  The economy, it says, is picking up and the foundation is being laid for a self-sustaining recovery.  Confirmation is expected in the next Tankan survey out on 1 July.  The new Japanese government is committed to addressing the fiscal challenges and this may reduce the fear of a near-term debt downgrade.  Recall S&P had put Japan on credit watch and had linked its decision to the government’s fiscal strategy which is expected in the coming weeks.  Prime Minister Kan said yesterday that he will consider a 10% hike in the retail sales tax and two opposition parties (notably the LDP) support higher consumption tax, which currently stands at 5%.  Some officials are touting the consumption tax hike to pay for a corporate tax cut.  The dollar has broken below its 200-day moving average against the yen, which comes in near JPY90.90.  Technical conditions and current market sentiment warns of the risk of additional dollar declines toward JPY90 and maybe even JPY89.00 in the days ahead. 

Some thoughts about the European bank stress tests:  The release of the US bank stress tests coincided with the market bottom, even though the tests were criticized for not being sufficiently robust.  What was at issue there and now in Europe is about investor confidence.  Spain and Italy appear to be the most anxious to publish the results.  Yesterday’s news that Spain’s largest bank was among the best position among large European banks helped boost sentiment.  Italy’s central banker has intimated that Italian banks are in good shape.  What has largely gone unnoticed though is that regulators are allowing commercial banks not to mark-to-market their portfolios of European sovereign bonds.   Thus, while the capital markets have stabilized and this is a positive development for the euro, the underlying debt dynamics have not really changed.  The need to roll-over debt and bank funding may re-emerge as a key driver, after the largely technical correction ruins its course. 

Upcoming Economic Releases
There are no US economic reports or speeches slated for today.   Canada reports April leading economic indicators and its April international securities transactions at 8:30 EST/12:30 GMT.  These are not typically market movers.  And in a soft US dollar environment, the Canadian dollar often under performs European currencies.

Marc Chandler

About 

Marc Chandler joined Brown Brothers Harriman in October 2005 as the global head of currency strategy. Previously he was the chief currency strategist for HSBC Bank USA and Mellon Bank. In addition to frequently providing insight into the developments of the day to newspapers and news wires, Chandler's essays have been published in the Financial Times, Barron's, Euromoney, Corporate Finance, and Foreign Affairs. Marc appears often on business television and is a regular guest on CNBC and writes a blog called Marc to Market. Follow him on twitter.