US dollar recovery, risk sell-off likely to continue

After consolidating for much of this past week, the US$ surged again to finish the week at new recent highs. The gains came in the wake of a disappointing US weekly jobless claims report and a shocking drop in the July Philadelphia Fed index of local manufacturers, which fell to -7.7 from 5.1  in contrast to forecasts of gain to the 7.0 level. US dollar strength in the face of weaker US data again illustrates the role of the dollar as a safe haven currency. As the US outlook continues to deteriorate it spells bad things for the global growth outlook, undermining confidence and raising risk aversion.

On Friday, Bundesbank president Axel Weber added another reminder of the dimming global outlook and latent Eurozone financial sector stress (see more below), sending the euro sharply lower, but ultimately the US$ higher across the board.

Every major asset class is screaming that risk is 'off' and markets are still struggling to play catch up following a sharp reversal just two weeks ago. Major government bonds made new highs/yields new lows as investors continue to seek safety in the most secure investments. Oil prices (West Texas Intermediate) shed nearly 3 per cent as global demand was marked lower and inventories (at least in the US) reached record levels of refined products. Given what we think is still the initial phase of major markets re-pricing a slower growth outlook, and aided by thinner summer liquidity conditions, we expect recent US$ strength to continue, with accompanying declines in commodities and most stock indexes. Our only source of hesitation is that US Treasury yields have dropped to near key 2.5 per cent levels in ten-year notes, and we think that could signal a near-term top for prices/low in yields. While we will continue to watch US rates closely for signs of a base forming, we will still look to re-buy US$ on pullbacks, anticipating further gains ahead, especially as there is little reason to expect more positive growth surprises and every reason to plan for further deterioration.

This Friday will see the first revision to second quarter GDP which could see the preliminary 2.4 per cent reading marked down to the 1.5 per cent area. Federal Reserve chairman Ben Bernanke will also speak on the US economic outlook this Friday, and it is difficult to see how he will find much positive to note.

Weber comments soften the euro

The euro softened as European Central Bank (ECB) governing council member and Bundesbank president Axel Weber spoke in Frankfurt yesterday, commenting on the ECB’s exit strategy as well as German and Eurozone growth divergences. The comments were viewed as dovish by his standards as he is a known hawk. Weber noted the ‘stellar performance’ by Germany in the second quarter pointing to the possibility of 3 per cent growth this year. However, he went on to state that ‘the current momentum is not sustainable’ and that Germany will face ‘weakening momentum ahead, which is in line with the global weakening of momentum’ such as that in the US economy. Weber called on European governments to consolidate budgets and focus on structural reforms at the national level to foster growth to halt the growing divergences between the core and peripheral countries. On the ECB’s exit strategy, he cautioned that it would not be ‘wise to continue with these very long operations’ and that he is firmly of the view to keep full allotment in weekly, monthly, and three-month refinancing operations until after the end of this year. Weber also mentioned that the market is re-pricing sovereign debt in peripheral European countries to find new equilibrium levels that will not be the same as pre-crisis levels. This implies relatively higher sovereign credit default swaps (CDS), a trend we have seen in recent weeks.

The comments by the potential-future ECB president sent the euro lower and €/US$ broke through key technical levels to signal further downside potential. A rising support line that starts from the 2010 lows of 7 June and the 100-day simple moving average was violated on Friday with the pair trading below 1.2750. Thursday’s price action saw a bearish crossover as the daily Tenkan line crossed under the Kijun line. €/US$ now faces near term support into its 55-day simple moving average (sma) and Ichimoku cloud top which come in around 1.2635-1.2665 area. A sustained move below here sees the next significant level of support between 1.2450-1.2500 where the cloud base and 61.8% retracement of the June-August rally comes in. Several failed attempts above 1.2900-1.2930 this past week bring this level in focus as resistance and should cap a move higher in €/US$.

Japanese yen strength may demand government action

US$/Yen tested 15-year lows this week in the 84.70/80 area and so far it has managed to hold. In recent weeks, we have cautioned about the increasing potential for some form of official intervention to limit further yen gains, whether it be renewed unconventional easing from the Bank of Japan, market intervention from the Ministry of Finance, or additional fiscal stimulus measures from the government. A much anticipated meeting between prime minister Naoto Kan and Bank of Japan chief Masaaki Shirakawa was postponed at the end of the week, suggesting there is still no immediate consensus on who should act and what measures might be adopted. In the meantime, semi-official buying interest appears to be stemming the decline in US$/Yen and we would expect that to continue until a larger policy response is agreed on. We are also mindful of a one-way mentality that has settled into currency markets, where the only way for the yen is higher. Additionally, we would note a potential 'descending wedge' pattern in spot US$/Yen and think the environment is ripe for an unexpected rebound in US$/Yen, likely in response to some new quantitative easing policy initiative. A sharp correction higher in US$/Yen would also fit with our expectations of a stronger dollar overall, and we would be reluctant to hold US$/Yen shorts for much past the 86.50 area.