FX Drivers in the Week Ahead

The US dollar and Japanese yen are starting the week on a firm note, despite their respective markets closed for holidays.  The gains are concentrated against the major European currencies, with the dollar-bloc itself little changed, against the greenback.  Equity markets are lower.  China re-opened after last week's holiday with the Shanghai Composite falling a little more than 0.5%.  The Nikkei reports that Japanese auto producers in China have seen a sharp fall in sales and are responding by cutting production there sharply.

European bourses are lower, with the Dow Jones Stoxx 600 is off nearly 1% near midday in London, led by basic materials (-1.5%) and financials (-1.3%).  Peripheral bonds yields in Europe are mostly lower.  In emerging markets, the stand out is the collapse of the South African rand and a sharp decline in asset markets amid concern over the widening labor strife. 


The US dollar continues to be pushed and pulled by opposing forces.  On one hand, there is one camp that says don't fight the Fed or the ECB.  Their actions have reduced the extreme tail risks.  The investment theme that flows from this is to buy what officials are buying, or will buy, including peripheral European bonds.  It also means buying those assets, like equities and emerging markets, that are expected to see inflows because of the actions by the Fed and ECB.

The other camp, and one that we more sympathetic to, says that this is what the smart money has been doing for the last several months.  They have not waited to buy equities or emerging markets or short-term peripheral bonds.  Isn't that why Italian 2-year bond yields have fallen 350 bp since late July and why Spanish 2-year yields have fallen 400 bp?  Isn't that why the euro is about 8.25% above the multi-year lows set around the same time ?   The investment theme that flows from this camp is to take profits on the risk-on trade and prepare for more treacherous investment waters, which tends to benefit the dollar. 

The foreign exchange market is looking past diverging economic news.  Last week, the US surprised with stronger than expected ISM data, especially given the poor regional surveys, and an employment report that showed more people working, a slightly longer work week, earning a little more.  Given the revisions, it now looks as if the US economy generated a average monthly net job gain of almost 67k in Q2 and twice as many in Q3 (monthly average 145k).    

There is a lack of visibility going forward as business executives are concerned about the approaching fiscal cliff, uncertain tax environment and the looming debt ceiling.  More immediately, US Q3 earnings season formally kicks off with Alcoa's report on Tuesday.  Pre-announcements have been running 4:1 in favor of negative guidance, while the consensus expects the first quarterly decline in corporate profits since Q3 09.  

European economic news has been dismal. It is not just the PMIs that warn the euro area continues to contract, the shockingly poor German manufacturing orders, released before the weekend (-1.3% vs consensus of -0.5%), warns that the contraction may be deeper than appreciated.  Germany's industrial output reported today fell 0.5% and on a year-over-year basis is lower for the second consecutive month.    Other euro area countries will report industrial production figures at midweek, including France and Italy. 

The final CPI figures for September will be released on Thursday, but the preliminary figures likely stole the thunder and the final figure will likely simply confirm the uptick.  One of the key take aways from last week's ECB meeting is that the bar to a rate cut is higher than many, including ourselves, had anticipated.  While we never expected the ECB to offer a negative deposit rate, we note that after the ECB meetings some investment houses came over to our view.  In some ways, it appears that the price of  the Outright Monetary Transactions scheme is a more limited ability to pursue a more accommodative monetary policy proper.   The Bundesbank lost a battle, but the war for the heart and soul of the ECB continues.  

Politics more than economics is the key in Europe.  The Eurogroup of euro area finance ministers meets today in prepare for the European heads of state summit on October 18-19.  Reports indicate that the EU, if not the Troika as a whole, will report progress with Greece, and Merkel's visit on Tuesday, her first since the crisis began, seems to be another signal of support.  Yet a final decision on paying the tranche of aid, due in June, is unlikely.  

Nor does it appear that Spain is about to formally request assistance.  The Deputy Prime Minister was still saying over the weekend that Spain needs to know how and if OMT will work.  While Spain continues to be coy and the markets are allowing it to, the full blue print of not only the terms of ECB buying, but also ESM purchases have not been announced.  At last week's ECB meeting, Draghi again underscored that  only countries with access to the capital markets can qualify for OMT purchases.  It is not immediately clear whether Portuguese bond swaps are sufficient.  

Other issues, such as banking supervision and aid for Cyprus also is unlikely to be resolved.  However, the tensions that were seen between creditor and debtor nations is increasingly seen within countries.  Catalonia in Spain and Venice in Italy seem to be playing that card.  In Germany, Bavaria has filed a case with the Constitutional Court, as it no longer wants to subsidize the poorer parts of the country.  

Australia's employment data on Thursday is unlikely to dissuade investors from continuing to price in another cut in rates next month.  Softer than expected retail sales and a much wider trade deficit, with Australian banks not passing on the full 25 bp cut rate the RBA recently delivered have shaped expectations and squeezing Aussie longs and driving the currency to its lowest level in three months. 

In a similar vein, Sweden's industrial production figures (Wednesday) and CPI data the next day will likely encourage expectations of an Riksbank rate cut, even though it also cut rates at its last meeting.  Meanwhile, the UK's data (trade and industrial production figures on Tuesday) will not prevent the BOE from extending its gilt purchase program when the current buying is completed next month.  

Lastly, we note several political developments in the developing world that may also shape the investment climate.  The labor strife is taking a turn for the worse in South Africa and the dollar has rallied more than 7% against the rand over the past three sessions.    Venezuelan President Chavez was re-elected, extending his reign for another six years.  Turkey and Syria have exchanged fire for nearly a week.    Lastly, while, Hungary appears to be capitulating to EU and IMF demands, many are suspicious that this is still part of their macabre gamesmanship.