Dollar Softer Ahead of ECB

The US dollar is trading heavily ahead of the ECB meeting. Of course, the Bank of England also meets, but this week's three stronger than expected PMI readings, coupled with this being Governor King's last meeting before Carney takes the reins, means that 3-person faction, that included King, favoring new gilt purchases for several months will gain no allies.

While not committing to any action, ECB President Draghi comments fanned speculation of a discount rate cut and some measures to help the funding for small and medium size businesses. Like the Fed's tapering and the OMT, a negative discount rate has arguably had desirable consequences with limited costs for policy makers. We do not expect the ECB to take any action and that it will keep all of its options open.  That is the way the game is played, though being "open minded" about a negative deposit rate will have less impact than before.

 

Even though the staff forecasts may tweak growth and inflation forecasts lower, this will likely largely be in recognition of the recent data rather than much fresh forward guidance.  The uptick in the PMIs this week give ECB officials little reason to doubt their base case of gradually recovery in H2.  Germany reported a disappointing 2.3% decline in April  factory orders, which points to continued softness in its manufacturing sector, but this was already evident from the PMI readings.  The issue of the rate corridor and the deposit rate need not be addressed this month.  

Our understanding is that there is also not a consensus on the asset-backed securities approach or collateral approach to helping facilitate lending to SMEs.  The problem is most important in Italy and Spain, but appears to be largely a reflection of higher costs of borrowing by the local banks and recessionary economic conditions which saps demand. 

The other main driver is the downgrading of expectations for tomorrow's US employment report.   The combination of the softer than expected ADP estimate and the decline in the employment component of the of non-manufacturing ISM (to its lowest level since last July) deflated expectations.  It seems clear that the US economy has lost some momentum here in Q2 and we see this being reflected in the labor market in recent months (jobs and hours).  

As investors, we are more interested in what the Fed will do rather than what we, or someone else, thinks the Fed ought to do.  The preferred measure of inflation is near record lows and labor market conditions have eased.  It was always understood by Fed officials that QE could ignite excess speculation in other markets.   Surely in the past couple of weeks, what ever froth there was has been reduced.   The S&P 500 is off about 4.75% from its late May high.   Ten-year Treasury yields are nearly 50 bp higher.  This move has been echoed throughout the international capital markets. 

The Nikkei has also continued to unwind this year's gains.  With today's 0.85% decline, the Nikkei closed below 13k for the first time in two months and is off nearly 20% from its May 23 peak.  This is what some use as a definition of a bear market.   The weekly MOF portfolio flow data suggests the selling pressure is not coming very much from foreign investors.  Foreign investors did sell JPY191 bln of Japanese stocks and have been sellers in 3 of the past five weeks.  Yet over this period it has only sold less than $3 bln worth and in May were still net buyers of $13.6 bln of Japanese stocks.  

For their part Japanese investors continued to sell foreign bonds.  They sold almost JPY1.2 trillion last week after selling JPY1.1 trillion the prior week or roughly $23 bln over the two week period.  This two-week pace may have been seen once or twice over the past decade. 

Meanwhile, a smaller than expected trade surplus gave the market the excuse of the day to sell the Australian dollar to new lows (~$0.9435).  It was near $0.9800 earlier this week.  There seems to be a bit of piling on as media reports play up the decline in the currency with out really adding anything new.  The Australian dollar has lost 7.2% over the past month and is the weakest major currency over the past three months; closing in on Japan's 12.5% year-to-date decline.