Markets Limping into Weekend; FOMC Looms

The global capital markets are subdued as the week draws to a close. Asian stocks, while European bourses are heavier. Bonds are firm. The dollar itself is little changed against the major currencies.

Chinese markets had been a source of global volatility, but they too are becalmed today. The large move on the offshore yuan yesterday has subsided. Although there was talk that the PBOC had directly intervened in the offshore market yesterday, confirmation remains elusive. More likely, the presence of large state-owned banks buying the offshore yuan (CNH) yesterday was interpreted many as operating on behalf of officials.

In order to "perfect" the new currency mechanism, two convergences are ultimately necessary. The first, as we have been emphasizing is the convergence between the daily reference rate (fix) and the spot market. This convergence has largely taken place.

However, this convergence in the first instance spurred a divergence between the onshore and offshore yuan. The second convergence is really the re-convergence of the onshore and offshore yuan. The increased fungibility of CNY and CNH is important for hedging purposes, and is also operationally important for the easily accessible criteria of joining the SDR.

Closing the gap between the two may also dampen the downside pressure on CNY. Many observers had seen the future of CNY in CNH, ie, the weakness in the offshore yuan was seen as a sign the need for a further decline in the onshore yuan. The spread between the two widened back slightly today, but we should think of it as a process. Market participant will likely this evolve in the coming days.

Just like the run-up to EMU facilitated various reform efforts in Europe, the drive for SDR membership is encouraging reforms in China. When China was experiencing capital inflows, officials took steps in the direction of liberalizing outflows. Now that is experiencing outflows, it is finding was to liberalize inflows.

If China has injected some volatility into the global capital market in recent weeks, the uncertainty of the Fed's course has also not been particularly helpful. Many observers and media coverage play up the risks of higher US rates on the world's largest economy as well as emerging markets. However, the opposite is true too, if not more so.

The growing sense from many officials and investors is that the Fed's lift-off is like the Sword of Damocles. The uncertainty itself has become a weight. It needs to get the move over with already. Given that 1) US is near full employment by the Fed's reckoning, with this week's JOLTS report suggesting strong momentum in job openings and 2) that Q2 GDP, which was already the strongest since 2006, when investment in the energy sector is excluded, the emergency setting of near zero interest rates is no longer warranted.

Contrary to the doom and gloom offered in many quarters, the US economy is strong enough to absorb a 25 bp increase in the Fed funds range. Some of the pressure on other markets is in anticipation of this increase. It is possible, and even likely that a hike couched in the Fed's gradualism and guidance of a lower terminal rate in this cycle, could see a relief rally in risk assets, including emerging markets and commodities.

Conventional wisdom is that the dollar typically sells-off when the Fed raises rates, but we suspect there is some curve fitting taking place. We have argued that this dollar rally is the third significant rally since the end of Bretton Woods. The first dollar rally began in the late 1970s, though it is often associated with Reagan. It was facilitated, especially at the start, by a dramatic tightening in US monetary policy under Volcker. The second dollar rally began in early 1995 and was preceded by the tightening of monetary policy in 1994.

Precisely how the dollar reacts in the first few hours, days, or weeks, seems less significant for investors, though it can be important for short-term speculators. The initial response seems to be an issue of market positioning, expectations for further hikes and the anticipated response by other central banks. That said, we acknowledge that all rate hikes have not led to a significant dollar rally, but all significant dollar rallies have been preceded by tighter monetary policy.

Over the last several weeks there has been an adjustment of speculative positioning, judging from the Commitment of Traders. This has entailed a reduction of net speculative short foreign currency positions in the futures market. Recall the euro was testing $1.0850 in early August, and before the end of the month, it had tested $1.17. The dollar was pushing toward JPY125 in the first part of August and spiked to almost JPY116 a couple of weeks later.

More immediately, the euro appears to be correcting the slide from almost $1.1715 on August 24 to just below $1.1090 on September 3. The $1.1325 area marks the 38.2% retracement, and above there is the 50% retracement at $1.1400. The dollar is showing little momentum against the yen. The immediate and narrow range seems to be JPY120 to JPY121.35. The BOJ meets next week as well. Some Japanese banks are highlighting the risk of a new BOJ initiative, though most who expect more monetary efforts are looking for it next month.

Sterling had a good week, rising nearly 2% against the US dollar and snapping a nine-day closing streak to start the week. Yesterday's high near $1.5470 neared the 50% retracement level (~$1.5490) of the slide from August 25's $1.5820 to September 4 low of $1.5165. Above there is the next retracement objective near $1.5570.

The Australian dollar is the best performer of the major currencies this week. It has gained about 2% against the US dollar, ostensibly helped by the stabilization of Chinese markets and higher copper and iron ore prices. The Aussie had begun the week with new multi-year lows just below $0.6900. The short-squeeze carried it up to $0.7100 yesterday, where it has run out of steam. Yesterday's outside up day has gone for naught. There has been no follow through buying. Initial support is seen in the $0.7000-$0.7020 area. A break of $0.6980 would confirm the correction is over and that a new down leg has begun.