The Meaning of Sterling and Aussie's Advance Today

The US dollar is mostly weaker today.  It appears to be consolidating the gains scored since the reversal on May 3. Sterling and the Australian dollar are leading the way early in Europe.  

The Australian dollar's gains appear more intuitively clear.  The minutes from the recent RBA meeting indicated that it was a closer decision.  This means that a follow-up rate cut next month is unlikely, which is what we have argued.  While short-term participants may be surprised today, the medium-term outlook has not changed. It seems likely that the RBA may still need to ease monetary policy.  

The resilience of the Australian dollar yesterday despite the disappointing data from China, and the follow through gains today, is notable.  If it is sustained, it is likely signaling the end of this leg up in the US dollar, which began in late-April against the Aussie and May 3 for most of the others.  The Australian dollar's upside momentum eased in the European morning, so the key to the outlook may be the shape and magnitude of the pullback.   Ideally, the Aussie holds above the $0.7280-$0.7320 band.     

We have argued that the place to look for investor anxiety about the UK referendum is not the spot market but the options market.  At the start of next week, it is a month away.  The one-month volatility and risk-reversal will replace the two-month tenor as the indication of the cost of insurance. More polls were out, and the one that has captured the market's attention sponsored by the Telegraph that found a seven-point swing toward the "Remain" camp over the past month.   That puts the status quo in a 55-40 lead.    

Some press accounts attributes sterling gains to this poll, but this seems a bit selective use of evidence.  The ICM conducted two surveys one by telephone and one online.  This produced conflicting results.  By telephone "Remain" was ahead 47-39.  Online participants gave Brexit the lead 47-43.    

Also, a seven point swing is large in a month and may be a statistical quirk.  Other surveys need to confirm that the undecideds are breaking toward the status quo, as is typically the case, to validate the Telegraph's results.    We note that there has not been comparable shift in the event markets.  

An alternative hypothesis is that sterling is responding to the same set of fundamentals as the Australian dollar.  There is no greater crisis that the RBA needs cut interest rates at back-to-back meetings.  Part the reason is the rebound in commodity prices.  The UK is not a large commodity producer of course.  However, there are several large companies that report their earnings in the UK, which are tied to the price of commodities.  In fact, there have been some reports linking the deterioration of the UK current account to the drop in profits and repatriated earnings from a couple of dozen companies.  

Behind that explanation lies the statistical fact that sterling and the Australian dollar are at their highest correlation in nearly four years.  On a percent change basis, the correlation of the two over the past 60-days is 0.65.  

The soft CPI (0.3% year-over-year, vs. expectations of an unchanged reading of 0.5%) took the wind from sterling's sails.  The weakness was in the core rate, which unexpectedly fell to 1.2% from 1.5%. Sterling was already stalling ahead of the report, so the key to the near-term outlook may be how far does sterling retreat.  After all, the April CPI report has little bearing on the outlook for rates, and whatever impact it may have under normal circumstances, the referendum will alter the outlook one way or another. The $1.4440-$1.4450 area may be key.  A break of it could warn of another 1.0-1.5 cent decline.  On the upside, the $1.4530-$1.4545 area has capped upticks since the May 3 reversal.  

The euro is little changed in the well-worn range.  On the other hand, the dollar is pushing above resistance around JPY109.50, helped by rising equity markets and the rise in US yields.  Ideas that if Q1 GDP contracts will boost the chances for fiscal stimulus miss the point.  The fiscal support plans on in the works.  Investors cannot say GDP is not a good metric of the state of the economy and then expect policy makers to put so much emphasis on a report whose components are already known.  

Moreover thinking that a small decline is materially different from a small gain for policymakers is to be fooled by the precision that measuring something to a tenth of a decimal point pretends.  The BOJ estimates that trend growth is about 0.2%.  

Speculators in the futures markets are holding a gross and net long yen position that is near record levels    Given the interest rate differentials; it is expensive to be short dollars and long yen without momentum.  Some of the long yen positions may feel trapped, and may now be looking for an exit.   The greenback is unlikely to got through JPY110, of psychological importance straight away.  Positioning warns that the pullback will likely be shallow.  

The US reports April consumer prices, housing starts, and industrial output.  The data will impact expectations for the pace Q2 growth, but the broad direction seems clear. After the soft patch the economy hit in Q4 15-Q1 16, the economy appears to be rebounding.  The Empire State survey yesterday was for May and the fall in orders was disappointing, but we need confirmation before investors should be concerned give the momentum of the other data.  

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