Run on Dollar and Yen Continues

The main driver of the foreign exchange market is the continued reassessment of the trajectory of monetary policy in the UK, EMU, and Canada.  The OIS market does not show that higher rates are discounted for the next policy meeting (August, September, and July respectively), but rather there is greater confidence that, outside of Japan, peak monetary stimulus is behind us.  

We have argued that the interest rate differentials more than external imbalances and politics explain movements in the foreign exchange market.  This still seems to be the case, but in the opposite direction than we had envisioned.  The US 10 year premium over Canada is the narrowest since Oct, over Germany since November and over the UK since February.  

At the shorter end of the curve, the US two-year premium over German fell to 191 bp earlier today, which is the smallest since February.  The two-year premium over Canada was nearly halved to 31 bp from 63 bp last month.  It is the smallest premium since last November.   The US offers 102 bp more than the UK on the two-year money.  That is down from 127 earlier this month and return the spread to its lowest level since January.  

We are concerned that the many are exaggerating the extent to which the ECB is truly mulling an exit from its extraordinary monetary stance, as one news wires claimed.  Draghi and Constancio were fairly clear on this point.  Their focus is on inflation, not growth, and they do not believe that inflation has yet reached a durable and sustainable path toward its target.  Therefore, a high degree of accommodation is still warranted.    Far from exiting its negative deposit and asset purchase regime, we expect the buying to be extended into next year, at the September meeting, and deposit hike from minus 40 bp over the year.  

Ahead of tomorrow's EMU flash CPI, Germany and Spain are reporting their figures today.  Italy reported yesterday, and the headline fell more than expected.  In Spain and Germany, prices appear a bit stickier.  In Spain, the headline pace slowed from 2.0% to 1.6%.  The median result of the Bloomberg survey was for a fall to 1.5%.  It appears to mostly the base effect as last June's rise housing and utilities were not repeated.    In  Germany, most of the states the have reported have seen the year-over-year rate tick up.  This risks the aggregate figure, due out later today, which is expected to decline to 1.3% from 1.4%. 

We recognize that the BOE decision earlier this week to raise the capital buffer is one way the central bank is removing some accommodation proved last year after the decision to leave the EU.  However, despite the apparent change in Carney's tone, the Governor did not seem prepared to hike rates at its next opportunity.   

Separately, though not totally unrelated, auto output in the UK fell sharply in April (-18.2%) and May (-10%).  Roughly 13% of UK auto production is sold domestically.  The rest is exported, and roughly half goes to Europe.  At the same time, nearly 2/3 of the components are outsourced with most coming from Europe.  

The rally in stocks seen in the US yesterday carried into Asia but is struggling in Europe.  News that all 34 of the US largest banks passed the second part of the Fed's stress test regarding their capital buffer excited investors.  The bank quickly announced share buyback and dividend plans.  More than $100 bln will be returned to investors.  It is the first time since the financial crisis that the banks will return an amount equal to their annual profits.  Last year, "only" 65% was returned.   

The MSCI Asia Pacific Index rally 0.6% to turn higher for the week.  Financials and materials (the latter benefiting from a weaker dollar) are among the strongest sectors.    Financials and materials are higher in Europe, but not sufficiently to offset the drag from other sectors, including utilities and consumer staples and consumer discretionary sectors.  The Dow Jones Stoxx 600 is nursing a small loss in late morning turnover in Europe.  

Asia-Pacific bond yields were mostly higher in the wake of yesterday's surge in Europe and the US.  However, we note that the 10-year JGB yield was flat.  European bond yields are rising today 2-3 bp, though UK Gilts are underperforming and the 10-year yield is up five basis points to 1.20%.   The Us 10-year yield is holding just below yesterday's high print of 2.25%.  

A weak US dollar coupled with news yesterday that US output fell 100k barrels a day in the latest week, the largest decline in a year, are helping to support oil prices.  Oil is trading higher for the sixth session as it continues to recover the from the recent slide.  The August contract has traded at its 20-day average (~$45.15) for the first since the start of the month., and $46 a equates to a 38.2% retracement of the decline since May 25 high near $52.20. 

Sterling briefly poked through $1.30, where it appears sellers were lurking.  A break of $1.2950 could be the first sign that the seven-day rally is over and a new consolidation/correction phase is at hand.  The euro traded as high as $1.1435, the highest in the year.  Although we did not expect the upside break this week, we recognized that a break of the $1.11-$1.13 range would target $1.15 and then last year's high near $1.1615.  Support now is seen near $1.1350.    Meanwhile, the dollar made new highs against the yen near JPY112.65.  It his now flirting with a trendline drawn off the January and May highs and is found today near JPY112.70.   

The Australian dollar has rallied a cent from yesterday's lows and is approaching a key resistance area near $0.7700.  The US dollar is consolidating its losses against the Canadian dollar.  The CAD1.30 area is giving the US dollar bears cause for pause, while a move above CAD1.3050 warns of corrective upticks toward CAD1.3100-CAD1.3120.  

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