UK, Euro Zone, Rate Differentials and Asia

Sterling’s nine-day advance has been placed in jeopardy today by the weakest service sector PMI in over a year. The 53.1 headline reading is the lowest in 13-months and contrasts with the 54.4 reading in June and expectations for a decline to around 54.0. Business expectations did rise, but CIPS noted that cancelled contracts and fewer business enquires. Sterling dipped below $1.59 briefly but quickly bounced back. Support is seen in the $1.5850-80 band and only a break of this would suggest corrective phase is at hand. The market does seem to have given up on a genuine test of $1.60.

The euro zone PMI figures weren’t anything to write home about either. The headline was reported at 55.8, down from the flash estimate of 56, though still above the June reading of 55.5. It stood at 56.2 in May. Spain and Italy surprised on the downside. The latter fell back below the 50 boom/bust level since Nov 09 and new orders were particularly weak. On the other hand, France surprised on the upside and the German report was spot on.

In a larger sense, though the pattern of euro zone economic activity has been unexpected. After near stagnation in Q1, some of which appears weather related, stronger Q2 activity was seen and this during the most intense phase of the debt crisis. Today we learn that as the op-ed pages were full of doom and gloom about the future of EMU, Europeans were shopping. The May retail sales estimate was doubled to show an increased of 0.4% on the month and 0.6% year-over-year. The June figures were softer with a flat month over month reading and a 0.4% year-over-year pace.

This is sort of indicative of what many in the market expect; namely that the euro zone’s economic activity moderates going forward. However, there seems to be disagreement over the currency implications, especially give the heightened risk of some new QE measures by the Federal Reserve.

We continue emphasize interest rate considerations in the dollar’s weakness, which many observers are still attributing to technical factors. While we recognize a role for these technical factors, we are wary of it becoming a vacuous substitute for more rigorous analysis. Yesterday we noted the performance of the two-year interest rate spread between the US and Germany.

To be clear one need not even go out that far to appreciate what is happening. Consider three month LIBOR. The dollar rate peaked in mid-June near 0.54%. Today it stands near 0.42%. In that same period, euro LIBOR has risen 20 bp and today Euribor was fixed above 0.90% for the first time in a year. The ECB meets tomorrow and no one is looking for a change in policy. Last month, Trichet seemed largely unconcerned about the backing up of money market rates. It will be interesting to see if he is pressed on this issue. The combination of the appreciation of the euro and rise in money market rates is imparting a tightening of monetary conditions in the euro zone. This can be expected to impact the economy with some unpredictable lag.

Turning our attention to Asia, there has been increased speculation that central banks in the region have stepped up their intervention to slow their currencies appreciation. Foreign purchases of local equities appear to be a major force. The Korean won, for example, is trading at two-month highs as local stock market reports that foreign investors were net purchases of shares for the eleventh consecutive session. The Taiwanese dollar advanced for the ninth consecutive session. In recent days it has slipped into the close and some suspect this is officially inspired. The Philippine peso rose to 3-month highs against the dollar today before what appears to have been central bank dollar purchases pushed the peso down. This in part illustrates another point we would make: the market is not waiting for China to move quicker on its currency before bidding up the regional currencies, contrary to a domino-like theory held by many. In fact, while the regional currencies generally advanced today, the Chinese yuan softened and the 12-month NDF is pricing in about a 1.4% appreciation. Meanwhile, China’s money market is flush with liquidity and this is reflected in the key 7-day repo rate slipping to its lowest level in 3-months (1.64%). Note that the service PMI rose to 56.3 from 55.6.