Capital Market Drivers

The RBA left rates steady, confounding market expectations and this led to a sharp sell-off in the Australian dollar, as one would expected. The RBA left the door open to additional easing. The next inflation report is due out Oct 27 and that will play a big role in shaping expectations for a Nov move.

The fundamental case for the Australian dollar may not be so much tied to higher rates--especially if the BOJ, and Fed and maybe the BOE are easing policy. Current high rates are attractive. The commodity story and the proximity to China theme also may continue to underpin the Australian dollar on a trend basis. The Australilan dollar fell to a low near $0.9540 and the high since has been about $0.9615. It looks likely to be capped near $0.9650.

The Bank of Japan surprised the market by cutting the overnight target rate to 0-10 bp from 10 bp and set up a new fund to buy JPY5 trillion of government bond and corporate paper. This will expand its balance sheet, which already is larger than the Fed's (as a percentage of GDP). The dollar popped up half a yen to JPY84 where sellers reemerged. I don't think the zero-interest rate policy nor the JPY5 trillion expansion of the balance sheet will have much impact.

The euro zone and the UK service sector PMIs are better than expected. The euro zone Sept reading stood at 54.1 vs the flash estimate of 53.6 in last Sept. It is still down from the 55.6 level in August and represents a six-month low. In terms of country highlights, Germany came in better than its flash (54.9 vs 54.6) and France came in a bit below (58.2 vs 58.8). More worrisome is Spain’s continued erosion below 50 (47.9), for the third consecutive month. Ireland’s reading also broke the 50 boom/bust level for the first time since March and th the forward looking new business falling sharply (47.8 vs 53.9). The UK surprised on the upside with a 52.8 reading compared to 51.3 in August. The market has expected a modest decline.

Lastly, apart from the PMI reports, the euro zone reported an unexpected decline in August retail sales. The consensus had called for a 0.2% increase after a0.1% gain in July. Instead, August retail sales fell 0.4%. The euro initially encountered follow through selling in Asia after the weak performance in Europe and North America on Monday. After stops were triggered near $1.3650, good buying, which market talk linked to Asian central banks and hedge funds snapped the euro back. It seemed to have run out of steam as the $1.3800 area was approached. It is too early to talk of a double top, but a break back below $1.3750 could spur the talk.

Moody’s placed Ireland on credit watch for a possible downgrade of its Aa2 rating, which is one notch above S&P and Fitch. It should not be surprising, given the recent developments, including the steep Q2 contraction and the magnitude of the bank support efforts. Moody’s also opined that Ireland does not require external aid. This appears true for now. Ireland has also indicated it will not go to the capital markets this month or next and it does not appear to have to go back until closer to the middle of 2011. Irish bonds sold off on Moody’s credit-watch decision and with today’s 6 bp rise the 10-year bond has replaced Portugal’s bond as the worst performer in the euro zone over the past month. Moody’s lifted Turkey’s Ba2 outlook to positive from stable and had unexpectedly nice things to say about Greece: Greece’s efforts have been impressive and if they continue, Moody’s said, the risk to the sovereign rating is on the upside. This is from the rating agency that had cut Greece to below investment grade less than four months ago, citing “ citing risks to its economic growth from the austerity measures.