Tug-of-War Keeps FX Choppy

Choppy trading conditions continue to prevail.   Some suspect these conditions are the result of lighter summer conditions.  However, it might instead by a tug-of-war between the poor US data on one hand and the unstable situation in Europe that is pushing Spanish 10-year yields above 7% and 2-year yields above 5%.  Similar Italian benchmark yields are above 6% and 3.5% respectively.

The dollar is trading with a small upside bias today.  With a brief exception, the euro has been confined to the ranges established Monday-Tuesday of this week--$1.2176-$1.2317.   We suggested that the $1.2330 level needs to be taken out to signal a correction rather than consolidation in the euro   Today is the first time since Monday that the euro has not tested the air above $1.2300.  The failure to do so appears to have brought some pre-weekend selling. 

We noted yesterday that the premier of the German state of Bavaria, the leader of the CSU (the Bavarian version of Merkel's CDU),  has taken the internal transfer payment scheme that it helped shape a little more than a decade ago to the Constitutional Court.  Bavaria is the wealthiest of the 16 states in Germany and accounts for about 50% of the internal transfers to the poorer states.  Today, the CSU is making more waves by suggesting that it would prefer a Greek exist to bending the bailout terms. Some attribute this to the heavier euro tone. 

The major fundamental development has been the continued string of disappointing US data. It is not just backward looking data, but the details of the Empire and Philly Fed reports for July warn that Q3 is off to a poor start. The Troika at the Fed (Bernanke, Yellen and Dudley) have suggested that if the data did not improve, further stimulus would need to be considered. 

One of the main arguments against new measures, outside of some tweaking of the guidance at the July 31/Aug 1 FOMC meetings is that the Bernanke has not signaled very much to the market, which he has done in the past as part of the effort to increase the transparency of the Federal Reserve.  

Several of the tools that Bernanke list pro forma this week's testimony, like the cut in interest on excess reserves or using the discount window facility likely require more work and preparation. The confab at Jackson Hole later next month is seen as the most likely window of opportunity for Bernanke to begin preparing the market for the next step.  Note too that the uncertainty about the "fiscal cliff" is seen as sufficient to deter employment and investment and estimates suggest such uncertainty can shave 0.5% off GDP. 

Despite heightened speculation about more Fed action, we note that today is the first time since January 2008 that 3-month Libor is above 3-month Euribor.  

Many observers suspect that the yen's relative strength is function of Japanese savers keeping more of the funds at home as the low interest rates deter the export of savings in the form of portfolio capital. Yet the weekly MOF flow data strongly contradicts that hypothesis. 

 It is not just because Japanese investors bought JPY1.165 trillion of foreign bonds in the most recent reporting week. After all, high frequency data is typically volatile. We looked at the four-week moving average, to smooth out some of that volatility. The four-week average stands at almost JPY930 bln. This is the highest since September 2010. 

 Moreover, to appreciate this consider that in early May the 4-week moving average was negative (meaning net sales of foreign assets) JPY664 bln, which was the largest net sales since December 2010. When investing overseas, Japanese investors typically prefer fixed income instruments and the low yields have not deterred them. The four-week moving average of bond purchases stands at JPY931 bln, which is larger than the total, suggesting some small sales of foreign equities.

The old saw is that the IMF stands for "It's Mostly Fiscal", yet it is advising the UK that is should reconsider its austerity if the economy falters in 2013, as is widely expected. The IMF suggests the UK government consider targeted tax cuts and infrastructure spending. Next week the UK reports preliminary Q2 GDP. It is expected to have contracted by 0.2%. 

At the same time, however, despite the austerity, the government sector was a net contributor to GDP in Q1 and it would not be surprising if it was the case in Q2 as well.   As today's data shows the government continues to miss its own fiscal targets. Tax receipts in the April-June period were higher than the same 2011 period, but the government is posting a larger deficit. 

Sterling's relative strength is seen as a function of flows out of the euro area both by the private sector and the diversification of reserves (SNB is a likely candidate). Reports also indicate that the UK property market continues to attract foreign investors.