Turn Around Tuesday or Not

Some of the US dollar's recent gains had been pared after its upside momentum slowed yesterday in North America. However, by midday in London the dollar came back better bid.  Although we anticipated this broader consolidation from a technical perspective, there are a couple fundamental developments that are encouraging the move.

Japanese government bonds have continued to sell-off sharply. The 10-year yield jumped 11 bp to 0.86%. Last Tuesday, after Japanese markets reopened from the Golden Week holidays, the 10-year yield was below 0.60%. The yield now stands at it highest level since last June. Reports suggest banks and funds are the main sellers. If this volatility is sustained, it risks a response by Japanese officials. The BOJ has reportedly already changed its tactics in terms of its asset purchases in line with what the dealers suggested, and this seemed to work for a little bit. 

The dramatic rise in yields can has several repercussions,  First, it would seem to run counter to the declared purpose of the aggressive monetary policy.  A gradual increase in interest rates as inflation expectations increase is one thing, a 50% increase in the yield three days is completely different kettle of fish.  Second, while US yields have also risen recently, the backing up in Japanese rates has been even more striking and this has resulting in a sharp compression in the spread.  Now around 104 bp, it is the at the lower end this year's range.  Third, the rise in domestic yields may deter life insurance companies and other institutional investors from aggressively implementing this year's international allocations.  Fourth, these considerations saw the dollar pullback to about JPY101.25 were good bids were found.  Additional support is seen near JPY100.80. 

The euro zone March industrial output rose a much stronger than expected 1.0% and this trumped the disappointment over the German ZEW survey.  The consensus forecast a 0.4% rise in industrial production and one important take away is that the surveys have been more pessimistic than the real data.  Given the high levels of unemployment, generally, the erosion of confidence and sentiment is understandable.  

The ZEW survey was released at the same time.  The assessment of the current situation slipped to 8.9 from 9.2.  The market had expected improvement.  The economic sentiment gauge ticked up to 36.4 from 36.3 and, perhaps, encouraged by a 12.5% rally in the DAX over the past three weeks, the market had expected larger improvement. 

The euro neared our initial target of $1.3030, but the upticks were quickly sold.  Nevertheless, it is not clear that the upside correction in the euro is over.   The market may have gotten a bit ahead of itself in talk of another refi rate cut next month or a move to a negative deposit rate and the stronger than expected industrial production figures suggest the ECB staff may not alter its economic forecasts very much next month. 

On the other hand, price pressures continue to subside, but the fact that Germany CPI (EU-harmonized) is at 1.1%, it sets a very difficult bar for other EMU members trying to boost their competitiveness.  Germany may have acquiesced to a more protracted, less intense austerity drive, but it continues to force deflation on the EMU.  

Although not a member of the euro zone, Sweden today reported it has deflation.  The headline CPI is 0.5% lower than a year ago.  While the doves will press their case, going forward, the month over month changes from last year that will drop out of the index going forward warn that the deflationary forces are unlikely to be sustained and the Riksbank core measure has held in better.  The market anticipates the Riksbank being forced to and has taken the krone lower.  It is as if the market is saying that if the Riksbank won't ease directly, it will through the exchange rate.  The euro has been bid to its highest level against the krone since late January (~SEK8.65).  

The Australian dollar has been sold to new lows following the somewhat larger projected budget deficit.  The market had been prepared for a A$17 bln deficit, but it Gillard government forecast A$18 bln deficit.   Recall that in mid-Oct last year it has forecast a A$2.2 bln surplus.  Sentiment has turned against the Australian dollar as illustrated by recent high profile bearish comments from hedge fund managers.  

The fundamentals have not changed as much or as quickly, though we had anticipated a weaker Australian dollar and have it as a "trade of the year" (short Australian dollars against the Mexican peso).. Moody's and S&PO have been quick to note that the budget does not effect their credit assessment or the country's sovereign rating.   The next level of support is seen in the $0.9870.