Asset Markets Mostly Improve, but Dollar Retains Firm Under Tone

Reassuring words from a number of Federal Reserve officials, continued easing of the acute liquidity squeeze in China and mostly firm data in Europe has seen global equity and bond markets general trading higher, but in the foreign exchange market the dollar has retained the underlying firm tone seen this week.  Generally speaking, we anticipate a modestly softer dollar in the coming days.  

The euro traded above yesterday's high in Asia and early Europe, but stalled in front of Wednesday's high just shy of $1.31. Sterling is trading in the lower end of yesterday's ranges. The Australian dollar slipped through yesterday's lows, though remains almost a cent above the multi-year low seen at the start of the week just below $1.09150. Follow through buying from the key reversal on Monday has been disappointing. The weakest currency ahead of the weekend, though is the Japanese yen. The dollar is trading near 3 week highs, just above JPY99.00.

A slew of Japanese data mostly surprised on the upside. The manufacturing PMI rose to 52.3 in June, a two year high. Industrial output for 2.0%. The market expected only a 0.2% increase. Retail sales rose 0.8% in year-over-year in May, recovering from the 0.2% decline in April. The pace of deflation in the national CPI (May) was halved to 0.3% from 0.7%, though the Tokyo figures for June was flat year-over-year, which is its best reading in almost two years. Excluding food and energy though, Tokyo CPI stood at -0.4% from -0.3% in May, warning that deflation forces have not been overcome yet. Japan's Tankan survey is out first thing Monday in Tokyo and is widely expected to show improvement.

Yesterday, the MOF figures showed foreign investors returned to buying Japanese shares, after have sold a small amount the previous week. Patience was rewarded and today's 3.5% rise in the Nikkei was sufficient to offset in full the losses in the first four sessions of the week.

The news stream from Europe was also mostly positive. French household consumption rose 0.5% to post its second consecutive monthly rise, defying expectations of a 0.1% decline. German retail sales rebounded to 0.8%, twice what the market expected, following the 0.1% decline in April. Some modest progress is being seen at the European summit. German inflation appears to have ticked up and this too must be understood as a favorable development for the euro area as a whole. The low inflation in Germany in effect exports deflation to the euro area, especially the periphery. The somewhat firmer inflation in Germany, though we are still talking about less than 2%, can help others regain some competitiveness over time. Although most observers emphasize the benefits of a weaker euro from the periphery, the inflation differentials can be just as important if not more so. Of course, the key measure here is unit labor costs, but higher German CPI is also helpful in this context and within reason.

Separately, Norway and Sweden also reported better than expected retail sales. There has only been a muted reaction to the news and both the respective currencies have slipped a bit against the euro.

The North American session features the Chicago PMI and the University of Michigan's consumer confidence. The former is expected to slip a bit, but remain well above the 50 boom/bust level. The interesting aspect of the consumer confidence survey is the inflation expectations component. Over the past several weeks the inflation expectations seen in the TIPS has fallen. However, we see the position adjustments as the driving force, overwhelming fair value, especially in the less liquid market segments Another way of conceptualizing it, is that the noise to signal ratio contained in prices may be greater than usual. Survey data is another way to triangulate the signal. We suspect that inflation expectations have not fallen as much as some market-based measures, like TIPS may suggest.  

Several  Fed officials speak too (Stern, Lacker and Williams).  However, in recent days, there underlying theme has been the same:  Fed is not tightening and the upcoming data is more important than any particular time frame, which many observers, including ourselves, see confused last week in Bernanke's remarks.  

Canada reports April monthly GDP figures. A 0.1% rise is expected for a 1.4% year-over-year pace. This would be a touch slower than March and is unlikely to do the Canadian dollar any favors. The US dollar is slightly firmer against the Canadian dollar today, but is within yesterday's ranges. The greenback may retest the air above CAD1.05, but ahead of the weekend, it is likely to prove limited.

Lastly, note that the IMF's COFER data, proving insight into reserve allocation is expected later today. It is reported with a quarter lag and tends not to move markets. What will be interesting this time, though, is that the IMF will break out the Australian and Canadian dollars from the "other" category. They will now be listed along side the dollar, euro, sterling, yen and Swiss franc. It is descriptive accounting of what central banks (who report currency allocation of their reserves) have done. It is not a normative claim. On the other hand, it is just as important to note what is not being broken out, the Chinese yuan, which some observers, have highlight to be the up and coming reserve asset. The data suggests--not really, not yet.