Dollar Bulls Still in Charge

The US dollar is firm against most of the major currencies today. There seems no fresh impetus behind its rise. Global capital markets have continued to stabilize, with most equity and bond markets higher. Money market rates in China have slipped now for the fourth day running.

The euro's corrective upticks were brief and shallow, after hitting what appears to be a wall at $1.3150. The single currency has been sold to new lows for the moves today. While there may be some psychological support near $1.30, we see the near-term risk extending toward $1.2975. 

The euro has not traded below $1.30 since the start of the month. The two main talking points today are ECB's President Draghi's pledge that the central bank is ready to act if needed and a Financial Times story warning that Italy faces significant losses related to several derivative products it used to manage its debt. Yet, we note that Draghi's comments are not new and Italian bonds are continuing to recover from their recent slide, with the benchmark 2-10 year benchmark yields off 8-10 bp.

The yen is firm, whereas JGBs and the Nikkei traded heavily. The Nikkei lost 1% today, with technology and health care sectors offering the largest drag. The 1 bp rise in the 10-year JGB yield is inconsequential and leaves the yield in the 0.80%-0.90% range that has confined yields since mid-May with a few exceptions. The dollar initially rose in Asia, through yesterday's highs to reach JPY98.25 where it met fresh selling by Japanese accounts. Dollar support is seen in the JPY96.80-JPY97.20 area.

After posting a potential key reversal day on Monday, the Australian dollar disappointed yesterday with the lack of follow through gains. New buying has emerged and it is the strongest of the major currencies today, gaining about 0.4% against the firm greenback. Never quite being able to quell angst within the Labor Party, Prime Minister Gillard bowed to pressures and called for a leadership vote. Former prime minister Rudd defeated her and now will be lead the party into the September election. Recall that Gillard had led a "palace coup" against Rudd three years ago.

Revisions to Q1 US GDP today are not very material to the outlook for policy. There are two issues that many are wrestling with. First, according to the latest Fed forecasts, 13 of the 19 members see Fed funds at 1% of higher in 2015. This was more aggressive than the market had been priced. While much of the post-FOMC adjustment has to do with positioning and less to do with fundamental models fair value, the market is still trying to digest the implications. Second, again, flows and momentum in thinner traders markets are playing a role, but the 10-year break-even is below 2% and this has been a rare occurrence post-Lehman. The two times inflation expectations were this low, it coincided with the initiation of QE-related purchases.

Lastly, in the emerging market space we note that after the Brazilian real hit four-year lows yesterday, the central bank announced it would eliminate the reserves required on short dollar positions held by local banks as of July 1. In 2011, to dampen the upward pressure on the real, the central bank required banks to deposit in a non-interest bearing account 60% of the short dollar position in excess of $3 bln. Separately, and unrelated, Taiwan, which has seen foreign investors sell $4.2 bln of its equities this month alone (completely reversing the inflows in the Jan-May period), announced it would cut the capital gains tax on sales of more than NT$1 bln to 0.1% from 2.25%.