FX Market Responding to Fundamentals

Ahead of Thursday's BOE and ECB meetings and Friday's US jobs data, the foreign exchange market is responding to fresh fundamental developments.  Three developments in particular stand out.  

First, China's service sector PMI showed a small gain in Oct, rising to 52.6 from 52.4.  Of note, new business stands at a 7-month high.  Talk of a hard landing has clearly quieted as growth stabilizes.  

China's trade figures are due Thursday, followed by inflation measures on Friday.  Export growth has slowed, but is likely to turn positive again after the year-over-year contraction in September.  Most of China's exports are embedded with modest amounts of value added (i.e, assembly work).  The modest appreciation of the yuan (not just against the dollar, but against most of the other regional currencies has little if any impact on Chinese exports.  The demand for Chinese exports is more a function of growth in its trading partners.  

China continues to experience deflation in producer prices.  Most of the inflation CPI stems from food prices, that is a relative price increase rather than a general increase in the price level. The rise in food prices is not really a function of easy monetary policy among the high income countries but in something particular to the agriculture sector.  

Separately, we note that while foreign investors and domestic investors in China do not seem especially enamored with Chinese equities, small cap shares are doing markedly better than the larger cap issues.  Today's performance illustrates the larger trend.  The Shanghai Composite (proxy for large cap) rose about 0.35%, while the Shenzhen Composite (proxy for small cap) was up about 1.35%.  Year-to-date, the Shanghai Composite has fallen almost 5%, the Shenzhen Composite is up a little more than 17%.  

The out-performance of small cap over large cap is a global theme.  We have previously noted it in Japan.  Year-to-date the Nikkei is up almost 37%, while the JASDAQ has gained nearly 69%.   In the UK, the FTSE 100 has risen about 14% year-to-date, while the FTSE Small Cap Index has risen twice as much.  In Germany, the DAX has risen 18% this year and the Classic All Share Index is up almost 35%.  In the US, the out performance is not as stark.  The S&P 500 is up 24% thus far this year, while the Russell 2000 is up about 30.5%.  

Second, as nearly universally expected, the Reserve Bank of Australia kept rates on hold.  Its statement was similar to last month's and no direct hint of another rate cut.  It did seem to upgrade its concern about the strength of the Australian dollar, but, on balance, is not prepared to cut rates on this ground alone.  Some of the interest rate sensitive sectors, like building approvals, appear to be recovering and the service sector PMI, reported earlier today rose to a 7-month high, though still below the 50-boom/bust level at 47.9.  

The Aussie initially declined about half a cent to almost $0.9460 in a knee-jerk fashion on the complaints about the Aussie's strength, but the combination of the service PMI improvement,  in both Australia and China, proved too much for the bears.  The Aussie has been squeezed higher, through Tuesday's highs to almost $0.9540.    The $0.9550 area corresponds to a retracement objective of the nearly 4-cent down draft since the key reversal on Oct 23 and the 20-day moving average.  

Although it is not reflected in indicative market prices, we continue to see scope for another rate hike by the RBA next year.  Today's statement seems to preclude a December cut, but few expected such a move in any event.  We look for a cut in the middle of Q1 2014 on ideas between the strength of the Aussie and inflation with the RBA's target, the economy can use more assistance to make the transition away from the natural resource sector. 

The third development was in the UK, where the CIPS service sector PMI rose to 62.5 from 60.3.  The Bloomberg consensus had forecast as small decline (to 60).  This is a new multi-year high and the new business component was especially strong and appears to be a new record high for this time series, which is a little less than 20-years old.   

Sterling rallied as data reinforces the sense that the Canadian BOE Governor under-estimated the strength of the recovery of the British economy.  The forward guidance delivered in July and August lacks credibility in the market.  The short-sterling futures market shows investors expect a rate hike toward the end of next year-- more than a year before Carney had signaled--and before the US as well. UK yield curve has not steepened today as much as the yields across the curve have risen.   

This has helped sterling recover the slide from the end of last week  Sterling has moved within striking distance of the $1.6067-75 area, which corresponds to a 50% retracement of the losses seen off of recent high on Oct 25 and the 20-day moving average.    Sterling 's strength has weighed on the euro and the cross is trading at one-month lows.  

The euro has also been weighed down by poor Spanish data, which showed unemployment jumping by 87k in October (second consecutive monthly increase and lends credence to ideas that the past improvement was largely seasonal in nature).  Separately, S&P warned that house prices will fall 5% next year and another 1% in 2015, after an 8% slide this year.  Spanish  (and to a less extent, Italian bonds) are under-performing today.  The premium over Germany is widening not just today, but over the past week or so.  

As real money and hedge funds moved into Europe over the past few months, the euro seemed to track the German-Spanish interest rate differential.  The widening of the spread should be monitored as it may be indicative of new phase.  

(Updates will continue to be sporadic.  The three-week business trip to Asia is winding down.  The normal commentary will resume shortly.  Your patience is appreciated)