Mounting Tensions Lift Dollar and Yen

Many observers had thought the island disputes in the South and East China Seas posed the biggest threat to peace, with some official and media drawing parallels between 1914 and 2014.  Yet if even if a Pacific Century has begun, Europe's geopolitical challenges persist.  

Reports suggest an estimated 120 armed group of people have taken over the parliament building in the Ukraine's Crimea region and have raised a Russian flag.    Meanwhile, Russia's Black Sea fleet (leases its main base from Ukraine, in Sevastopol) began what were claimed to be "unrelated" military exercises.  A jet fighter mission today was part of that drill, according to report.  Russia has also placed its air defense of the western border zone and jet fights on the highest alert. 

Although the Ukrainian and Russian currencies are under pressure, the knock-on other emerging markets has been mild at best.  The MSCI Emerging equity index is up almost 0.3%.  Perhaps, helped in part by the fragile stabilization of the Chinese yuan, whose weakness in recent days has caused some consternation.  Today was the first in eight sessions that the US dollar did not rise above the previous day's high against the yuan.   At the same time, though, it did not push through the lows either.    The PBOC drained another CNY60 bln from the banking system (via 14-day repos) to bring the total amount of liquidity removed this week to CNY160 bln on top of the CNY108 bln last week.  

We are cautious about reading much into the 0.3% rise in the Shanghai Composite, though it was the biggest advance in two weeks.  Breadth was poor with decliners leading advancing issues by 3:1.   Speculation of new reforms from the National People's Congress next month saw flows into state-controlled companies.    The 1.8% decline in the Shenzhen Composite is consistent with this.  

European equity markets are not faring well, with the Dow Jones Stoxx 600 is off by nearly 0.9%.  It had reached its highest level since 2007 earlier this week,  All the major bourses are paring this month's gains.  Meanwhile, the heavier equity markets and the extension of the rally in US Treasuries, for the fourth consecutive session (despite considerably stronger than expected January new home sales) has helped trigger a sharp rally in European bonds.  Italian 10-year yields are at new multi-year lows (~3.46%) to slip below similar Spanish yields.    The German 10-year bund yield is off 6 bp to 1.55%, its lowest yield since last July. 

There are three main events to note. First, the governing coalition in Cyprus has seen its junior member withdraw in opposition to the resumption of unification talks.  Second, M3 growth was in line with expectations; lackluster even after the passing of the period that the Asset Quality Review and stress tests were to cover.  More importantly, private sector lending fell for the 20th consecutive month.  Third, every German state that has reported February data has seen the year-over-year increase in CPI fall.  

This is important for two main reasons.  In order for other EMU countries to gain competitively, they need to have lower inflation than Germany.  Germany is making this difficult without flirting with deflation.  In addition, tomorrow the euro area will report its preliminary estimate for the region's Feb CPI.  A soft German report points to a soft aggregate report and, in turn, this will heighten speculation of new ECB action.  

After repeatedly bumping against resistance ahead of the $1.38 level the euro was pushed back yesterday and has seen its losses extended today.  It is toying with its 20-day moving average (~$1.3650), for the first time in two weeks.   The $1.3625 area corresponds to a retracement objective of the euro's advance off the low set in late Jan near $1.3480 and the 100-day moving average.  

We suspect it will hold as the market turns its attention to the two main events in the North American session:  January durable goods orders and Yellen's testimony to the Senate.  Durable goods orders are expected to have fallen for the second consecutive month, with the headline driven by a decline in Boeing orders.   We suspect that the market is almost to the point of writing off a weak first quarter.  The question how much of the weakness is due to transitory influences and this is most important aspect of Yellen's testimony.  Her prepared remarks will be the same as comments before the House earlier. 

Recall that the FOMC minutes showed that, in December, officials realized that growth in H2 13 was not sustainable and looked for slower growth in H1 14.  There were at least two transitory factors:  inventory accumulation and the tax incentives for capital investment.  On top of that here at the start of Q1, two other factors have emerged:  Congress' refusal to renew emergency jobless benefits (impacts about 1.7 mln people) and the weather.    Yellen is likely to try to help the Senators see past the noise and focus on the economic signal, as the Fed sees it.  No reason to think another step in the tapering process won't be delivered. 

 

The pressures have pushed the dollar to new lows for the week against the Japanese yen and pushed the greenback below the nearly month long uptrend line.  The next level of support is seen in the JPY101.25-50 area.    We'd look for it hold ahead of the slew of Japanese data on Friday.   Separately, but not totally unrelated, this environment has also proved supportive of the Swiss franc.  The franc is at its best level against the euro since last April.  Euro support is seen in the CHF1.2135-50.    There is beginning to be talk of SNB action. 

Lastly, the Antiopodeans are moving in opposite directions.  Poor Australian capex, especially the 14% cut in the FY2014-2015 projections.    The RBA meets next week, a day before Q4 GDP is reported.  Given the recent string of economic news, the risk is that the RBA is more dovish, though on hold, than many may have expected given its neutral tone.  The Aussie has been pushed below its 20-day moving average (~$0.8965) for the first time since Feb 4.   If the $0.8900 level is broken, the next band of support is seen in the $0.8940-$8980 area.  

Meanwhile a larger than expected trade surplus and a hike milk prices at Fonterra's auction (to new record high) has lent the Kiwi support.  The RNBZ is widely expected to begin a rate hike cycle next month.  The $0.8400 area remains the four month ceiling.