May Day: US Dollar Remains on the Defensive

The May Day holiday has thinned market activity in both Asia and Europe. The US dollar has been unable to sustain even modest upticks. While US Q1 GDP was considerably weaker than expected, investors seemed to look through it, as did the Federal Reserve. There seems to be little doubt that stalling of the economy was a bit a fluke and before the quarter was even over activity was picking up.

This will be illustrated by April's manufacturing ISM report out today. It is expected to have risen for the third consecutive month ad edge closer to the cyclical high recorded last November near 57. The consensus calls for a rise to 54.3 from 53.7.

The personal income and consumption data for March have already been built into the Q1 GDP estimate reported yesterday and therefore, contains no new information. Separately, Fed's Yellen speaks to independent community bankers today, but it seems that Fed policy is about as clear as it gets leaving aside when the first hike is, which is still understood to be more than a year off still. The Fed's tapering continues apace, and neither the stalling of the economy in Q1, nor a few poor employment reports, or stock market corrections is sufficient to knock it off its course.

There were four manufacturing reports released today, two in Asia-Pacific and two in Europe that are noteworthy. First, Australia manufacturing index fell to an eight month low in April of 44.8 from 47.9. Perhaps, the disappointment was blunted by a sharp rise in the export price index (3.6% in Q1, more than twice the consensus forecast). The Australian dollar was bid back toward the week's high above $0.9300.

The Australian dollar has also been resilient in the face of the sharp drop in iron ore prices, which have fallen nearly 5% this week, as Chinese officials reportedly crack down on iron ore backed loans as well as the excess capacity and redundant investment in the steel industry. That bring us to the second manufacturing report from the Asia-Pacific area: China's official manufacturing PMI edged higher to 50.4 from 50.3. It fits our view that after slowing considerably over the past year or so, the Chinese economy has begun stabilizing. That said, it is uneven. New orders rose to 50.6 from 49.8 and represents a four month high.

On the other hand, export orders fell to 49.1 from 50.1. This is important. Many observers are concerned that the depreciation of the yuan is to boost exports. We argue against this, accepting that the main driver is trying to break the moral hazard and speculative excesses. The value-added by Chinese workers and the yuan denominated input cost more generally are too low to allow a 3-4% currency depreciation to be much of a competitive advantage.

Turning to Europe, with much of western Europe closed for the May Day holiday, most will report the manufacturing PMI tomorrow. Today Ireland and the UK did, and if they suggest anything it is potential for an upside surprise. Ireland's manufacturing PMI rose to 56.1 from 55.5. This is a three-month high.

The UK's manufacturing PMI jumped to 57.3 from 55.8, which itself was revised from 55.3. The consensus had looked for a small pullback; instead it is approaching the cyclical high from last November near 57.9. This sent sterling to new four year highs of $1.6920. The $1.70 level beckons. Even if it does not penetrate it on the initial attempt, given the widening interest rate differentials and momentum, it seems as if it is simply a matter of time. Above the $1.70 level, the next targets are near $1.72.

Separately, the UK reported somewhat fewer mortgage approvals, but an increase in mortgage lending. Nationwide reported a larger than expected increase in house prices. The 1.2% increase in April, was twice the pace the market expected and lifts the year-over-year increase to 10.9% from 9.5%. Several officials have commented about the increase in house prices, but rather than try to check it with rate hikes, the signals appear to be moving in the direction of macro-prudential measures.

Lastly, we turn out attention to Japan. A key issue for many investors and policy makers is the impact of the sales tax increase. Initially, Finance Minister Aso had been suggesting that the economic hit may not be as great as feared. This seems a very premature judgment. Producers are cutting back sharply, as was picked up in the manufacturing PMI out earlier this week. Today, Japan reported auto sales slumped 5.5% in April, with overall sales down to their lowest level since Abe's election in December 2012. Separately, Sony cut its earnings expectations for the third time in a year. It reported a JPY130 bln 12-month loss after project JPY110 bln loss a couple of months ago and a JPY30 bln profit last October.

Still the dollar-yen is flat. It is capped apparently by the pullback in US yields and is supported by gains in the US equities. We note that the dollar-yen is twice as correlated with the S&P 500 than the Nikkei (on a rolling 60-day percent change) at 0.46 (vs 0.23).