The Dollar and Bonds Stabilize after Yesterday's Wilding

After yesterday's dollar gyrations, today's narrow ranges are a relief. The dollar had rallied in Asia and Europe yesterday, but reversed lower following the disappointing April data, especially industrial output and manufacturing figures, which raised questions for about the strength of the recovery. 

 First quarter US GDP is now widely expected to be revised to show a contraction of between 0.5% and 0.8%. The rebound in Q2 is being downgraded by some economists. While recognizing that the optics were not good, we caution against the pessimism, and note that weekly initial jobless claims, one of the best real-time metrics of the economy, fell to new cyclical lows. And the regional Fed surveys, like the Empire State and the Philadelphia reports, suggest the economy is continuing to recovery from a poor first quarter.

The dollar sold off yesterday in the North American session, but there has been no follow through today among the major currencies, with sterling being a small exception. It pushed a little through yesterday's high. There is little momentum, and the $1.6820-40 area is likely to block stronger gains into the weekend.

Importantly, US Treasuries have also stabilized just above the 2.50% threshold. This is true for "core" bond markets in general today as bunds and gilt yields are a couple of basis points higher after yesterday's sharp decline. Peripheral bond yields are mixed. Bargain hunters have returned to Italy and Spain, but not Portugal and Greece.

Reports yesterday that there is a new retroactive tax on foreign investment in government bonds was denied. Essentially, it appears that foreign investors who bought Greek bonds between in the 2012-2013 period will be taxed based on the legal framework that existed then. Investors from countries with tax treaties that avoid double taxation are not subject to the tax, while the capital gains tax on Greek bonds has been abolished as of the start of this year. Apparently, this has not yet been sufficient to calm the market, and the 10-year bond yield is up another 12 bp today to push above 6.75%. The rout lifted Greek bond yields 65 bp this week.

Many observers had recognized the link between the peripheral bond markets in Europe and the euro. Some suggested that the euro was a proxy for credit. It seemed simpler to us. The foreign demand for Spanish and Italian bonds and stocks fueled euro gains. Most asset managers, limited by their mandates to investment grade instruments, could not venture into Greece and Portugal, but many leveraged funds did. That point is that the relationship has weakened and appeared completely to break down yesterday. While we had anticipated profit taking the peripheral bond markets this week, we had thought 1) it would be led by a backing up of US yields, but the US 10-year yield is off 15 bp coming into today and 2) that it would be euro negative, and instead the euro recovered yesterday after initially selling off to its lowest level since late February.

It appears that the ECB is more inclined to cut rates that introduce an asset purchase scheme. Some funds managers had bought peripheral bonds in anticipation of QE, i.e., that the ECB would be buying bonds too. A cut in the repo rate is seen as largely symbolic and not necessarily support of peripheral bonds. Many participants are trying to work through the implications of a negative deposit rate Some suspect it would make for cheaper funding for carry trades, we are less sanguine.

We remain concern about the unintended, but not necessarily unforeseeable, consequences of what would be an unprecedented measure for a major central bank.  Banks have warned officials that a negative deposit rate could in effect be a new tax on lenders. It is hard to see how a negative deposit rate will boost inflation or new lending. Recall that when the ECB pushed the deposit rate to zero, it was argued that that would encourage banks to increase their lending. It did not. It simply changed how banks managed their liquidity; switching, for example, for the deposit facility to the current account facility.

In any event, there are two important takeaways for investors. First, the apparently tight relationship between peripheral bond yields and the euro's performance appears to have broken down, but it will take a few more sessions to see if this was an aberration or whether it is a sustained development. Second, a QE scheme is seen as more supportive of peripheral bonds than rate cuts, including a negative deposit rate.

The rally in US Treasuries this week has lifted the yen, which is the best performing major currency, appreciating almost 0.4% against the dollar this week. It is the first two-week advancing streak in the yen for three months. The US premium over Japan dipped below 190 bp yesterday for the first time since last October.

The yen's gains are probably not best explained by some reference to the yen as a safe haven, though that is the penchant for many. Instead, we suggest, that the yen's gains are primarily the result of short covering rather than investors increasing exposure to the yen. The yen has been used as to fund purchases of higher risk assets and as those assets fell, short yen positions were unwound. We suspect that when the latest Commitment of Traders is reported later today covering the speculative positioning in the CME currency futures, that the gross short euro position will surpass the gross short yen positions for the first time in over a year.

The economic highlight of the North American session is the April report of US housing starts. The housing market has been disappointing. The NAHB housing market index warns of lingering weakness. The consensus calls a 3.6% increase in April housing starts after a 2.8% increase in March. Although this report is not often a market mover, today it may be. A disappointing report, especially given the strong seasonal factors, could push Treasury yields through the 2.50% level again and weigh on the dollar.