Short Squeeze Lifts Euro, while Falling Yields Weigh on Dollar

The key driver of the global capital market is the heightened geopolitical risks ahead of the weekend.  These now include the US air strikes in Iraq, as well as a sense that the situation in the Ukraine is reaching an inflection point.  Putin needs to step up his support for the insurgents in east Ukraine in some fashion, or risk losing that insurgency effort. 

The rally in debt market has pushed S 10-year yield  to new lows since June 2013 (just below 2.35%) and sent bund yields to new record lows (just above 1.0%).  Equity markets, which we have been highlighting as exceptionally vulnerable from a technical point of view are ending the week on a poor note.  The Nikkei shed almost 3% to two-month lows.   

The MSCI Asia Pacific index was off nearly 1.3%, with only Chinese markets managing to buck the regional move.  European bourses are faring only slightly better, with the Dow Jones Stoxx 600 off a little more than 1%.   Losses are led by the telecoms and health care sectors, but all sectors are lower.  After closing at its lowest level since late May yesterday, the S&P 500 may gap lower today.  The 1894.50 area is a retracement level of the rally since the February lows.  Below there, the next retracement target is a little below 1865. 

The dollar-yen rate had been unexpectedly resilient in the face of US equity market losses and the decline in US Treasury yields.  However, it finally succumbed to the pressure and fell to JPY101.50, the lowest level since July 25.  The price action reinforces the JPY101.00-JPY103.00 trading range that has largely confined prices for four months.  

The yen's gains come despite the BOJ cutting its assessment of exports and industrial output at its policy making meeting in which no new initiatives were taken.  BOJ's Kuroda continues to sound optimistic and confident that the impact of the retail sales tax is fading and the growth and inflation will return to higher paths.  Many participants are less sanguine, suspecting new efforts will have to be made to achieve the higher inflation goals.  Separately, Japan reported its first current account deficit in five months as the investment income balance did not fully offset the trade deficit.  Next week Japan reports its first estimate of Q2 GDP.  A contraction of around 7.0% annualized is expected. 

The euro has also squeezed higher and reached a three-day high near $1.3410.  The advance caught many participants by surprise.  It seems largely to be a function of short-covering, some players are moving to the sidelines given the greater uncertainty.  There are reportedly large option expirations today, with strikes near $1.3400. 

We do not think there was anything from Draghi yesterday that warranted a stronger euro, except perhaps sell the rumor and buy the fact type of behavior.  Draghi was not content with the euro's recent pullback, but cited a number of market based metrics and some macroeconomic developments that are consistent with a weaker euro.  Among the macroeconomic factors he cited, was a smaller current account surplus.  And as if on cue, Germany reported a smaller than expected June current account surplus  (15.0 bln euros vs expectations for 18.5 bln surplus).  The trade surplus of 16.5 bln euros (rather than 18.9 bln the consensus expected) was a function of a 0.9% rise in exports and a 4.5% rise in imports. 

France offered a rare upside surprise with its June industrial output figures, but this does not really explain the euro's gains.  Industrial production rose 1.3% (1.0% consensus) fueled by a 1.6% rise in manufacturing output.  The strong rise in manufacturing production was sufficient to left the year-over-year rate into positive territory for the first time in Q2.  Recall the manufacturing PMI had fallen to 48.2 in June from 49.6 in May, warning sentiment is more negative than the actual performance.  

Sterling has been unable to keep pace with the yen and euro.  This too could be a function of positioning.  We note that as of last week, the gross long sterling position in the futures market was larger than the combined gross long euro, yen and Swiss franc position.    Sterling briefly traded below $1.68 for the first time since mid-June and the hawkish tone Carney took at the Mansion House talk. Although sterling looks stretched, our reading of the technical indicators suggests no compelling evidence that the low is in place. 

The 1.2% gain reported in construction output prevents expectations of  Q2 GDP revisions, but the deterioration of the trade balance underscores an economic headwind.  The bulk of the deterioration came from its EU partners, where growth differentials and a strong pound likely played a role.  The overall trade deficit of GBP2.46 bln is the third consecutive month that it widened.  It is the largest since January. 

Initially, the monetary policy statement from the Reserve Bank of Australia sent the Aussie down to new two-month lows near $0.9240.  The central bank reduced both its GDP and inflation forecasts, which dashes any lingering ideas of a rate hike (we are still biased toward another rate cut in the cycle).  The Aussie turned better bid in early Europe.  A move above $0.9280-$0.9300 would help to stabilize the fragile tone.  

Lastly, we note that China reported a record trade surplus in July.  Exports doubled on a year-over-year basis to 14.5% (from 7.2%), while imports unexpectedly fell 1.6% (the consensus forecast a 2.6% increase after 5.5% in June).  This resulted in a $47.3 bln surplus.  The yuan depreciated by 3.25% against the dollar in the first four months of the year and has since recouped half of it.  Today, the dollar is at its lowest level since mid-March (~CNY6.1550).

The US reports Q2 productivity and unit labor costs.  These are derived from the GDP figures and are unlikely to impact the market.   Wholesale inventories will be more important to economists fine tuning forecasts for Q2 GDP revisions than to investors.