Observations about the Dollar and the Week Ahead

A fragile stability has returned to the Chinese currency and stocks.  With the help of the Social Democrats, the German parliament is likely to endorse Greece's third aid package, even if a rump of Merkel's CDU/CSU balk. The next adjustment of expectations for Fed policy, and the possibility of a rate hike next month, requires the next cycle of data, especially this month's employment data.  

With these recent drivers in abeyance, we expect broad trading ranges, and lower volatility.  The implied three-month euro volatility is the lowest since early March, and sterling volatility is at its lowest level for the year.  The dollar's volatility against the yen has not fallen as much, but it has softened and is at the lower end of its recent range.

Despite the fact that there may not be direct or immediate policy implications for the macroeconomic data in the coming days, there still are a number of things that are on investors and traders will be focused.  

China:  The implication of the PBOC's recent moves are still be scrutinized by market participants and the media.  We make two suggestions.  First, the focus on the few minor decline in the yuan, which will have little direct economic impact, including on the attractiveness of Chinese exports, seems misplaced   The more important development was in the changing of the central reference rate, or fix.  Second, the more significant comparison may no longer be between fixes but between the previous day's close and the next day's fix.  This will be more revealing of what officials intend.

Currency Wars:   This is an overused metaphor.  Many confuse a metaphor with reality. Far from a shot in this imaginary currency war, the Chinese move, and in particular, the new commitment to give market forces greater sway has been encouraged by both the IMF and the United States.  Both welcomed the developments and wanted the China's operational policy to match the declaratory policy. Moreover, it appears that whereas the market may have been surprised, the IMF, and possibly the US, had advanced warning.

Greece:  The Eurogroup gave their blessing to the third aid package for Greece.  The next step is for several parliaments to approve, and the key one is Germany.  Reports indicate that that vote will be held at the last possible moment, 24 hours before Greece's payment of 3.2 bln euros is owed to the ECB.    Much of Merkel's European policy has relied on support from the Social Democrats, whether they have been part of the government or not.  This vote will be consistent with that pattern.  Recall that 60 members of her caucus did not approve of initiating talks for this aid package.

Greece's Tsipras had to rely on pro-European centrists to secure parliamentary approval. The 149 Syriza MPs, 31 opposed and 11 abstained.  There were 35 defections in July's decision to accept the creditors' demands.  The political situation in Greece is in flux. Tsipras may call a vote of confidence, but his left-wing may not abandon him until the emergency party conference in early September.  If elections are held relatively quickly, it would be less disruptive in meeting the first review by the creditors.  Tsipras remains the most popular politician in Greece and what we have dubbed as the "realos" wing of Syriza is likely to be the center of a new coalition government.

ECB:  The ECB has not granted Greece more ELA funds since July 22.  Pessimists and cynics argue that by doing so the ECB is tightening the proverbial screws on Greece.  This is not true.  The reason the ECB has lifted the ELA ceiling is that Greece central bank has not requested more funds because the liquidity situation at the banks has improved. Deposit flight has slowed if not reversed.  Tourism receipts have increased.  The agreement by the Eurogroup that the recapitalization of Greek banks (following the stress test and asset quality review) will not entail the bailing in of depositors (but senior bondholders are a different story) is something we advocated, and may help draw more deposits back into Greek banks.

US Data:  The July CPI report and the FOMC minutes from last month's meeting are the two highlights of the week ahead.  The US also reports housing starts, which have exploded lately.  They rose by an average of 8.1% a month in Q2 (the 12-month average was 2.8% in June).  Some moderation, therefore, should not be surprising.  Moderation in existing home sales is likely after a blistering pace in H1 (from 5.07 mln unit pace at the end of last year to 5.49 mln unit pace in June).

US headline and core CPI is expected to rise by 0.2%.  The firmness of the rental market is a key contributor to the 1.8% year-over-year rate.  We argue that the FOMC minutes dilute the policy that emanates from the Fed's leadership.   There have been three key developments since the late July FOMC meeting:the continued improvement in the labor market (the July jobs report and the new cyclical lows in weekly initial jobless claims), the Chinese move on its currency, and some volatility in the US equity market.  NY Fed President Dudley's recent comments suggest that the slightly weakening of the yuan is not a game-changer for the trajectory of monetary policy.  We think the signal from the Fed's leadership is that barring a significant downside surprise in the coming weeks, a rate hike remains the most likely scenario.  The Fed is independent from national politicians, but also from the vagaries of the stock market (within reason) and international politics, including the IMF's advice, and Beijing machinations.

UK Data:  There two reports that will draw attention in the coming days.  CPI and retail sales are unlikely to provide more fodder for those expected the BOE to raise interest rates anytime soon.  Wage increases moderated with the latest data point. Headline CPI is expected to fall 0.3%, which will be sufficient to keep the year-over-year rate at zero. While US headline CPI is likely to have improved (risen) for the third month to 0.2%, UK headline inflation has averaged zero since February.   Core inflation has been alternating between 0.8% and 0.9% since April.  The June rate was 0.8%, and July is expected at 0.9%.  Core inflation in the eurozone stood at 1.0% in July.  Retail sales are expected to have risen 0.4% at the headline level and when excluding petrol. In June both had fallen by 0.2%.  

Japan Data:  The Japanese economy likely contracted in Q2, a distinction shared only probably only by Canada within the G7.  The Bloomberg consensus sees a 0.5% contraction in the quarter and a 1.8% contraction at an annualized pace.  Weakness is likely to be found in consumption (expected to have declined by 0.4% in Q2 after a gain of the similar magnitude in Q1) and business spending(expected to have stagnated after a 2.7% increase in Q1). Many economists continue to expect the BOJ to commit to more QE, with October seemingly the favorite time frame, like last year.  However, BOJ Kuroda is not giving any encouragement whatsoever.  He continues to suggest the recovery is intact, and that price trends are favorable.  At JPY80 trillion a year now, it is not self-evident that boosting it to JPY90 trillion, as many expect, would generate proportionately better results.

Canada Data:  As with the UK, retail sales and CPI provide the highlights for Canada. Retail sales in June likely fell back off after the heady 1.0% rise in May.  Over the past 1-2 years, Canadian retail sales rose on average 0.2-0.3% a month.  June sales likely fell back toward the longer-term trend. Canada is in an enviable position in terms of inflation. Headline CPI is expected to have risen 0.1% in July for a 1.3% year-over-year rate (1.0% in June), the highest in the G7.   Its core measure, which excludes eight of the most volatile items, is expected to be flat for the second consecutive month, but rise to 2.4% from 2.3%.  Pressure to cut rates again comes from growth concerns, not deflation.

Norway Data:  Norway's central bank does not for another month (September 24), but the pressure to cut rates is coming from the economy rather than deflation pressure.  Norway reports Q2 GDP on August 20.  It is expected to have contracted by 0.1%.  The mainland economy likely avoided the energy-induced contraction.  It is expected to have expanded by 0.2%.  This would be the slowest since Q3 14 (flat), which itself was the slowest since Q4 10 (-0.2%).   Over the last three years, the krone has lost about a quarter of its value against the euro but it is not weak. On the eve of the Great Financial Crisis, the OECD estimated that the krone was more than 40% above fair value.  Now it is about 13%, which is the second most behind the Swiss franc (28.8%).  

Markets:  The S&P 500 and the DAX briefly slipped below their 200-day moving average in the middle of last week, and both managed to finish the week above it.  The S&P 500 remains confined to a narrow range that has prevailed for months: 2040-2130. The DAX was unable to close the gap created by the sharply lower opening on August 12. That gap is found between Tuesday's low (11278.71) and Thursday's high (11153.96) which was a few cents above Wednesday's high.  A failure to close that gap in the coming days would be a bearish technical development.  Of the major markets, only the UK's FTSE is below its 200-day moving average.

The gyrations in the debt markets had put the US 10-year yields below its 200-day moving average, but the stabilization of the yuan, Chinese markets more broadly, and oil, and the healthy 0.6% rise in US retail sales, saw yields pop back up to finish the week near 2.20% after briefly trading below 2.05%.  The yields at the shorter end of the coupon curve also fell during the week.  The US 2-year yield fell to 61 bp but recovered smartly (~72 bp), and actually closed the week with a slightly higher yield than the previous week.  German 2-year yields slipped to new record lows near -28 bp and finished the week near there.  As a consequence, the US 2-year premium over German rose to a new cyclical high just below 1.0%.

The widening of the US premium is supportive of the dollar.  The premium against German speaks to the increasing cost of holding euros against dollars.  The US premium is within a basis point of its cyclical high against the yen.  It appears set to push to new highs against Canada in the days ahead.

The premium the US pays over Japan to borrow 10-year money tested its 200-day moving average near 1.74%, where it is carved out a bottom this month.  It closed above 1.81%, which puts it above the 100-day moving average as well (~1.78%).  The US 10-year premium over Germany is near 1.54%.  This is well off the year's high set in late March near 1.90% when so many were so sure that the German bund yield was going to fall below zero.  However, it remains in the upper end of what it is has traded since the late 1980s.  The 10-year US premium over Canada stands near 80 bp, which is the biggest since at least 1989 when the Bloomberg time series begins.

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