Dollar Losses Extended Ahead of the Weekend

There are two main forces in the foreign exchange market that are rippling through the capital markets.  The first is the continued weaker dollar tone.  The combination of what appears to be a stagnating US economy (0.5% annualized pace in Q1) and a market that does not believe the Federal Reserve will hike rates in June, and is in fact, judging from the Fed Fund futures strip, skeptical of a single hike this year.  

The effect of this US dollar weakness help the commodities and emerging markets extend their recoveries that began 2-3 months ago.  Economic fundamentals and the reaction function of the Federal Reserve has also contributed to keeping US yields low, which has global knock-on effects as well.  

The second force is the strength of the yen.  Sure, part of the yen's strength reflects the weakness of the US dollar.  However, part of it looks independent of US developments. Although many economists and observers try tying the yen's strength to its alleged role as a safe, have, we think it is misunderstood.  Among the riskiest assets, emerging market equities, or high yielding bonds, or commodities, have been rallying.  

There is no compelling sign of panic, heightened anxiety, or need for a safe haven.  In addition, there is scant evidence that investors are flocking to Japanese assets.  Through mid-March, foreigners were net sellers of Japanese equities.  It is true they have turned net buyers in April, though the amounts are modest  (JPY1.7 trillion or ~$15 bln over the past four weeks, after being net sellers over the previous 13 weeks selling roughly $36.8 bln of Japanese shares). 

Foreigners have been steady buyers of Japanese bonds this year, except a few weeks in March.  It is a noteworthy development that has received very little attention.  Who are buying negative yielding Japanese government bonds besides the BOJ?  Foreign investors. 

At the same time, there has been a surge in Japanese portfolio capital outflows.  It appears that Japanese investors were not repatriating their foreign holdings as the safe have hypothesis would suggest, but buying prodigious (record) amounts of foreign bonds in March.  Japanese investors were also consistent, even if less dramatic, buyers of foreign shares.  There are some seasonal patterns at the start of the new fiscal year (April 1) that may be distorting the recent weekly data, which is why we note the larger pattern, which does not suggest the yen has been bought as a safe haven.  

We suspect that flows that are less transparent, like repatriation of foreign earnings by Japanese or unwinding of hedges by foreign investors liquidating Japanese equities that have fallen in price, or Japan institutional investors hedging their currency risk (buying yen) played a role earlier this month. 

Using the futures market as a proxy for trend-following and momentum speculators, a buyer of yen is clear.  As of around 10 days ago, speculators in the futures had amassed a record long net and gross yen position.  However, the flows in the futures market seem to small compared with the spot market to be a key driver.   That said, we recognize this as a dynamic process and can feed it on itself, with money management considerations driving decision-making, allowing a move to take on a life on of its own, as it were.

Japanese markets were closed today, but the yen's strength has continued.  The dollar traded below JPY107 for the first time since October 2014.  The JPY106.60 area may be the next technical target.  The market may draw more cautious if the JPY105 level is approached as some observers tout intervention there, though we suspect that such claims mistakenly see BOJ action (that would be ordered by the MOF) as defending a fixed level. 

The euro briefly poked through $1.14 for the first time since April 12.  It has recorded a higher and a higher low now for the fourth consecutive session after holding above $1.12 at the start of the week.  The euro, then, was already bid before reporting stronger than expected Q1 GDP.  The 0.6% quarter-over-quarter pace was above expectations and twice the pace of Q4 15.  However, it was necessary to sustain the year-over-year pace of 1.6%. 

We think that this is near trend growth for the eurozone.  It is uneven, and it may be fragile, but its quarterly growth bests the US, UK, and Japan (which may have contracted).  Of note France surprised on the upside with a 0.5% expansion, and Spain, despite the political morass that is leading do-over election in late-June, grew by 0.8%.   Separately, the final April CPI reading showed a minus 0.2% headline year-over-year rate, which is a little worse than the flash reading, and is the third consecutive month with deflation.  The core rate slipped to 0.8% from 1.0%. 

Germany is criticized by the EU, the ECB, the IMF and the United States for not bolstered domestic demand given its large current account surplus in excess of EC rules, given its low (mostly negative) interest rates, and the clear need to modernize its infrastructure.  Today's data provides more fodder.  Retail sales in March slumped 1.1%.  The median estimate on Bloomberg was for a gain of 0.4%.  The fact that the 0.4% decline in February was revised to flat is helpful, but the year-over-year pace of 0.7% is poor and more telling. 

Given the market's mood, we see scope for only a modest pullback in the euro ahead of the weekend, and peg support near $1.1360.  It takes a break of the $1.1325-$1.1335, coincidentally where the five and 20-day are moving averages can be found, to be anything noteworthy. 

Sterling is the laggard here today.  It initially rallied to $1.4665, stopping just shy of the early February high, before reversing lower.  Yesterday's low was near $1.4425, and a move below there would sour the technical tone. 

Yesterday's Q1 US GDP steals much of the importance from today's report on March personal income and spending, though the core PCE deflator, the Fed's preferred inflation measures, will receive attention.  It is expected to slip to 1.6% from 1.7%.   The April Chicago PMI is seen as a help guide to the national reading out next week.  It is expected to ease to 52.6 from 53.6.  University of Michigan's consumer confidence's final reading may tick up, but the inflation expectations measures are more important.     Canada reports February GDP.  It may have fallen by 0.2%, leaving the year-over-year rate steady at 1.6%.  The softer US dollar tone and the 20% rally in oil this month are helping the Canadian dollar extend its recovery gains. 

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