Sterling Slips and Aussie Pops as Investors Await Fresh Insight into Fed Trajectory

The US dollar is broadly mixed.  The main narrative of increased prospects for a Fed hike in June or July has been pushed off center stage as the market reacts to local developments as investors await from US economic data.  Ostensibly the data will determine whether the Fed raises rates in June or July. 

On the other hand, despite the Fed's data dependency, we argue that the determining factor is the Fed's risk assessment.  In particular, we accept at face-value the official recognition of the risks posed by the UK referendum. In the larger picture and from an economic and financial point of view, it matters not if the Fed hikes in June or July. Given the uncertainties surrounding the UK referendum, we think the Fed would prefer to wait six weeks until its next meeting than risk adding to the potential market disruption and tightening of financial conditions that could result from a UK decision to leave the EU. 

Sterling is the weakest performer among the major currencies today.  Initially, it was bid to a three-day high near $1.4725 before reversing to a five-day low.  Technically, the outside down day requires a close below the previous day's low ( ~$1.4588).  The proximate cause is two-fold.  First, the latest ORB poll confirmed reports that contest is much tighter than some of the recent polls suggest (51% to 46% for the remain), and a London bookmaker indicated that the new money placing wagers favor the "leave camp."    This can be seen in the options market, where one-month volatility has jumped to 17.25%  from 16.6% before the weekend and 11.1% a week ago.  The premium for sterling puts over calls widened to 5.7% yesterday, and indicative prices suggest it remains near there today.  

There is also some concerns that regardless of the outcome of the referendum, the heated battle will generate a challenge to Prime Minister Cameron.  And Chancellor of the Exchequer Osborne has not yet be rehabilitated after the poorly received budget, and in any event is seen as too close to Cameron to be an alternative.  

The dollar, which was straddling the JPY110 area last week is now straddling the JPY111 area. The price action continues to support US and Europe position at recent G7/G20 meetings that Japanese intervention was unnecessary.  The market has pushed the dollar from JPY105.50 on May 3 to a high yesterday just shy of JPY111.45.  The JPY111.80 area, seen in late-April, to JPY112.00 is the nearby ceiling.  

There have been several Japanese economic reports in the last two sessions, but none convince the market that the Abe government will provide fresh fiscal stimulus (including postponing the sales tax increase), and many are looking for more support from the BOJ with July seen as more likely than June.  On balance, the data, from retail sales and overall household spending, the job-to-applicant ratio, and industrial output were firmer than expected.  One key takeaway is that the recent earthquake was not as economically disruptive as had been feared given the supply chains that were exposed.    Nevertheless, Japan's Finance Minister Aso, who at the G7 finance ministers meeting had indicated the official intention of pressing ahead with the sales tax increase backpedalled, and at a press conference tomorrow, Abe is expected to make a delay official.  

Nevertheless, the fact that the data was mostly better than expected does not conceal the fact that in absolute terms, the economy is still struggling to sustain positive momentum.  For example, retail sales and overall household spending is still falling on a year-over-year basis.   Industrial output is 3.5% lower than a year ago, the second-largest decline since the late-2014 even though it was up 0.3% in April (median forecast was for a 1.5% fall).  Recall Japan's manufacturing PMI fell for the fifth month in May to 47.6 (preliminary reading, the final report will be released in Tokyo first thing on Wednesday).   

Two other developments stand out from the Asian-Pacific session.  First, Australia reported stronger than expected exports for Q1. This has the effect of making participants less confident that the RBA will cut rates at back-to-back meetings like so many thought likely.  Exports were flat in Q4 15 but contributed 1.1 percentage points to Q1 16 GDP.  The market expected a 0.7 point contribution.  Australia also reported stronger building approvals (3% instead of minus 3%), and even though the March series was revised lower, the generally favorable data helped the Aussie extend yesterday's recovery. 

Yesterday's the Australian dollar briefly traded near $0.7150 before recovering to close near new session highs just below $0.7190 (possible hammer pattern--Japanese candlestick), and today tested $0.7250.  Provided it holds above $0.7220 now, it can work its way a bit higher.  As a mile marker, note the that 20-day moving average is found near $0.7285.  The Aussie has not been above this average since a downside reversal was posted on May 3.  

Chinese shares closed broadly higher (Shanghai Composite +3.3%, its biggest rise since early March).  It fully recovered from an intraday flash crash.  The main impetus appears to be increased speculation that the mainland's A shares may be included by MSCI in its global indices next month.  We are not convinced.  Last August's experience, lack of transparency and the fact that many shares did not trade for an extended period is concerning.  Note that the previously announced changes to include more technology and service ADRs are effective tomorrow.  

The yuan continued to weaken.  Yesterday, the dollar spent the Shanghai session above the pre-weekend high and edged higher today.  With the dollar approaching its best levels of the year, the lack of contagion for the weaker yuan is remarkable.  

More broadly, MSCI's Asia-Pacific Index advanced for a fifth consecutive session, and seven of the past eight sessions.   The Nikkei gained nearly 1% and finished on its month's high for a 3.4% gain in May.  European bourses are lower.  The Dow Jones Stoxx 600 is off a minor 0.25%, but every main sector is lower, led by the energy sector.  Brent oil is lower on the day but is unchanged from pre-weekend levels.  Gold is snapping an eight-day losing streak that saw the yellow metal trade briefly below $1200 yesterday for the first time since mid-February.  

Eurozone economic data today included money supply (with its lending report) and the final May CPI.  Money supply growth M3 disappointed with  4.6% three-month year-over-year pace.  It is the slowest pace since February 2015.  The lending data was also not particularly inspiring.  Lending to non-financial firms edged higher to 1.2% from 1.1%, while lending to households slowed to 1.5% from 1.6%.  The data is unlikely to impact the ECB assessment later this week or the staffs updated forecasts.  The final CPI reading was unchanged from the preliminary estimate of a minus 0.1%  headline rate after minus 0.2% in April.  The core rate ticked up as expected from 0.7% in the preliminary report to 0.8% in the final.  

Separately, Germany reported an unexpected decline in the unemployment rate to 6.1% from 6.2% as the unemployment queues fell by 11k rather than 5k that economists estimated.  Like we saw in Japan, strong labor market readings have not spilled over to boost consumption.  Germany reported that April retail sales fell 0.9%.  The median forecast found in a Bloomberg survey was for a 0.9% rise, after a 1.1% decline in March.  

Although there are several US economic reports, we do not expect much market reaction.  April personal income and expenditure data will help solidify expectations for Q2 GDP, which have been creeping higher in any event.  The Fed's targeted inflation measure, the core PCE deflator is expected to be unchanged at 1.6%.  The CaseShiller house price report is not typically and market mover, while the Chicago PMI is expected to be little changed.  The key report this week is the US jobs data. The strike at Verizon could shave headline number by 40k.  

Canada reports monthly GDP figures for March and Q1 growth.  The Canadian economy likely contracted 0.1% in March as it did in February.  However, because of the strong advance in January (0.6%), Q1 growth picked up from the 0.8% annualized pace in Q4 15.  The Canadian dollar is soft but shows little momentum presently.  The US dollar has gained about 4% against the Canadian dollar this month after falling in the February-April period.  The greenback is supported in front of CAD1.2980, and the CAD1.3180 area seen last week offers a nearby cap.  

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