Euro Slides on Portuguese Downgrade

A Portuguese downgrade dragged the euro lower in generally quiet trading. The Swiss franc appears to have regained its footing as US stocks declined for the first time in six sessions.

The lone market-moving news was from Moody’s who slashed Portugal’s rating to Ba2, down four notches and below investment grade. The move is ominous and suggests a very high possibility Portugal will need to follow Greece toward a second bailout. EUR/USD fell as low as 1.4397 but has rebounded to 1.4426. See the earlier IMT for more.

The euro was spared by expectations of a rate hike on Thursday. Traders looking to exploit further sovereign concerns in Europe should look to the Swiss franc. It has rallied broadly and will not be overwhelmed by the ECB decision. The commodity currencies were all lower versus CHF on Tuesday after 5 days of gains. Another trade that was boosted by the flight to safety from Europe was gold as it surged $30 to $1515.

Unfortunately, the data calendar remains scarce. The lone release in Asia is Japan’s May preliminary leading indicators report. A rebound to 99.8 from 96.2 is expected but the report is unlikely to have any market-moving impact. In Monday’s session, rumours circulated of a Chinese interest rate hike this weekend. Moody’s also spooked markets with a report saying local government loans may default at a 10% rate. The fallout may dictate trading on in the hours ahead.

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RBA Will Remain on the Sidelines, AUD Vulnerable

Signs of a slowdown in the Australian economy will force the Reserve Bank to hold rates unchanged on Tuesday and are making expectations of an August hike vulnerable. The Australian dollar is likely to fall if policymakers do not take strong incremental steps toward future rate hikes.

 

At 0430 GMT, all 28 economists surveyed by Bloomberg expect the RBA to leave interest rates at 4.75%. Yesterday’s unexpected drops in retail sales and inflation cemented those expectations and are cutting into the chance of an August hike.

 

May retail sales fell 0.6% compared to the 0.3% rise expected. At the same time, the Melborne Institute/TD Securities monthly inflation gauge was flat in June after a 0.2% rise in May; the annual rate fell to 2.9% from 3.3%. Building approvals also slumped 7.9%.

 

At the previous meeting, on June 6, the market had priced in a 16% chance of a hike. When it didn’t come, AUD/USD fell 60 pips to 1.6080. The pair eventually bottomed at 1.0390 on June 26 but popped back to 1.0775 during last week’s risk rally. What’s critical from a fundamental and technical perspective is that the pair has failed to close above 1.0774 — the high before June’s unexpectedly dovish RBA statement. This will be a key closing level in the day ahead.

 

The market is still hanging on to the idea that the RBA could hike in August but we see it as a long shot. We also expect the chance of a hike in August to fall to virtually nil if the RBA continues to say: “The Board judged that the current mildly restrictive stance of monetary policy remained appropriate.” The OIS market is pricing in just 15 bps of tightening in the next 12 months.

 

Given that, AUD/USD is looking rich at the moment (1.0732). Even if the RBA introduces slightly more constructive rhetoric, we think the rally will be short-lived (48 hours max). It will take a significant hawkish shift to propel AUD back toward a re-test of the all-time highs at 1.10. This would manifest itself in something like the Feb. 2010 statement which said: “The Board considers it likely that monetary policy will, over time, need to be adjusted further in order to ensure that inflation remains consistent with the target over the medium term.”

 

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The Bank of Canada Will Hike, Look to Buy CAD

The Canadian dollar jumped after May CPI hit the highest rate in eight years. The Canadian dollar trailed AUD and NZD despite the miss as Canadian bank economists held onto predictions of no hike at the July 19 meeting. Some continue to forecast no hikes this year, noting gas prices have been down since the report. As traders, we think the money lies in establishing longs ahead of the decision at an opportune time. First, the BOC is hyper-conscious of inflation expectations (like Trichet) and terrified of allowing them to creep up at all. Second, it’s an unpredictable central bank and will not foreshadow a hike with a code word like “strong vigilance.” Third, there is no meeting in August, so the BOC will have to wait until Sept. 7 to move and policymakers may feel that they will sleep better through the summer holidays with a pre-emptive move. The clincher may come with Thursday’s report on April GDP; a 0.1% contraction is expected. With a flat or positive reading you will see the stubborn Canadian bank economists begin to shift their tone.

 

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Euro Rebounds on Greek ‘Plan B’

Positive sentiment emerged in US trading on hopes that Greece will pass an austerity budget and news that Europe is working on Plan B if the vote fails. The euro was the top performer while AUD and NZD lagged on the day. Japanese retail sales are the highlight of Asia-Pacific trading.

EUR fell in early trading and overall sentiment was negative after Moody’s warned that deposits are rapidly being pulled from Greek banks but the trade reversed on talk that Europe may incentivize its banks to rollover Greek debt with a Brady bond-like structure. Greek PM Papandreou also predicted HE WILL HAVE ENOUGH VOTES to pass the austerity budget required for bailout funds. A vote is likely on Tuesday. The ECB’s Stark said the central bank is “very vigilant.” A JULY HIKE IS ALREADY PRICED IN but this helped traders feel a bit more confident about it.

US personal spending was flat compared to the +0.1% expected. Core PCE rose 1.2% y/y compared to the 1.1% expected. Although this is well below the Fed’s threshold, it is moving in higher and we believe it must fall below 1.0% before the Fed considers QE3.

Treasuries fell badly pushing yields higher by 5-9 bps across the curve. The selloff accelerated after a soft 2-year auction. The rising yields underpinned USD against JPY and CHF. Auctions continue on Tues (5yr) and Wed (7yr). The S&P 500 climbed 0.9% to 1280. Gold fell $5 and closed below $1500 for the first time since mid-May.

Comments from the Fed’s Kocherlakota (voter) did not relate to current policy, instead he called on the gov’t to lower the tax deduction on mortgage interest – something that has zero chance of happening in the next five years.

Japanese Retail Sales

Japanese retail sales are expected to be down 2.2% y/y in May compared with a 4.8% drop in April. PM Kan appears to be closer to resigning at the end of the current Diet session in mid-August. Nikkei News reports he has offered to quit once bills are passed authorizing a supplementary budget and deficit financing.

 

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Bernanke Frustrated With Recovery, No Hints of Action

The US dollar fell and stocks declined for the fifth consecutive day after Fed Chairman Bernanke lamented the recovery and retained a dovish tone. The euro was strong on speculation Trichet will stress inflation risks on Thursday. We look at the warning signals in the bond market and the chance of a double dip.

Sentiment about the US economy continues to deteriorate and it is dragging down the dollar and stocks. The S&P 500 was higher with 1.5 hours remaining in the session but fell and then fell further after Bernanke delivered his remarks. Dollar bulls were hoping the Fed Chair to would dismiss economic weakness as transitory or that inflation was accelerating but Bernanke was cautious and said US growth so far this year is “somewhat slower than expected” and that inflation was a concern but doesn’t see much evidence it is becoming broad-based. Stock market participants were hoping Bernanke would leave the dollar open for QE3 but he gave no hints at further stimulus.

In a separate speech, Atlanta Fed President Lockhart (voter) said there is a high bar for QE3 even though he is “troubled” by the slowing recovery. In order for the Fed to buy more bonds (beyond re-investments) he said there will need to be a dramatic GDP reversal, more unemployment or the risk of deflation.

EUR/USD rose to the highest since May 5 as it pushes up against 1.47. Strong EZ economic data and speculation Trichet will signal rate hikes on Thursday were behind the move higher. The pound also had a strong day while AUD lagged on the dovish RBA.

The bond market continues to flash concerning signals. A three-year auction was very strong and 10-year yields fell back below 3% despite supply later this week. Two year yields fell to just 0.41%. The bond market is flashing signs of more than just a dovish Fed; there is a demand for safety. Indications are also that Treasury dealers are positioned for bond yields to rise. This trade has gone badly against them, which tells us: 1) They will have to unwind the trade 2) Something they didn’t anticipate is happening in the economy (Weakness? Disinflation?)

This is one of the five or so times that the US has looked like it could tip back into recession since the crisis ended. It has proven resilient but this time neither the Fed, nor the Federal government is in a position to provide support. Remember that the bond market moved far before the crisis and that the USD weakened for some time before it became clear that the problems far exceeded US borders.

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Foreign exchange analysis from Adam Button