Risk-correlated trades continue to trade in bullish style while the USD is being sold off across the board. The general worry surrounding the US economy, reinforced by the Fed's official comments and yesterday's weak pending home sales, is that the US recovery is running out of steam. There has been further buzz among analysts of further QE by the Fed and there's a strong article in the WSJ which hints that the Fed's new strategy will use proceeds from maturing mortgage bonds to purchase assets rather than allowing their balance sheet to shrink naturally. The renewed focus on US deflation and lack of tightening by the Fed is clearly resurrected the Dollar Carry Tradefor the summer.
The current economic environment is building the case for contracting US yields and the selling of the USD. However, we suspect that the rumors of further QE have been overblown - primarily because we believe US economic data has only temporarily softened and will not deteriorate to the levels at which the Fed would enact such emergency measures. As a result, US 2yr Treasury yields dropped to record low. It's important to point out that if the US were truly inching closer to the edge of the abyss, then the global economy is headed that way as well. If the US goes over the edge, it will drag down the global recovery.
We should expect to should see the reverse reaction in the market as we did in early 2009, with stocks and commodities being sold-off and the USD appreciating. The current trend must be temporary and is unsustainable. We suspect USD weakness will be part of the needed normalization period as the EUR is still overly bearish due to the sovereign crisis. In front of Thursday's BoE and ECB meetings (see our Central Bank Preview) and Friday's Non-farms, we don't expect any shifts in market direction except maybe a slight pull back in risk appetite.
In Japan, the story remains the strong Yen and what the Minister of Finance is waiting for to act. The BoJ is due to release a monetary policy rate decision and that may be the catalyst for the Finance Minister to take stronger action. At the 85.50 level, the rhetoric is increasing but the overarching sentiment among institutional participants is that FX intervention is not currently on the table for the Japanese.
The main reasoning is that unilateral intervention by the Japanese would have limited effectiveness and so far the Yen strength has not damaged the Nikkei. If the Nikkei were to drop below 9000, this might trigger the action on the Japanese's part. Still, there is a feeling of nervousness surround the depressed USDJPY level and the option market is quite heavily short gamma which would amplify any sudden break to the downside. We are still taking this opportunity to build a long USDJPY position and suspect that strong verbal intervention is not as far away as many in the market believe.
And on a final note, the UK had a string of soft data recently including yesterday's PMI construction and today's PMI services (53.1 vs. 54.5 expected). The soft data will likely erode some of the market's growing confidence in the UK recovery and weigh on sterling. In the US ADP employment and the ISM non-manufacturing index, both for July, are due this afternoon.
Today's Key Issues (time in GMT):
00:00 GBP BoE MPC begins two-day meeting.
07:13 EUR ESP Jul services PMI, 51.5 exp; prior 51.8.
07:43 EUR ITA Jul services PMI, 52.0 exp; prior 51.5.
07:48 EUR FRA Jul services PMI, 61.3 exp; prior 61.3.
07:53 EUR GER Jul services PMI, 57.3 exp; prior 57.3.
07:58 EUR Jul services PMI, 56.0 exp; prior 56.0.
07:58 EUR Jul composite PMI, 56.7 exp; prior 56.7.
08:28 GBP Jul services PMI, 54.4 exp; prior 54.4.
09:00 EUR Jun retail sales, +0.1% m/m and y/y exp; prior +0.2%, +0.3%.
12:15 USD Jul ADP employment report, +60k exp; prior +13k.
14:00 USD Jul ISM non-mfg index, 53.3 exp; prior 53.8.