Highlights
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Fireworks are likely in carry trades and USD weakness |
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More uncertainty over mortgage-backed market expected |
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BOJ Tankan on Monday in Tokyo |
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BOE expected to raise rates, RBA hold steady |
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US NFP on Friday |
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Commentary
Brian Dolan, Chief Currency Strategist
The US dollar is closing lower across the board after an extremely choppy week of trading. The week opened up with a sharp sell-off in USD/JPY and the JPY-crosses, collectively representing the carry trade, as concerns mounted over the extent of losses in the mortgage-backed securities market, fallout from the sub-prime mortgage meltdown. I had cautioned in last week's report that there was a disconnect between the resilience of the carry trade (Strong JPY-crosses) and the mortgage market problems, and that something had to give. The sell-off early in the week validated my concern, but the carry trade proved resilient and came storming back by the end of the week, with the JPY-crosses returning to re-test the highs made last week. So I'm left in much the same position as last week and continue to anticipate a larger shake-out in the JPY crosses.
The quick recovery in the carry trade does little to eliminate my concern over an imminent increase in market volatility that will ultimately lead to a significant sell-off in the JPY-crosses. From the fundamental side, the plight of the mortgage-backed security market has not suddenly improved over the last two days, despite the resurgence of the carry trade. That the market stabilized after being routed in the first half of the week likely emboldened traders to think the worst was over. Once a recovery set in, there was a healthy round of short-covering followed by a rush to get back in on the trade. Major tops are frequently defined by late stage attempts to make new highs and this week's price action certainly fits that pattern.
In fact, the fallout from the mortgage-backed market is very likely to worsen in the week ahead. The reason is that hedge funds are typically required to revalue their portfolio holdings at the end of each quarter (today) and report the results to their bank lenders. Such portfolio revaluations take several days, usually five days according to the WSJ, meaning hedge fund revaluations will be in bankers' hands by the end of next week. The mortgage-backed revaluations are likely to be quite negative, and losses that have been rumored for many weeks and months will finally see the light of day. Whether this leads to the withdrawal by banks of credit to hedge funds, which would trigger the unwinding of numerous trade strategies like the carry trade resulting in massive JPY-cross selling, remains to be seen. However, with the recent example of a major investment bank seizing a portion of the assets of the troubled mortgage-backed hedge fund and selling them as quickly as possible in the market, a looming credit crunch seems likely. Given the spotty liquidity in the CDO market, it would seem the first to sell has the best chance to get out with the minimum of losses.
Additionally, the June bonus payment season in Japan is coming to an end and I suggested last week that this would be the beginning of the end of the surge of investor outflows from Japan. The reduced off-shoring of JPY will also see a reduced demand to sell the JPY on any rallies.
On the official front, Japanese news reports earlier this week suggested that the Ministry of Finance (MOF) has concluded that JPY weakness has reached a tipping point, where the boon to exporters is now being surpassed by the pain felt by importers and the overall economy. The reports suggested that the MOF had shifted stance to no longer condoning additional JPY weakness and in favor of a mild JPY appreciation. Finance Minister Omi's comments early this past week, taken as verbal intervention, would suggest there is more than a grain of truth to the reports of a shift in MOF sentiment on JPY weakness. Another reported reason for the MOF shift against further JPY weakness is to head off protests from international trading partners complaining about undue JPY weakness, most recently voiced by NZ and S. Korean finance ministry officials. The net result could be that USD/JPY has a medium-term (multi-week) top between 123.50-124.00.
Looking at the technicals, there is also plenty of reason to anticipate a sharp unwinding of the JPY-cross carry trades. Daily candlestick charts on Friday reveal Shooting Stars, which suggest a reversal lower after an uptrend, in USD/JPY, NZD/JPY, CAD/JPY, AUD/JPY, and GBP/JPY. Similar shooting stars were made last Friday. Weekly candlesticks reveal Hanging Man formations in NZD/JPY, GBP/JPY and AUD/JPY, which are another reversal pattern after an uptrend. Weekly USD JPY looks to have made a bearish engulfing pattern, yet another downside reversal signal. In terms of daily close price action, the late-week rebound in the JPY-crosses essentially established double tops in most of the JPY-crosses, with new highs in NZD/JPY and CAD/JPY in particular being sharply rejected. Not to beat a dead horse, but my screens are blinking red with signals of an imminent JPY-cross sell-off that could easily surpass the drop seen earlier this week.
The US equity market remains for me the trigger point for the expected carry-trade wipe-out. Both the DJIA and the S&P made intra-week lows at the low point in between the two most recent tops at 13,690 and 1540, respectively. Those lows, 13,250 and 1485, are the key to confirming that a double top has formed and weakness below should trigger a wave of technical selling, as well as unleashing a bout of market volatility that will undermine the existence of the carry-trades. The risk is that an equity market meltdown may actually be triggered by a carry-trade sell-off, so to be on the safe side, keep a close eye on equities and currencies in the weeks ahead.
Carry trades are not the lone focus of the market at the moment, and the USD is showing signs of a renewed bout of weakness. The primary indicator there is a break of trendline support in the USD index which captures the US dollar recovery since the beginning of May. The loss of that support, which coincidentally comes in at the psychological round number of 82.00, suggests the USD is set to continue losing ground across the board. USD/JPY may lead the way, but more likely, it will be a choppy mix of JPY-cross selling coupled with overall USD selling. I would favor trading the USD from the short-side in USD pairs, and continuing to sell JPY-crosses on strength in the weeks ahead. Additional tangential USD negatives are terrorism threats highlighted by the foiled London car bomb plot on Friday and the continued political woes of the Bush administration, which show no signs of abating and are arguably worsening.
Turning to next week, keep in mind that the US 4th of July holiday falls on Wednesday and there will be reduced liquidity during the North American session for most of the week as a result. Such holiday-thinned markets are ripe for increased volatility, and given the overall backdrop, it may be time to strap on the helmets.
US data next week is fairly heavy for a holiday week, starting with June ISM manufacturing and prices paid on Monday. Tuesday sees May pending home sales and factory orders. On Thursday, ADP employment change, initial weekly jobless claims and June ISM non-manufacturing are all scheduled. Friday will see the release of the June NFP report, with forecasts currently centered on an increase of +120K jobs and a steady 4.5% unemployment rate. The only scheduled Fed speaker is SF pres. Yellen, speaking from Singapore on Friday afternoon local time.
Eurozone data begins with June PMI manufacturing surveys for the major European economies on Monday. Tuesday sees May Eurozone PPI. Wednesday sees the PMI services surveys for major Eurozone countries, along with June Eurozone retail sales. Thursday's highlight will be the ECB rate announcement, with no change expected, and the focus will again be on any indications as to the timing of the next ECB rate hike. ECB pres. Trichet will speak at a banking conference on Tuesday, but he is unlikely to deliver any signals prior to the ECB press conference. Friday sees May German factory orders as the key data point.
Japanese data begins on Monday morning Tokyo time with the BOJ's quarterly Tankan surveys of business sentiment for the 2Q. Forecasts are for steady readings in 3 of the 4 indexes, with a 2-point increase expected in the large manufacturing outlook gauge. Most importantly, the Tankan large all-industry capital expenditures survey is currently forecast to show a 9% increase in Capex outlays, up from the 1Q's 2.9%; a potential catalyst for JPY-strength. Tuesday morning in Tokyo will see May labor cash and overtime earnings. Thursday afternoon sees the preliminary May leading economic index, which is expected to improve significantly for the first time since last October.
In the UK, June PMI manufacturing sentiment surveys are due out on Monday. Tuesday sees PMI construction sentiment and June Nationwide Bldg. Society consumer sentiment. Wednesday will see the PMI services sector survey, BOE 1Q mortgage equity withdrawal data, and the June BRC shop price index, a privately issued inflation gauge. On Thursday, the BOE MPC is expected to raise UK benchmark rates 25 bps. to 5.75%, with only a handful of some 60 economists predicting a steady outcome. Friday sees May industrial and manufacturing production reports.
In Australia, the RBA is expected to hold rates steady at 6.25% when it announces its decision on Wednesday morning local time/Tuesday evening NY time. The risk, however, would be for a surprise tightening, but it seems highly unlikely.
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