Highlights
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Sub-prime mortgage concerns raise risk aversion |
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JPY carry trade unwinding is major risk ahead |
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Expect limited further upside in EUR/USD and GBP/USD |
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US advance 2Q GDP report on Friday |
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Commentary
Brian Dolan, Chief Currency Strategist
The US dollar is closing slightly weaker against European currencies and down more significantly against the JPY, which translates into a lower weekly close for the JPY-cross carry trades. The USD continues to be seen as vulnerable against the backdrop of the losses in the mortgage-backed securities market. Despite those concerns, US stock markets DJIA and S&P) reached new all time highs, but were unable to sustain the gains on the last trading day of the week. The equity sell-off weighed on USD/JPY and JPY-crosses, and provided the only major excitement for the week.
Last week I suggested that the US dollar's decline had reached a likely period of consolidation against European currencies (EUR, GBP, CHF) with a decent potential for a rebound. This past week's price action was largely consolidative in those pairs, with minor new USD lows being reached (EUR and GBP new highs). But there was no sign of any USD rebound, as the US dollar index looks set to close about 20 points lower around 80.30, though I would point out the pace of weekly declines in the dollar index have slowed substantially. USD/JPY was responsible for most of the USD's on-week declines in the index, and this is the result of rising investor risk aversion in the wake of the mortgage-backed securities market, coupled with equity market declines.
While I remain convinced that sub-prime market problems are unlikely to spill over into the larger US economy and remain largely confined to the institutional investor community, ongoing deterioration in credit spreads, rumors of major losses, and position adjustments appear set to continue for the foreseeable future and will continue to cast a shadow over the USD. In that environment, it will be difficult for the USD to stage any rebound of consequence. The most likely scenario for a spill over into other markets is further investor flight to safety/quality, and that augurs poorly for further gains in equity markets. However, keep in mind that while the root cause of mortgage-backed losses is the US housing market, the fallout is not confined to strictly US investors. Global asset managers and financial institutions are heavily exposed to the US mortgage-backed security market and will not escape unscathed. As a result, global equity markets in general may be in for a tough road ahead. The major risk in this regard is that a further contraction in credit conditions disrupts previously announced LBO/M&A deals or scuttles others in the works. The global M&A frenzy is a major factor behind the recent run-up in share prices worldwide, and if that apple cart gets upset, equities may be in for a serious rout.
For the major currencies, global financial market unease equates with rising risk aversion, which increases the potential for sharply higher volatility, which in turn represents a serious threat to the continuation of carry trades, most clearly in the JPY crosses. We got a taste of this on Friday, and while JPY-crosses have experienced similar set-backs in recent weeks, it feels like the shake-out might not be viewed as a buying opportunity this time around. I will be closely following the JPY and JPY-crosses in the next few weeks as I think they will supplant USD weakness as the primary theme in the currency market. USD/JPY, in particular, suffered some technical damage as it fell into the support zone known as the Ichimoku cloud. The top of the cloud is around 122.00 and will now act as resistance if the course lower is to be continued. The base of the cloud is located at 120.65/70, and a drop through that level shifts the overall focus of USD/JPY lower.
In the midst of all the concerns over credit issues in derivative debt markets, investors have been flocking into sovereign bonds in a flight to quality response. That shift has seen 10 year benchmark yields spreads move in favor of the USD against the EUR and GBP, and in favor of the JPY against all. Another shift in interest rate markets has seen expectations reduced for two further rate hikes out of the ECB and BOE. Interest rate futures continue to price in another rate hike from each, but expectations of a second rate hike have now been pared back to about 60% from nearly 100% just a week ago. With EUR/USD and GBP/USD far closer to their highs against the USD, it would seem the currency market has yet to adjust pricing accordingly. Those interest rate expectation adjustments were based on incoming data that continues to suggest Eurozone growth has likely crested, while UK data indicators point to a further ebbing of the extremely bullish outlook. I think the upside for the EUR/USD and GBP/USD remains constrained as a result, and I prefer to continue to trade them from the short-side on remaining rallies. At the same time, I'm circumspect about their downside potential while the gloom hangs over the USD, and I'll look to take profits opportunistically. The downside for those currencies increases with a further pressure in the JPY-crosses.
Next week has a relatively busy data calendar, and Eurozone and UK data will likely prove pivotal to those currencies recent highs. Eurozone data begins on Tuesday with June German import prices and June French consumer spending, but the highlights are likely to be the advance July PMI (purchasing manager's index) sentiment surveys for the Eurozone. Wednesday has only July French business confidence of note. Thursday sees July German IFO sentiment and outlook gauges, which may fall more than expected in light of weaker ZEW readings this past week. Friday sees August German GfK consumer confidence and preliminary July German CPI.
UK data starts on Sunday evening with the release of Rightmove house price index for July, currently expected to see a 2% decline in YoY home price gains. Tuesday sees the July CBI industrial trends survey. Thursday sees July Nationwide Building Society house prices and British Bankers Association data on new mortgage loans.
US data starts on Tuesday with the July Richmond Fed manufacturing index and the weekly ABC consumer comfort index. Wednesday sees weekly mortgage application data and June existing home sales followed by the Fed's Beige Book in the afternoon. Thursday sees June durable goods orders along with weekly jobless claims and June new home sales. Friday will see the preliminary 2Q US GDP report and final July Univ. of Michigan consumer sentiment. Fed speakers of note next week include: Mishkin at an ECB conference on globalization on Tuesday; Poole on energy on Tuesday; and Geithner on global integration on Wednesday.
Japanese data begins with the June trade balance on Wednesday morning. Thursday morning sees the June corporate services price index and weekly net stock/bond investments data. Friday morning concludes with July Tokyo-area CPI and June national CPI data, followed by June large retailers sales and June retail trade. BOJ Gov. Fukui will speak on Tuesday afternoon Tokyo-time and BOJ MPC member Noda will speak on Thursday afternoon Tokyo-time.
The RBNZ will hold an interest rate setting meeting next week and announce their decision on Thursday morning local time/Wednesday afternoon EDT. A two-thirds majority of estimates are expecting a rate hike to 8.25%, with the result likely to be Kiwi negative whether they hike (brief rally, then down) or not.
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