Dollar Soft as Markets Limp Into the Weekend

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  • The cycle of sanctions, recriminations, and provocative actions continues as the Trump Administration leads a confrontation with North Korea
  • S&P followed up its cut to China by taking away Hong Kong’s AAA rating
  • New Zealand goes to the polls tomorrow, with the National Party expected to beat Labour to form the next government
  • Stronger than expected eurozone PMIs were reported; the German election does not appear to be a market factor
  • Bank Indonesia is expected to keep rates steady at 4.5%; Mexico mid-September CPI is expected to rise 6.59% y/y

The dollar is mostly softer against the majors as the week winds down.  Aussie and the yen are outperforming, while sterling and Swissie are underperforming.  EM currencies are mostly firmer.  ZAR and PHP are outperforming, while IDR and KRW are underperforming.  MSCI Asia Pacific was down 0.1%, with the Nikkei falling 0.3%.  MSCI EM is down 0.5%, with the Shanghai Composite falling 0.2%.  Euro Stoxx 600 is down 0.1% near midday, while S&P futures are pointing to a lower open.  The 10-year US yield is down 2 bp at 2.25%.  Commodity prices are mostly lower, with oil down 0.1%, copper down 0.5%, and gold up 0.5%.

The cycle of sanctions, recriminations, and provocative actives continues as the Trump Administration leads a confrontation with North Korea.  The US announced yesterday a new round of sanctions on North Korea.  Reuters reported that the PBOC has instructed its banks not to take on new North Korean clients and to begin unwinding existing relationships.  While the implementation and enforcement will be scrutinized, the measures are very much supportive of the US efforts.

Still, there are serious doubts, which some other countries have already expressed, that sanctions and economic and financial depravity will get North Korea to abandon its nuclear efforts.  For North Korea, this is an existential issue.  If it were not from credible deterrence, it fears and not completely unfounded, that there be a more sustained effort to topple his regime.  We have suggested that a credible deterrence requires not only first strike capability, but also the ability to unleash a second strike if it is hit first.

Up until now, North Korea has tested its hydrogen bomb on its territory.  On the escalation ladder, there are many rungs.  One of them is to detonate a hydrogen bomb beyond its territory, like in the Pacific as the US has done in the past.  This appears to be what North Korea is now threatening.

As we have noted before, treating the confrontation with North Korea like a version of the Cuban Missile Crisis, which requires urgent action, is not the only precedent on which to draw.  The other one would be the Iranian experience.  Sanctions were part of what brought Iran’s nuclear ambitions to the negotiating table, but the key point was that there were negotiations, in part because a military confrontation could have been so devastating.   Churchill once famously quipped that the Americans can be trusted to do the right thing after they have exhausted all the other alternatives.  North Korea has, it would appear, convincingly and credibly demonstrated that it will sacrifice the well-being of its people to preserve its regime.

Still, the newest round of hyperbolic claims, sanctions, and threat of provocative actions is a modest market force today.  Gold and the yen are paring this week’s losses.  US Treasury yields have lost the upside momentum that lifted the 10-year yield from nearly 2.0% on September 8 to almost 2.29% on September 20, after the FOMC meeting.  It is now a little above 2.25%.  Gold is up about 0.5% on the day, which trims its loss for the week to 1.75% (@ ~$1297).

The correlation between the percent change in US yields and the percent change in the dollar-yen exchange rate is near not only the highs for the year, but is at the upper end of where it has been since 2000 (~0.80).  The yen is recouping about a third of this week’s losses today.  The 0.5% gain today leaves it a little more than 1.0% lower on the week.  It is the strongest major currency today, but the weakest on the week.

There are several large dollar-yen options that expire in NY today.  There is $1.5 bln struck at JPY111.00.  There is $1.7 bln struck at JPY112, and another $540 mln struck at JPY112.50.  We would peg initial support for the dollar near JPY111.50, which corresponds to the 38.2% retracement of the rally from last Friday’s low near JPY109.55.

Yesterday, S&P cut China’s sovereign debt rating (first time since 1999), expressing concerns over its debt.  It followed up today by taking away Hong Kong’s AAA rating.  The reason for the HK move was the potential for spillover from deleveraging on the mainland.  Note that when Moody’s downgraded China four months ago, it also followed up by cutting Hong Kong’s rating as well.  Incidentally, of the eleven sovereigns that S&P still sees as AAA, only Australia has a negative outlook.  The Hang Seng is surrendering most of the week’s gains today, but more broadly, the MSCI Asia Pacific Index is recorded its second consecutive losing session for the first time in nearly a month.  The regional benchmark is extending its advance for a sixth consecutive week.  It has fallen once in the past 11 weeks.

New Zealand goes to the polls tomorrow, with the National Party expected to beat Labour to form the next government.  The continuity and anticipated policy mix is understood as investor friendly.  For today, the risk off push is being blunted by the heavier tone for the greenback.  The Aussie’s gains are notable insofar as they come in the face of dovish comments by RBA Governor Lowe and continued weakness in industrial metals, including a 1% fall in iron ore today (which brings the weekly loss to nearly 8.5%).  The entire industrial metals complex is lower today and rebar and coil steel are also extended their losses.

The stronger than expected ZEW survey earlier in the week may have given a hint of today’s flash PMI reading.  Germany’s flash PMI was stronger than expected and the composite reading rose to 57.2 from 55.0, a new cyclical high.  France’s September flash PMI was also stronger than expected, with the composite rising to 57.2 from 55.2.  The composite reading for the region as a whole rose to 56.7, returning toward the cyclical peak recorded at the end of Q1 and the start of Q2.

What appears to be new acceleration of activity is unlikely to play a significant role the ECB asset purchases decision that will likely be unveiled next month.  The main challenge facing the ECB, as with several other central banks, including the Federal Reserve, lies not so much with the real economy as it does with the low-price pressures, leaves it to close to deflation for officials.

The euro extended its recovery after falling to nearly $1.1860 in response to the FOMC meeting, where 11 of 16 Fed officials continue to see a hike in December as appropriate and anticipate three hikes next year.  The euro reached almost $1.20 in the European morning.  In the three episodes beginning in late August, when the euro pops above $1.20, there seems to be unsourced comments that seem designed to knock it back.  Also, there are euro options struck at $1.1950 (1.0 bln euros) and $1.20 (1.4 bln euros) that expire in NY today, which could be in play.

The German election does not appear to be a market factor.  There seems to be little doubt that Merkel will be reelected Chancellor and that Schaeuble will likely retain the Finance Ministry.  Although the CDU may have preferred a coalition with the center-right Free Democrats, it does not look like it will secure sufficient support.  There may be little alternative than a return of the Grand Coalition.

UK Prime Minister May’s speech in Florence is awaited.  The EU negotiations over Brexit were delayed in hopes that her speech gives new impetus to the talks.  She is expected to make some concessions on funds and EU migrants, while formally seeking a “standstill” transition period.  Sterling spent this week largely consolidating last week’s gains spurred by a more hawkish sounding central bank.

The North American session features the Markit PMI preliminary September report for the US, which is typically not a market mover.  The FOMC embargo has ended, and so the Fed’s Williams, George, and Kaplan all speak today.  Of these three, only Kaplan is a voting member of the FOMC this year.

We suspect that it was Fed President George that cast the dot plot indicating that two rate hikes this year would be appropriate.  She is one of the most vocal hawks on the Fed and is concerned that the persistence of low interest rates distorts economic signaling and risks financial instability.  If that is her dot, it does not mean that she is forecasting two hikes this year, as the media suggests, but that it is her way of putting forth her argument that the Fed is slipping behind the curve.

Canada reports August CPI and July retail sales.  Today’s reports are unlikely to have much impact on expectations for Bank of Canada policy.  After taking back the two rate cuts from 2015, the Bank of Canada is not in a hurry to move again.  Comments by Deputy Governor Lane earlier in the week encouraged the market to think again about the likelihood that it would deliver three hikes in three consecutive meetings.  The signals from the Bank of Canada do not appear that aggressive.  Next BOC policy meeting is October 25.  Right now, consensus sees no hike then.

The implied yield of the December BA futures has fallen a few basis points this week.  Coming into today’s session, it is 10-12 bp above the low seen after the employment report on September 8.  Since then the US dollar has recovered from near CAD1.2065 to nearly CAD1.2400. Initial support for is now pegged by CAD1.22.

Bank Indonesia is expected to keep rates steady at 4.5%.  Inflation was 3.8% y/y in August, just below the 4% target and within the 3-5% target range.  BI surprised markets with a 25 bp cut at the August 22 meeting, but another cut so soon seems unlikely.  We believe another cut will be seen in Q4, however.  High yields have attracted foreign portfolio investment, but more rate cuts will surely impact these inflows.

Mexico mid-September CPI is expected to rise 6.59% y/y, same as mid-August.  Inflation remains well above the 3% target and the 2-4% target range, but appears to be topping out as the August full month reading was 6.7%.  Bloomberg consensus sees the first rate cut in Q2 2018, and we concur.  Next policy meeting is September 28, no change seen then.