The euro enjoyed its strongest one-day rally against the U.S. dollar since the beginning of July. While we would love to see the EUR/USD bottom because that would mean the end of all this uncertainty and volatility, yesterday's recovery was nothing more than a relief rally. The rebound was triggered by comments from ECB member Nowotny who argued the merits of giving a banking license to the European Stability Mechanism. The mere hope that additional crisis management solutions are being discussed by European policymakers helped to stem the losses in the euro. However lets be clear, a license has not been announced and in fact Germany's Constitutional Court has not even approved the ESM.
Economic data out of the Eurozone continues to surprise the downside with German business confidence falling to its lowest level in more than 2 years. Independent rating agency Egan Jones also cut their rating of Italy's sovereign debt to CCC+ from B+, which puts the country deeper into junk status. While the impact on the euro was nominal because Italy is still rated as BAA2 by Moody's and BBB+ by S&P, Egan Jones' decision reflects the growing risk of holding euros. With Spanish bond yields at a level that is unsustainable over a long period of time, unless we see a permanent decline in yields, the Eurozone sovereign debt crisis is far from over and for this reason, the EUR/USD recovery is nothing more than a relief rally.
Yet it is still important to mention that Spanish 10 year bond yields fell for the first time in 10 trading days. Given how the EUR/USD has been deeply oversold, yesterday's recovery certainly reflects some degree of short covering. Spanish and Italian stocks also rebounded after dropping more than 10% since the beginning of the month. While we believe that the ECB will eventually come to aid of the Europe, giving the ESM a banking license may not be their first option.
Earlier this month, ECB President Draghi said "I don't think there is anything to gain by asking the institution to act outside the limits of its mandate, thereby destroying its credibility" when asked about allowing the ESM to use the ECB. Nowotny admitted that he is not aware of any specific discussions about this possibility within the ECB at this point. In other words, Nowotny is only sharing his own views. Additionally, the ESM can't come into effect until the German Constitutional Court approves it, which won't be until mid September at the earliest - another reason why we believe the support the EUR/USD should be fleeting.
German consumer confidence and import prices are the only Eurozone economic releases on the calendar tomorrow. Italy will be holding a bond auction and strong demand will help the euro while weak demand will hurt it. The Spanish Finance Minister will also be testifying in Parliament on the bank bailout.
USD: Gauging U.S. Risks
Thanks to the recovery in risk appetite, safe haven flows eased out of the U.S. dollar. This morning's U.S. economic data was very disappointing but U.S. fundamentals are still not weak enough for the Federal Reserve to say yes to QE3. However if stock markets around the world resume their slide and bond yields in Europe continue to rise, external developments could force the Federal Reserve into action. If credit markets around the world seize up and Europe finds itself having to figure out how to bailout its third or fourth largest economy, the Federal Reserve may throw out a lifeline by announcing QE3.
At that point, the U.S. central bank probably won't be too heavily criticized about increasing asset purchases because the world will be desperate for help and thankful that the Federal Reserve has stepped in with support. While the central bank's main focus is the labor market, the most widespread drought in 60 years has caused food prices to soar to record levels. Rising costs for animal feed, soyameal and corn are also beginning to affect the price of beef, pork and chicken. Slow growth and high unemployment will make it difficult for producers to pass on these costs and for those who choose to do so, sales could suffer. So while QE3 could support the U.S. economy, rising food prices poses a risk to growth.
As for yesterday's housing economic report, U.S. new home sales dropped 8.4% in the month of June, which was the steepest slide since February 2011. The total number of homes sold slowed to 350k from 382k while the average price fell 1.5%. Although this report is inconsistent with the recovery in housing reported by the Beige Book, the weakness is not a major surprise considering that existing home sales also declined significantly last month, which may explain the muted reaction in the dollar. U.S. durable goods, pending home sales and jobless claims are scheduled for release tomorrow.
GBP: Recession Deepens
Weaker U.K. economic data prevented the British pound from participating in yesterday's risk rally. Although sterling held steady against the U.S. dollar, it lost value against the euro and Swiss franc. As we expected, the recession deepened in the second quarter. The U.K. economy contracted 0.7 percent in Q2, which was not only the third consecutive quarter of negative GDP growth but also the weakest performance in 3 years. While the extra holidays in June for the Queen's Diamond Jubilee helped to boost spending, it led to a sharp contraction in construction and industrial activity that can be largely blamed for the weakness.
The U.K. government doesn't seem to be particularly worried about the GDP numbers because preliminary GDP numbers can be subject to major revisions and the data could be distorted by one-off factors. Yet with this in mind, the level of growth is far from desirable and it may be time for the U.K. government to consider the IMF's suggestion to shift their focus from austerity to growth. Regardless of whether Cameron agrees that a shift is needed, the worst double dip recession in 50 years will keep the Bank of England in easing mode.
NZD: Keep Rates Steady
The Australian, New Zealand and Canadian dollars rebounded against the greenback thanks to the improvement in risk appetite. This afternoon, the Reserve Bank of New Zealand left interest rates unchanged at 2.5%. The RBNZ has held rates steady for the past year and with no major improvement or deterioration in the economy since their last meeting, the central bank did not feel that it was necessary to alter monetary policy. According to RBNZ Governor Bollard, while there is limited risk that euro conditions will worsen, the outlook for their trading partners remains poor.
The strong level of the New Zealand dollar is constraining demand growth but housing market activity has improved thanks to quake reconstruction efforts. Overall their outlook for the economy is unchanged from June and for this reason, monetary policy settings are appropriate. Meanwhile inflationary pressures in Australia increased in the second quarter with consumer prices rising 0.5%. While the increase was less than the market anticipated, it still represented a material pickup in price pressures. Recent rate cuts by the RBA may have contributed to the rise in prices but overall inflationary pressures remain tame at 1.2% and explain why the Australian dollar initially weakened on the report. Leading indicators also improved in May but this data is extremely dated. No major economic reports are scheduled for release from the commodity producing countries, which means the commodity currencies will continue to trade on risk appetite.
JPY: Improvement in Trade Deficit Masks Weakness
The Japanese yen weakened against all major currencies except the British pound which fell victim to its own problems. Japan's Finance Ministry diffused claims that its intervention on the yen last year was unsuccessful and BOJ Deputy Hirohide Yamaguchi stated in his speech and press conference last night that officials won't refrain from easing. Two new members, Takehiro Sato and Takahide Kiuchi, were appointed to the BOJ policy board yesterday and voiced dovish support for more aggressive monetary easing. Sato, who proposed to buy a wider range of assets, said, "I think one possible idea will be for the bank to buy foreign securities." He also said that the BOJ's 1% inflation target was too low compared with other central banks and may provoke the yen to rise even more.
He said, "There is criticism that if the US aimed at 2% inflation over the long term but if Japan's target were 1%, this would be the same as allowing 1% appreciation in the yen every year." He thinks, that "2% is an ideal level." Kiuchi was also skeptical of BOJ Governor Masaaki Shirakawa's prediction of achieving its inflation target in 2014. Kiuchi said, "We are lacking the necessary tools to achieve further price goals." Although the two new additions to the policy board are still a minority they are likely to spark discussions with other members in the next BOJ meeting in August.
It is clear that new and old policymakers in Japan are getting weary of yen strength and are actively considering ways to diffuse it. Meanwhile Japan's trade balance narrowed to its smallest level in 9 months which should be good news for the yen but unfortunately the improvement was caused primarily by the 6.5% drop in imports and 1.4% drop in exports. In other words, internal and external demand deteriorated in June, which is ultimately bad news for Japan.
Economic data out of the Eurozone continues to surprise the downside with German business confidence falling to its lowest level in more than 2 years. Independent rating agency Egan Jones also cut their rating of Italy's sovereign debt to CCC+ from B+, which puts the country deeper into junk status. While the impact on the euro was nominal because Italy is still rated as BAA2 by Moody's and BBB+ by S&P, Egan Jones' decision reflects the growing risk of holding euros. With Spanish bond yields at a level that is unsustainable over a long period of time, unless we see a permanent decline in yields, the Eurozone sovereign debt crisis is far from over and for this reason, the EUR/USD recovery is nothing more than a relief rally.
Yet it is still important to mention that Spanish 10 year bond yields fell for the first time in 10 trading days. Given how the EUR/USD has been deeply oversold, yesterday's recovery certainly reflects some degree of short covering. Spanish and Italian stocks also rebounded after dropping more than 10% since the beginning of the month. While we believe that the ECB will eventually come to aid of the Europe, giving the ESM a banking license may not be their first option.
Earlier this month, ECB President Draghi said "I don't think there is anything to gain by asking the institution to act outside the limits of its mandate, thereby destroying its credibility" when asked about allowing the ESM to use the ECB. Nowotny admitted that he is not aware of any specific discussions about this possibility within the ECB at this point. In other words, Nowotny is only sharing his own views. Additionally, the ESM can't come into effect until the German Constitutional Court approves it, which won't be until mid September at the earliest - another reason why we believe the support the EUR/USD should be fleeting.
German consumer confidence and import prices are the only Eurozone economic releases on the calendar tomorrow. Italy will be holding a bond auction and strong demand will help the euro while weak demand will hurt it. The Spanish Finance Minister will also be testifying in Parliament on the bank bailout.
USD: Gauging U.S. Risks
Thanks to the recovery in risk appetite, safe haven flows eased out of the U.S. dollar. This morning's U.S. economic data was very disappointing but U.S. fundamentals are still not weak enough for the Federal Reserve to say yes to QE3. However if stock markets around the world resume their slide and bond yields in Europe continue to rise, external developments could force the Federal Reserve into action. If credit markets around the world seize up and Europe finds itself having to figure out how to bailout its third or fourth largest economy, the Federal Reserve may throw out a lifeline by announcing QE3.
At that point, the U.S. central bank probably won't be too heavily criticized about increasing asset purchases because the world will be desperate for help and thankful that the Federal Reserve has stepped in with support. While the central bank's main focus is the labor market, the most widespread drought in 60 years has caused food prices to soar to record levels. Rising costs for animal feed, soyameal and corn are also beginning to affect the price of beef, pork and chicken. Slow growth and high unemployment will make it difficult for producers to pass on these costs and for those who choose to do so, sales could suffer. So while QE3 could support the U.S. economy, rising food prices poses a risk to growth.
As for yesterday's housing economic report, U.S. new home sales dropped 8.4% in the month of June, which was the steepest slide since February 2011. The total number of homes sold slowed to 350k from 382k while the average price fell 1.5%. Although this report is inconsistent with the recovery in housing reported by the Beige Book, the weakness is not a major surprise considering that existing home sales also declined significantly last month, which may explain the muted reaction in the dollar. U.S. durable goods, pending home sales and jobless claims are scheduled for release tomorrow.
GBP: Recession Deepens
Weaker U.K. economic data prevented the British pound from participating in yesterday's risk rally. Although sterling held steady against the U.S. dollar, it lost value against the euro and Swiss franc. As we expected, the recession deepened in the second quarter. The U.K. economy contracted 0.7 percent in Q2, which was not only the third consecutive quarter of negative GDP growth but also the weakest performance in 3 years. While the extra holidays in June for the Queen's Diamond Jubilee helped to boost spending, it led to a sharp contraction in construction and industrial activity that can be largely blamed for the weakness.
The U.K. government doesn't seem to be particularly worried about the GDP numbers because preliminary GDP numbers can be subject to major revisions and the data could be distorted by one-off factors. Yet with this in mind, the level of growth is far from desirable and it may be time for the U.K. government to consider the IMF's suggestion to shift their focus from austerity to growth. Regardless of whether Cameron agrees that a shift is needed, the worst double dip recession in 50 years will keep the Bank of England in easing mode.
NZD: Keep Rates Steady
The Australian, New Zealand and Canadian dollars rebounded against the greenback thanks to the improvement in risk appetite. This afternoon, the Reserve Bank of New Zealand left interest rates unchanged at 2.5%. The RBNZ has held rates steady for the past year and with no major improvement or deterioration in the economy since their last meeting, the central bank did not feel that it was necessary to alter monetary policy. According to RBNZ Governor Bollard, while there is limited risk that euro conditions will worsen, the outlook for their trading partners remains poor.
The strong level of the New Zealand dollar is constraining demand growth but housing market activity has improved thanks to quake reconstruction efforts. Overall their outlook for the economy is unchanged from June and for this reason, monetary policy settings are appropriate. Meanwhile inflationary pressures in Australia increased in the second quarter with consumer prices rising 0.5%. While the increase was less than the market anticipated, it still represented a material pickup in price pressures. Recent rate cuts by the RBA may have contributed to the rise in prices but overall inflationary pressures remain tame at 1.2% and explain why the Australian dollar initially weakened on the report. Leading indicators also improved in May but this data is extremely dated. No major economic reports are scheduled for release from the commodity producing countries, which means the commodity currencies will continue to trade on risk appetite.
JPY: Improvement in Trade Deficit Masks Weakness
The Japanese yen weakened against all major currencies except the British pound which fell victim to its own problems. Japan's Finance Ministry diffused claims that its intervention on the yen last year was unsuccessful and BOJ Deputy Hirohide Yamaguchi stated in his speech and press conference last night that officials won't refrain from easing. Two new members, Takehiro Sato and Takahide Kiuchi, were appointed to the BOJ policy board yesterday and voiced dovish support for more aggressive monetary easing. Sato, who proposed to buy a wider range of assets, said, "I think one possible idea will be for the bank to buy foreign securities." He also said that the BOJ's 1% inflation target was too low compared with other central banks and may provoke the yen to rise even more.
He said, "There is criticism that if the US aimed at 2% inflation over the long term but if Japan's target were 1%, this would be the same as allowing 1% appreciation in the yen every year." He thinks, that "2% is an ideal level." Kiuchi was also skeptical of BOJ Governor Masaaki Shirakawa's prediction of achieving its inflation target in 2014. Kiuchi said, "We are lacking the necessary tools to achieve further price goals." Although the two new additions to the policy board are still a minority they are likely to spark discussions with other members in the next BOJ meeting in August.
It is clear that new and old policymakers in Japan are getting weary of yen strength and are actively considering ways to diffuse it. Meanwhile Japan's trade balance narrowed to its smallest level in 9 months which should be good news for the yen but unfortunately the improvement was caused primarily by the 6.5% drop in imports and 1.4% drop in exports. In other words, internal and external demand deteriorated in June, which is ultimately bad news for Japan.