Fed dovish nuances press down dollar, lift financial assets

Tom Tong15/Jul/2013Currency Updates

Markets continue to be fixated on the prospect of tighter Federal Reserve policy, as macroeconomic fundamentals take a back seat for now. Investors chose to interpret the latest Bernanke speech on Thursday of last week as relatively dovish. Thereafter, almost every financial instrument, including stocks, commodities, bonds and credit, rose strongly, and the dollar pulled back after the previous week’s rally. An ominous exception to the generalized risk asset rally last week were European peripheral bonds. Political turmoil in Spain and Portugal brought spreads to their highest point of the past few months. These developments lead us to conclude that last week’s euro rally against both sterling and the dollar point is not sustainable.

GBP

The string of positive surprises about UK growth ended last week, as construction and manufacturing data both came out modestly lower than expected. However, given the healthy rises we have seen in the PMI business sentiment indicators, it is almost certain that the British economy returned to growth in the second quarter of 2013. However, given the surprisingly dovish statement of the previous week MPC, investors remain squarely focused on monetary policy. Sterling behaved again last week as a low-beta version of the euro, dropping 0.5% against the common currency while rising a bit over 1% against the dollar. All eyes are now fixed on this week’s publication of the minutes of the MPC meeting, which will provide further information on the shifts in monetary and communication policy within the Bank of England.

EUR

The ECB provided further clarification on its decision to start issuing forward guidance on the likely path of interest rates. The goal seems to be to prevent the repricing of Federal reserve hike expectations from affecting short-term euro rates and Eonia forwards. There were few important macroeconomic releases out of the eurozone, besides a mild pull back in May industrial production after the previous month’s surge. A more important development that was largely ignored by currency markets may have been the continued upward creep in bond yields in Spain and Portugal, and to a lesser extent Italy. The possibility of early elections in Portugal were the main catalyst. The enormous unpopularity of failed austerity policies everywhere in the periphery means that a general election in any country there will probably mean, at the very least, a renegotiation of austerity terms and a political confrontation with the German-led core. We don’t think this instability is consistent with a euro above 1.30 US dollars, and therefore expect the downward trend in the common currency to resume shortly.

USD

A spate of softer-than-expected data led many strategists to revise lower their GDP growth estimates for the second quarter. Business inventories are looking soft, though this only signifies a transfer of growth from this quarter into the next. More importantly, in spite of continuing strength in job creation, the downward trend in the unemployment rate seems to have stalled, and it has not dropped for the past four months. Second-tier job market data, such as the JOLTS report, also seem to confirm this. It bears repeating that the expected “taper” in Fed purchases of bonds is strongly conditional on continued improvements in the unemployment rate. Another month without gains in this front may lead us to revise our expected date for the start of the “taper” from September to December. At any rate, Bernanke’s twice-yearly Humphrey-Hawkins testimony next week will provide badly needed clarification on this issue.

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Written by Tom Tong

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