The narrowing in the U.S. trade deficit to $58.5 billion, from a revised $62.39 billion (initial at $63.89 billion), stemmed from a 0.2% increase in exports and a 1.9% decline in imports. The increase in energy partially resulted from a rising unit oil price failed to prop the overall import bill, thus a reflection of the fact that the U.S. importing prowess is finally being affected by the overall slowdown in economic growth. The report is a net positive for second quarter gross domestic product (GDP) growth and should primarily boost USD/JPY towards the 121.80s, especially in the event that U.S. stocks obtain a respite from a stabilizing U.S. trade deficit.
We saw the dollar rallying amid a more aggressive unwinding in carry trades resulting from the widespread sell-off in global equities. While the current market developments bear resemblance to that of the late February sell-off, the major exception remains that of USD/JPY, where the pair is now moving higher and that is partly due to lower than expected jobless claims yesterday and ahead of an expected improvement in the U.S. trade deficit. The notion of stronger-than-expected U.S. data weighing on U.S. equities, based on reduced expectations of Fed easing, remains the underpinning factor, while rising bond yields are boosting the U.S. currency.
Rising bond yields are the result of a normalizing U.S. yield curve10-year yields breach above two-year yields, a development typical of surging volatility and/or gloomy economic data. The lack of weak economic data is replaced by rapid selling in equities. We mentioned earlier this week that a prolonged sell-off in U.S. equities on the back of deteriorating U.S. data would boost hopes of a Fed easing and hurt the dollar at a time when European, Asian and Canadian central banks pursue restrictive monetary policies. But if U.S. economic data, excluding housing, become positive, a prolonged rally in bond yields, as in recent days, should place a drag on U.S. equities, in that case a broader sell-off would add equities to housing and gasoline as the third bearish threat to the wealth effect and threaten an already uncertain retail environment.
The chart below shows the positive correlation between the rise in the VIX (volatility index) and the steepness of the yield curve, measured by the 10-year/two-year yield spread. While much ink is being spilled over the rise in 10-year yields past the 5.0% level, this development is part of the normalization in the yield curve, which reflects further weakness stemming from market erosion or weak economic fundamentals. The first circle shows the reaction in the VIX and yield curve during the February-March market sell-off. The VIX doubled to 20 in a matter of days, while the spread between the 10- and two-year yields shot up from -0.4 to -0.02. Ever since, the spread has remained mostly above 0% (black horizontal line). The latest episode of market volatility (second circle) is once again underlined by rising volatility and a positive yield spread. Further declines seen ahead as early as next week, with the FX spillover likely developing in AUD/USD, GBP/USD and NZD/USD, while USD/JPY seen falling below 120.60 in the event the U.S. trade balance comes out higher than $66 billion.
Sterling pounded by its high yielding status Sterling shrugged the 0.3% rise in April industrial production as the currency remains victim to its own high-yield status from the ensuing retreat in carry trades. The pair has dropped well below our projected support of 1.9810, now at a two-month low of 1.9620. We do not see this morning’s U.S. trade figures to give a reason for a sterling rebound past the 1.97 figure, unless the report shows a drastic widening in the trade gap past the $65 or $66 billion level.
Breaking the key support of 1.9650, nest support stands at 1.9605, followed by 1.9580. Selling would especially ensue in the event of protracted declines in US equities. A breach below the 1480 level in the S&P 500 would be a breach of a key 388% retracement support, which would give way to further damage. Resistance stands at 1.9670, followed by 1.97.
USD/JPY defies carry unwinding due to weak Japanese data Weak Japanese data is the reason why USD/JPY continues to defy the partial unwinding in carry trades, providing support for the pair. Although Japan's core machinery orders rose for the first time in three months in April, the 2.2% increase was less than the expected 4.4% rise, raising fresh concerns about the strength of capital expenditures sustaining overall growth.
We expect the pair to sustain bullishness towards the 121.70s as long as the US trade deficit remains below $64 billion. Support stands at 121.30, followed by 120.60. Upside capped at 121.60, with key resistance at 121.85 potential broken if the trade figures drops below $63 billion.
Euro may get a boost from stabilizing stocks We cautioned yesterday that EUR/USD was vulnerable to 1.3430. Indeed, the pair dropped from 1.3520 to 1.3420. A disappointing 2.3% decline in Germany is adding to the euro’s woes as markets were expecting a 0.6% increase. The ongoing sell-off in the euro results from a combination of reduced risk appetite eroding the underlining euro longs and the improved U.S. data picture on the jobs front – as seen in yesterday’s jobless claims. And with the ECB interest rates expected unchanged for at least another two months, this is adding to the overall euro downside pressure.
Nonetheless, today’s better than expected U.S. trade gap may actually give the euro an indirect boost via stabilizing U.S. stock markets. EUR/USD support starts at the 100-day moving average of 1.3320, a break of which could test 1.3290. Resistance stands at 1.34, followed by 1.3430.
Aussie’s head and shoulder remains intact Failing to break above the right shoulder of 0.8440, AUD/USD resumed its bearishness dropping to 0.8375 in overnight Asian trade and may fall to further selling in the event of data upside in the US and/or resumed equity declines. Interim support stands at 0.8380, backed by the full target of 0.8360. Upside capped at 0.8450.
Ashraf Laidi Chief FX Analyst CMC Markets US 140 Broadway, 30th Floor New York, NY 10005 (212) 644-4220a.laidi@cmcmarkets.com
