The yen is rising anew and carry trades are being pared back as “U.S. recession” is increasingly uttered by economists, commentators and soon by central bankers. The latest blow to the dollar today is not only that of slowdown in the U.S. economy but reduced dollar holdings by oil rich Qatar, which indicated today it would shift some of its USD-denominated investments to Asia to offset the weakness in the greenback. Most significantly, the announcement did not refer to the Qatari central bank’s reserves, which stand at no more than $12 billion, but the State’s sovereign wealth fund of $50 billion. There has been much complacency by market pundits dismissing Gulf States ’ intentions to diversify their dollar reserves because of the relatively small size of their central banks’ currency reserves. Yet these nations’ SWFs hold about 10 times the amount of their central bank reserves, with the funds mandated to asset management arms of U.S. and Europe fund managers and the assets allocated across a wide array of investments.
The 10 am release of the U.S. ISM manufacturing index is expected to show a drop to 53 in August from 53.8, after 56 and 55 in June and May respectively. Given the weakening trajectory for the U.S. dollar sentiment, a figure lower than 52 would be more punishing for the U.S. currency as it further raises the already escalating odds of a September Fed funds rate cut. We should also watch the employment sub index, which fell to 50.2 in July from 51.1 in June and 51.9 in May.
Also at 10 am are construction spending seen flat in July after a 0.3% decline in June.
The August events in the currency markets dealt a severe blow to carry trades amid a sharp reduction in risk appetite affecting liquidity in a highly leveraged financial landscape. Escalating margin calls led to soaring yen moves, up as much as 6% versus the dollar, 10% versus the euro, 9% versus the pound and as much as 17% versus the Kiwi. Despite such sharp unwinding of carry excess, we are unlikely to have seen the end of the unwinding of trades that have accumulated over the past see ½ years.
Last week, yen positions against the U.S. dollar showed the second net long positions amid speculators since June 2006. USD/JPY has yet to retrace more than 38% of the fall from the June high of 124 to the 1-year low of 111.68. Not only the yen carry trade is unlikely to go into full recovery against the U.S. dollar, but we also see room for further selling in USD/JPY. Ongoing uncertainty in credit markets and the onset for further losses in U.S. equities set the stage for further pullback in USD/JPY especially as the Fed is forced into easing by 50 bps this year. While this may sound counterintuitive, the Fed's inauguration of easing cycles has proven to increase equity market volatility, rather than reduce it. This would be especially the case for the current central bank whose staunch anti-inflation stance heightens the urgency of the situation once rates have eased. Selling USD/JPY on the highs will gradually replace the remaining carry trades in the market as long as the short-term charts continue to exhibit lower highs. A September Fed cut can potentially drive up USD/JPY towards the 118 figure, but the ensuing volatility is expected to prevent a break of 119.50. The market has yet to retest the 200 day MA of 113 before end of the quarter.
Aside from the market arguments for further yen strength, there are also economic arguments for further housing-led slowdown in the United States. Unlike in the market crisis of 1998 when the U.S. economy grew 4.7% and 6.2% in Q3 and Q4 respectively, today's U.S. economy is growing at a sub-par pace of 3.0% with housing and manufacturing recessions threatening to disrupt an increasingly fragile consumer fabric especially with oil prices and gasoline prices 320% and 200% greater than in 1998 respectively . Even the much praised tightness in the labor market is now waning. Beside the fact that non-farm payrolls have fallen below their 3-month average for the last 2 months and that manufacturing, services, construction and retail payrolls have all worsened over the past 3 months, the unemployment rate is also creeping higher. Moving from 4.4% to 4.5% and 4.6% in May, June and July respectively, the trend is firmly in line with the past Fed cuts occurring after a 0.2 increase in the jobless rate. The exception to that rule took place during the inter-meeting rate cuts of fall 1998 when the argument was mainly liquidity than economy.
The other major threat to the U.S. economy is that from falling stocks on personal expenditure. We already saw a decline in personal consumption expenditure in Q2 to 1.3% from 3.7% in Q4, the lowest since Q4 2005. When stocks fell more than 7% in Q2 2006, PCE growth slowed to 2.4%, a 45% decline. Today, with stocks down 7% in the first half of the quarter alone, the probability of PCE growth to come in flat are significant, and so are chances of a flat Q3 GDP.
With chances of a funds rate cut next month standing above 80%, a decision to leave the funds rate unchanged is likely to trigger renewed market sell-off thereby, forcing the Fed's hand. More importantly, deteriorating macroeconomic evidence is likely to be the more compelling argument for two rate cuts this year, which has been our call throughout this year.
Once U.S. macroeconomic concerns (weaker growth) take over from market concerns (market contagion), dollar weakness will likely become broader in nature as the Fed reduces the dollar's interest rate differential by cutting rates while the ECB, BoE and BoC maintain rates unchanged rather than raise interest rates.
USD/JPY eyes 115
Falling global equities on economic weakness from the credit market woes are boosting the yen across the board, and dragging USD/JPY under the 115.50. We expect further weakness to reach interim support at 115, followed by 114.70. 114.00 remains a viable target later this week as the flurry of U.S. data is increasingly viewed from the angle of a possible U.S. recession. Upside capped at 115.80 and 116.25.
EUR/USD targets 1.3550 on falling risk appetite
EUR/USD to fall below the 100 day MA of 1.3575 amid a combination of falling risk appetite and weak Euro zone data on PMI manufacturing. Monday’s release of the August purchasing managers index for the Euro zone’s manufacturing fell to a 19-month low of 54.3 from 54.9 in July versus expectations of an unchanged figure.
A deteriorating picture in U.S. stocks, especially on the heels of weakness in today’s U.S. auto sales reports may is seen extending losses towards 1.3530. Key support stands at 1.35. Upside seen limited at 1.3620, while an ISM figure below 50 may boost the euro to as high as 1.3670.
Cable vulnerable to 2.0080, but weak ISM may support
Cable’s weakening foundation amid renewed equity volatility is seen calling up the 2.01 support, a break of which to extend towards 2.0080. At this point, a weak ISM figure to act as the main element behind any notable sterling strength, with 2.0165-70 pressure point seen playing out.
Ashraf Laidi
Chief FX Analyst
CMC Markets US
140 Broadway, 30th Floor
New York, NY
(212) 644-4220
a.laidi@cmcmarkets.com
