I’m getting confused. Is USD a risk-on or risk-off currency? On Monday it was the best-performing G10 currency as risk-taking sentiment returned, but yesterday it was also the best-performing currency even though risk-taking sentiment declined notably.
In fact there seems to be little correlation between the dollar and risk sentiment, as gauged by the S&P 500. The correlation in changes between the two this year is -0.16%, meaning that in general, when the S&P 500 rises, the DXY index falls slightly – but very low correlation. As you can see from the scatter graph below, there’s little connection, as indicated by the R2 of 0.027, which means there’s little correlation between the two. They’ve moved in the same direction 50.8% of the time this year, which is exactly what you would expect if the correlation were random.
Furthermore, while the US economic indicators were generally better than expected on Monday, they were mixed on Tuesday. The headline durable goods orders figure fell less than expected but excluding transportation, it was much worse than expected (-0.3% vs +0.5% expected) and core capital goods orders fell instead of rising as expected. Pending home sales were a disaster (-0.5% mom vs +0.5% expected).
The big surprise though was a narrowing in the US trade deficit as exports rose sharply while import growth slowed. The deficit narrowed to -$64.8bn, whereas it had been expected to widen to -$69.0bn. The previous month was revised to -$67.3bn from the initial -$68.2bn. Perhaps under the current administration, trade is having an outsize impact on FX.
It appears that the message from last week’s Commitment of Traders report was correct: the market has capitulated and is bullish USD. That’s the only explanation I can think of for why they would buy dollars whether risk was on or off, or whether the indicators were good or bad.
Both Bank of England Gov. Carney and Bank of Canada Gov. Poloz echoed Fed Chair Powell’s recent comments highlighting the risks to the economy from trade tensions. Gov. Carney noted that, “trade tensions have intensified…the question is the extent to which these measures start to affect business confidence…it’s one of the potential triggers for a broader risk-off attitude or adjustment to risk appetite in financial markets.” Gov. Poloz stressed that the bank “cannot mechanically follow the rate path provided by our models because there is simply too much uncertainty in the world…these include the degree to which uncertainty about trade policy is holding back business investment…we expect these issues to figure prominently in our upcoming deliberations.” The message is clear: trade is no longer affecting FX just via stock markets but directly through expectations for monetary policy. The comments suggest that measures of business confidence will have more weight in monetary policy deliberations than before and will therefore be more important for FX market participants to watch.
NZD fell further after what was interpreted as a modestly dovish Reserve Bank of New Zealand meeting. While the main points and the forward guidance were basically the same, some of the details had a dovish tilt, for example when Gov. Orr said that the weak Q1 growth “implies marginally more spare capacity in the economy than we anticipated,” and that the fiscal impulse would be “also slightly lower and later than anticipated." He also referred to the trade tensions. I expect though that with the currency having been beaten up so much recently, it could be in for a modest recovery on short-covering if risk sentiment returns.
EU Summit: migration, Brexit, trade and other topics
The two-day EU Summit starts today. The summit will take up a number of difficult topics:
- The hardest one is probably migration. The question of migrants and asylum in Europe has always been a source of disagreement among the EU countries, but now it’s an even bigger crisis as German Chancellor Merkel’s coalition is starting to fall apart over the issue. There was a “mini-summit” on Sunday to prepare for today’s discussions, but that event ended in disarray as the new Italian government demanded a total rethink of the EU’s rules for dealing with migrants. If this meeting can’t come up with a position that’s acceptable to all sides in Germany, her coalition may crumble. That would probably mean new elections in Germany in a few months. The increased political uncertainty would be negative for the euro.
- As for Brexit, the EU’s view is that there’s not much new to discuss, that Britain still hasn’t put forward a viable position for the two sides’ relationship after Brexit. There probably won’t be much disagreement within the EU side about the issue, but the conclusion is likely to be negative for Britain and the pound, in my view.
- The summit will also discuss trade with the US. The EU leaders are likely to take a hard stance in opposition to the US’ talk of more tariffs, with the result of a further “risk off” mood pushing the dollar down and JPY and CHF up.
- Finally, they will discuss measures to strengthen the Eurozone’s fiscal stability, such as a common Eurozone budget to fund investment programs and provide financial support for countries facing recession; a banking union; and transforming the European Stability Mechanism(ESM) into something resembling a European Monetary Fund (EMF) to better address future crises. Don’t hold your breath waiting for these issues to be resolved however
The website “Mishtalk” gave a valuable summary of some of the mutually exclusive EU positions on migration. These include:
- Germany - Merkel's CDU: Seek a consensus solution under existing EU rules.
- Germany - Seehofer's CSU: Turn them back at the border, which effectively means sending them back to Italy through Austria.
- Italy Five Star and the League: Change the "Dublin Rules," which state migrants must apply for asylum in the first country in which they land (which is Italy for many people fleeing from Libya). Italy wants to distribute existing migrants throughout EU. It also supports "safe areas" in Africa.
- Czech Republic, Hungary, Poland and Slovakia: All refuse new migrants
- Austria: Austria's Prime Minister, Sebastian Kurz, wants quotas and "safe areas" in refugees' countries of origin. In a controversial twist, he said Brussels should organize it and "back it militarily." Austria position is particularly important as the country will take over the rotating Presidency of the European Council on 1 July. Austria's stated goals for its Presidency include the fight against illegal immigration by securing external borders.
As you can see, the main fault line is between Chancellor Merkel, who wants a solution under current EU rules, and the others, who favor various degrees of restricting migrants. It seems likely then that Merkel will lose the argument. That could endanger her position as Chancellor. Her resignation would be distinctly EUR-negative, as we saw last year when she was trying to form a coalition.
Other indicators and events
Getting back to today’s indicators, German CPI (to be specific, the HICP, or harmonized index of consumer prices) is expected to rise only modestly on a mom basis, while yoy growth is forecast to decelerate. Nonetheless the market expects tomorrow’s EU-wide CPI to accelerate somewhat (although core CPI is forecast to slow). Since 2009 the German HICP and EU-wide HICP have moved in the same direction 73% of the time, but that still leaves 27% of the time that they don’t – meaning it is possible for the former to slow and the latter to pick up. Nonetheless, I think a slowdown in German inflation would be seen as a warning for the rest of Europe and would probably be negative for the euro.
The third revision of US 2Q GDP is expected to result in the figure remaining unchanged. However, the the Quarterly Services Survey (QSS) indicated that there was less spending on services than previously assumed. That could lead to a downward revision, which would be negative for USD if indeed it does happen. But as the graph shows, the third revision of US GDP hasn’t shown much change in the last several years. Since 2015 the average of the absolute values of the revisions has been about 25 bps. Still, I imagine that a 25 bps downward revision (actually it would be 20 or 30 bps) would be enough to move USD, at least temporarily.
Bank of England Chief economist Andy Haldane will deliver the Academy of Social Sciences Annual Lecture on productivity. Haldane was third person who joined the two regular hawks in dissenting at the latest BoE Monetary Policy Committee meeting. The speech will give him an opportunity to explain his dissent. That could be positive for GBP, although with the EU Summit starting today, politics may outweigh economics for GBP. Sluggish productivity growth has been a major concern for the BoE for some time, although the Eurostat data suggests Britain’s productivity growth is no worse than Germany or France, and much better than Italy’s.
Overnight there are a number of indicators out for Japan. The most important of these is the Tokyo CPI. Inflation is expected to remain sluggish, with the headline rate of change forecast to stay at the previous month’s rate, while core CPI is forecast to perk up but by an insignificant degree. That news could be negative for JPY if indeed anyone cares any more about inflation – even the Bank of Japan seems to have given up hope that it will ever return to the 2% target.
Japan’s unemployment rate and job-offers-to-applicants ratio are both expected to remain unchanged, so I don’t see them having much effect anywhere.
Meanwhile, Japan industrial production is also coming out, but I haven’t seen any impact of that figure on the yen and so I don’t follow it.
Australia’s private sector credit is expected to rise at the same mom pace as in the month before, while the yoy rate is forecast to be almost the same. In that case, we can expect an impact on AUD only if the actual deviates notably from the forecast. AUD-neutral.
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