The new troika: the rupee, Treasury yields and the dollar

Some strange market dynamics are going on today – the rupee collapsed yet again, increasing the risk of a full blown economic crisis in India, this led to risk aversion during the Asia session, which seeped into Europe as equities fell alongside Treasury yields. However, the second half of the London session has seen a change in trend: US equities have opened higher and the EUR and GBP are strengthening.

With no unifying theme it makes it extremely difficult for even the most sophisticated trader or algo to predict where markets may go next. Is traditional summer market volatility playing tricks on us? It can’t be denied that volumes are thin, added to that in the absence of other news, the financial media are jumping on the back of another EM crisis. But it’s the dollar that holds the most mystery for me. As we mentioned yesterday, USDJPY had diverged from Treasury yields. We certainly did not expect yields to trend lower and re-couple with USDJPY, we expected USDJPY to get its groove back and follow yields higher, but that was not to be. Added to that we did not expect EURUSD to break out so easily and end the European session above 1.34.

So what is limiting dollar strength?

· If the US is a growth currency, then the recent fall in equities could be the reason why the buck has come under pressure, however by that logic then the recovery in US stocks today should be USD positive. We shall have to wait and see if that pans out in the NYC session.

• Is the dollar pre-empting a decline in Treasury yields as they approach a major barrier at 3%? Since August 12th yields have risen by nearly 30 basis points, a pullback after such a sharp move higher is completely natural. Could we see yields moderate until we get more info that could determine the pace of Fed tapering?
• Don’t expect too much from the FOMC minutes, not only are they fairly dated at this stage, but even if they do provide further evidence of a tapering bias at the Fed they are unlikely to provide us with any firm dates about the timing of tapering, thus the minutes could end up weighing on Treasury yields, and thus the dollar…
• Three key risk events that could determine both the future direction of Treasury yields and the dollar include: the Jackson Hole conference this weekend, Non-Farm payrolls on 6th September and finally the famous Sep-taper FOMC meeting itself on 18th Sept.
• A left-field thought that I had earlier today: could the rise in Treasury yields and taper expectations that have weighed so heavily on emerging markets that it starts to dent broader risk sentiment causing the Fed to think twice about tapering? I have no answer for this one, but if we see a disorderly sell off in developed market equities then the Fed may delay its taper plans.

What about the rupee?

If Treasury yields are to retreat then we could see some respite for the rupee, along with Indian equity and bond markets that are also under intense pressure right now. However, in the long-term the outlook remains grim. There is also growing political risk, the longer this currency crisis lasts the more likely it is that elections scheduled for 2014 could be brought forward, potentially after this monsoon season ends. There are also some big state elections this autumn, including in the capital Delhi, which could increase political risk and make the twin fiscal and trade deficits worse if they include big election giveaways in the coming weeks and months. Thus, the worse may not be over for the rupee.

The RBNZ: not willing to risk a rate hike

While India has been slow to implement reform, the same cannot be said for New Zealand, after the RBNZ said from October 1st banks would be limited to no more than 10% of their total new house lending on mortgages exceeding 80% of the value of the property. This was designed as an attempt to avert a property bubble after some sharp gains in house prices in recent months. This is potentially being used by the RBNZ as an alternative to a rate hike, which could be damaging to the broader economy especially if we are in for a bout of global risk aversion in the coming months. The Kiwi plunged today, NZDUSD backed away from 0.8105 – the 100-day sma, but it found support below the key 0.8000 level at 0.7980. 0.7910 – the 50-day sma, is a key support zone in the next 24 hours.

The summer lull looks to have come to an end for another year, expect volatility to come back with a vengeance as the market tries to deduce if Fed tapering is on the cards for September and if the currency crisis in parts of the emerging wold turns into a full blown economic crisis.