USD still on the back foot

Mon, Jul 5 2010, 12:33 GMT
by Kenneth Broux


Market Outlook

Tactical view:

= USD still on the back foot

The Swiss franc has replaced the USD as preferred store of refuge in the G10 as the US economy clouds over and global equity benchmarks sink to the lowest levels for the year. With risk aversion stepped up and US short-term yields sinking to new historic lows, we look for the USD to stay under pressure over the coming week and the dollar index to close in on key support in the 83.19 area. The aggressive unwinding of short EUR and GBP positions is likely to slow ahead of the BoE and ECB meetings though no policy changes are anticipated. The ECB weekly refinancing operation is set to attract close scrutiny after the expiry of the one-year tender and the smooth transition to 3-month funding. We look to the RBA and Canadian jobs data for guidance on AUD and CAD, though feel defensive strategies are advised as the CRB and S&P eye pivotal support levels. 


Recap

  • A broad-based retreat in global equities and an unrelenting run of weak US macro data boosted demand for the Swiss Franc and the JPY, propelling both currencies to the top of the weekly G10 rankings. USD/CHF has now extended its slump to 10 big figures since mid-June, sliding below 1.06. GBP enjoyed a mixed week, posting gains vs the high yielding and commodity currencies, but losing ground vs the Franc, EUR and SEK. The US employment report for June the June 17 SNB meeting, and progressed to below 1.35 vs the EUR. USD/CHF slipped below 1.10.

  • UK macro data brought news of slowing housing market activity and confirmation of a rebound in business investment in Q1 (+7.8% q/q). The latest credit conditions survey from the BoE presented a sobering picture for Q3, with credit availability of secured credit to households set to decline, but to increase slightly to corporates. The manufacturing and construction PMI were steady in June, holding at 57.5 and 58.4, respectively vs May. MPC members Miles and Posen made no judgement on whether further asset purchases will be necessary and reiterated that credit developments in the euro zone pose a challenge for the UK economy. The US unemployment rate fell to 9.5% in June from 9.7% in May.

  • UK rates extended their bullish run backed by flight-from-risk and weak US macro data. 10y yields hit a 3.30% low, supporting the bullish flattening influence in 2s/10s (255bp). 5y swaps fell to a 2.41% low but ended the week at 2.48%. Trendline resistance runs at 2.55%. The 3mth Libor/Ois spread held steady at 24bp in contrast to the widening in EUR (+6bp to 33bp). The ECB switched successfully from a one-year to a 3-month tender, attracting bids of ‘only’ 132bln eur. The special 6-day fine tuning operation attracted bid of 111.2bln eur, leaving the ECB with excess liquidity of 289bln eur. Gilt sales (IL 2047) and the syndicated 2040 deal attracted very solid demand.


G10 FX - Q1 currency reserves: EUR below 30% in EM, ‘others’ gain

The IMF earlier this week published its latest quarterly update of the composition of official foreign exchange reserves (Cofer data). Concentrating on the allocated reserves at the World level, the share of the USD fell marginally to 61.55% in Q1-10 from 62.17% in Q4-09. The share of EUR edged lower to 27.2% from 27.3%. Gains were noted for GBP (4.34% vs 4.29%), the JPY (3.14% vs 3.01%) and the Swiss Franc (0.12% vs 0.11%). The biggest increase, however, was recorded for the so-called ‘others’. These include G10 currencies like the NOK, SEK CAD, AUD and NZD, which saw their share climb to 3.65% from 3.12%. In dollar terms, this is equivalent to a rise of roughly $24bln.

The picture at the World level is representative of the changes in Emerging and developing economies where most of the international reserves are currently managed. Though the share of unallocated reserves rose by approx. $50bln to $3.305trln, changes in the individual composition in emerging markets have a major influence at the global level simply because emerging markets currently hold 66% of the world’s total currency holdings. Whereas the share of EUR in Emerging economies rose in Q1 to 25.15% from 24.81% (+$13bln), the contribution of the EUR fell back below the 30% threshold to 29.5%. Though swings on this scale are hardly alarming, they are significant in the context of and back up the bearish price action in EUR crosses over Q1.

How the EU debt crisis plays out, the outcome of the EU bank stress tests, and the shift to a mindset where the USD is no longer considered an attractive safe-haven play as the economy slows (see separate note: ‘safe haven flows desert the USD’) will be instructive as to how reserves are managed during the second half of 2010. A fading of risk appetite and growing doubts over the pace of the US and euro zone economic recoveries y may thwart demand for non-G3 currencies, with GBP potentially set to increase its appeal in the wake of the fiscal policy objectives set out in the June 22 Budget. A stalling of rate hike expectations in Sweden, Norway, Canada and Australia may also temper diversification flows into the ‘other’ currencies, though this should be offset by unrelenting growth rate in Chinese exports (+48.5% y/y in May).

A further sell-off in EUR crosses in Q2 implies that EUR holdings were probably cut back further in Q2. The weak performance of the EUR and commodity and high yield currencies in Q2 (AUD, CAD, NOK) as a result of sovereign debt jitters in the euro zone and the rotation out of risk assets into government bonds implies that the USD probably saw its account in global reserves improve from the 61.5% rate at the World level and 58% in Emerging markets. The explosion in SNB currency reserves to SwF232bln between April and May implies that greater swings should transpire in the Q2 data, especially with regard of the EUR. The substitution of the USD as the safe-haven by the Swiss franc means that the allocation of the latter at the World level to 2008 highs.