Dollar Bulls Require Patience during Equity Strife

The FX market is again turning its attention to global equity markets for inspiration, as investor moods darken quickly, and everyday bourses test key levels. Risk aversion is maintaining a foothold on sentiment amid concerns that the global economic outlook is worsening.

So far in today’s opening European session, equity markets have opened lower following the sharp losses seen stateside on Tuesday, and ahead of the Federal Open Market Committee (FOMC) minutes due this afternoon. The DAX is underperforming as it again trades -10% below its previous record high, mostly on the back of German corporate earnings worries, and various airline profit warnings resulting from the Ebola scare that’s rippling throughout the leisure and travel industry.

European misfortunes seem to be only getting worse, as yesterday’s weak Germany August industrial production (IP) data has been able to mirror the horrid factory orders print. So far this week, European indices are contemplating taking a good run at closing at or near their recent lows, while gold, bonds, and the JPY (¥107.89) remain better bids overall. The 10-year U.S. Treasury yield has dropped to +2.34%, Bunds to +0.90% — their lowest levels in a number of weeks — and spot gold is firmly back above the psychological $1,200 (at $1,218) as investors’ appetite for risk has again taken a huge hit.

IMF Warns on Eurozone

Yesterday, the International Monetary Fund (IMF) cut its 2014 global growth forecast from +3.4% to +3.3%, and its 2015 forecast from +4.0% to +3.8%, citing eurozone recession risks and the emerging market slowdown. The outlook for the global economy has blackened and the IMF sees a “four-in-10” chance that the eurozone will slide into its third recession since the financial crisis erupted. Despite the softer data touch of late, the IMF is maintaining its Chinese 2014 gross domestic product forecast at +7.4% (somewhat piggybacking Chinese officials’ forecast of +7.5%). It seems only natural for IMF Director Christine Lagarde to raise the U.S. 2014 forecast from +1.7% to +2.2% on the back of much stronger data being revealed.

U.S Jobs Climate Paves the Way

An example of firmer U.S. data was yesterday’s Job Openings and Labor Turnover Survey headlines. It’s one of Federal Reserve Chair Janet Yellen’s favorite gauges of labor market health in the U.S. The month of August happened to be mixed, nevertheless, the number of job openings rose +5% to the highest level in a baker’s dozen of years, while the labor market turnover slowed and the number of “quits” declined nearly 3%. The latter decline reflected a reversal of the July increase, leaving the level of quits roughly equal to its average over the first six months of the year (but still up +5%, year-over-year). Worker mobility is a close indicator of possible wage growth. Last Friday’s nonfarm payrolls report would suggest that the American economy is on firmer footing, certainly in stark contrast to some of the other major developed economies that seem to require further monetary stimulation sooner rather than later. It’s no wonder that equity markets continue to signal their disappointment with a perceived lack of urgency by both the European Central Bank (ECB), and to a lesser extent, the Bank of Japan (BoJ).

ECB and BoJ Need to Act

So far, the weapons of choice for developed economies to combat low inflation or heightened deflation are to limit domestic currency strength. The Reserve Bank of Australia, Reserve Bank of New Zealand, BoJ and ECB have all applied this tactic.

Thus far, the Antipodean central banks favor verbal intervention to adjust currency levels that are “fundamentally unjustified.” Overnight, Australian intraday volatility action was driven by the big downward revision to Aussie August job numbers that had been aggressively overstated (now +32k from +121k). The AUD initially fell to $0.8752, where outright short AUD positions have been able to provide some support. Investors will be looking to September’s jobs data out Thursday for confirmation.

The BoJ and ECB are using zero interest-rate policy (ZIRP) and negative interest-rate policy (NIRP) actions, and are actively looking to expand their balance sheets. Despite the mighty U.S. dollar’s strength having a massive FX impact since July, it’s the ECB and the BoJ, respectively, that are having the greatest impact on their own currency values as investors play on the central banks diverging interest rate outlooks. Many suspect that the ECB will be unable to get to its desired asset-backed securities and covered bond program amounts of approximately €1B for various administrative reasons. The ECB’s “whatever it takes” attitude will probably require eurozone policymakers to consider launching full-blown quantitative easing in the first half of 2015.

Abenomics Petering Out

Overnight Japan’s ruling party suggested that USD/JPY trading ¥110-120 is positive for their country’s economy and that further weakening would probably do more harm. The market believes that the BoJ needs to ease policy again to meet its +2% inflation target in 2015 or 2016. Due to the economic fallout of the initial consumption sales tax implemented last April, many analysts are suggesting that Prime Minister Shinzo Abe is required to postpone the next sales tax hike until April 2017. Proceeding as planned would ruin Abenomics, as the economic policies advocated by Abe are known.

The BoJ, as expected, kept monetary policy unchanged overnight, with its assessment on IP revised lower. Governor Haruhiko Kuroda suggested that the “virtuous cycle of economic activity continues to operate firmly, IP is weak now, but forecasts show growth. The consumer-price index is likely to hit the +2% between the periods of 2014 and 2016,” — if the goal can be met then there is no need to adjust policy anytime soon.

Weakening currencies are inclined to dampen inflation externally, even at a time when global inflation risks are now weak. Already, the Fed is signaling that U.S. inflation is running below the FOMC’s longer-term objective despite the improving U.S. labor market. If the dollar’s continued strength begins to weigh on import prices and inflation, it will probably prevent the Fed from communicating a “normalization of monetary policy.” In other words, U.S. policymakers will eventually begin to mouth off their concerns surrounding rapid USD appreciation. This is a part of any sustainable currency strength cycle.

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