EUR Strangled By Options And Yield

Today is starting off rather anticlimactic, especially after last week’s fundamental events, where market participants spent weeks building up and buying into various scenarios depending on what the European Central Bank (ECB) was to bring forth and on the strength of the U.S. jobs market. ECB President Mario Draghi and company ended up deciding to throw their whole tool bag at the eurozone’s deflation concerns and growth problems – a tad more ‘dovish’ than what had been expected. While in the U.S., they happened to cap off one of the best four-month stretches for job creations in 18 years (May’s nonfarm payrolls was +217k as expected), certainly supporting stocks, but not necessarily the big dollar, thereby confounding some positions taken. Typically, upbeat spells in most economies are usually associated with a weaker domestic currency.

Where to from here? The Group of 10-currency war argument remains intact. In Europe, the aftermath of the ECB meeting continues to support sentiment – equities higher, while some periphery bond spreads tighten to bunds. The ECB cut its main interest rates, put deposit rates into negative territory and outlined a number of further measures, including a fresh series of cheaper loans to banks. These decisions and initiatives should help stabilize the region’s inflation and reduce the risk of deflation. However, the economic recovery will continue to be gradual. The supposed proposals are not a “magic bullet” to weaken the EUR immediately. This would be done far quicker and more aggressively if the ECB decided on direct intervention. So far, the EUR aftermath response has confounded many.

Periphery Spreads Tighten

So why is the EUR not suffering? The ECB measures taken last Thursday are very supportive for European financial assets like equities and peripheral bonds (Spanish 10-year government yield at +2.60% and below its U.S. equivalent for first time in four years). Draghi’s actions are stimulating further portfolio investments into the euro-region, and it’s this that would obviously bid up the EUR itself. Friday morning’s nonfarm payrolls (NFP) number was always going to be a coin toss outcome. Any negative surprises (sub +200k print) and the EUR would have garnered immediate support. A strong headline print (along the line of last month’s +288k – actual +217k) would keep the Federal Reserve on track and aid the ECB’s best intentions. However, anything in the middle and the market would find it difficult justifying full engagement.

For now, with eurozone peripheral spreads tightening and equities in the black, it somewhat continues to underpin the EUR. However, with U.S. payrolls running at a healthy clip and the end of quantitative easing probably just months away, it should create risks to U.S. short-term yields to the upside. This will eventually underpin the USD and support the EUR to become a more popular “funding” currency. Nevertheless, positional timing is critical with a large percentage of the market more comfortable selling EUR’s on rally’s up to €1.3750. But, will they get their chance? There are yards of EUR/USD expiries in the vicinity this week (€1.3550, $3.8B; €1.3600, $8.8B; €1.3650, $3B; and €1.3700, $3.7B) that should keep this market under-foot and frustrated. Mind you, the month-long World Cup will again be weighing on capital markets volume and volatility.

Europe and the U.S. cannot hog all the limelight. Chinese trade data released over the weekend painted a mixed picture despite the impressive five-year surplus beat on the headline. Exports were particularly impressive with a +7%, year-over-year rise – shipments to the European Union were up +13% and those to the U.S. up +6%. However, the imports component surprisingly contracted, shrinking by -1.6% against a +6% expected rise. The commodities component fell, mostly due in part to the recent crackdown by Chinese regulators on the use of commodities as collateral to finance deals.

In Japan, first-quarter final gross domestic product (GDP) was revised higher despite expectations of lower than initially reported growth. Their quarter-over-quarter final GDP stood at +1.6% versus +1.5% preliminary, and annualized, it was up +6.7% versus +5.9% preliminary. Japan’s corporate CAPEX (capital expenditure for future benefit) component revision stood out with a whopping +7.6% rise versus +4.6% estimated. USD/JPY hit a high of ¥102.64 on the release before retreating to current levels. Bank of Japan (BoJ) Governor Haruhiko Kuroda indicated that while the bank’s stimulus policies have achieved the goal of boosting the real economy and ending deflation, the official +2% inflation target may take more than the initially projected two-year timeframe to be reached sustainably.

Investors’ Carry Appetite Improves

Both forex volume and volatility have taken a massive hit since the onslaught of low interest rate policies by Group of Seven central banks. What the forex market needs, and has been looking for, is a divergence in central bank monetary policy. Are capital markets finally on the route to getting their wishes granted? In translation, the ECB’s policy action last week means that over the next 12-18 months there will be some divergent monetary policy between the eurozone, the U.S., and the U.K. However, this knock-on effect from the ECB’s perspective will take time. With the hunt for “carry” now in full swing, KRW and TRY are the emerging market’s outperformers, while the AUD looks to be the contender for the G-10 title.

For the remainder of this week, investors will be watching China’s May economic data including consumer and producer prices, industrial production, and retail sales to see if the economy is picking up. Stronger data usually aids the Australasian currencies (NZD and AUD in particular). The BoJ and the Reserve Bank of New Zealand will announce their respective monetary policies this week. The latest jobs reports from Down Under will be monitored closely as well. AUD is now being touted to reach parity by year’s end, supported mainly on the yield carry front.

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