Q3 GDP No Barrier to QEII

Q3 US GDP rose 2%, in line with the expectations which had drifted slightly higher in recent weeks. Consumption contributed 1.8 percentage points to growth and auto output added 0.4 percentage points to growth. Inventories added 1.4 percentage points, while net exports subtracted 2 percentage points. Business spending on equipment and software remained strong rising 12%, but that is half the pace seen in Q2. Residential construction spending fell at a 29% annualized pace after rising at nearly a 26% pace in Q2. The core PCE deflator rose 0.8% after a 1% increase in Q2.

Another Piece of the Yen Puzzle

Investors and policy makers are befuddled by the yen. Its strength continues to defy the traditional explanatory models that typically give a privileged position for the risk appetite, interest rate differentials, or external positions.

Earlier in October, the BOJ announced that it would purchase JPY5 trillion (~$61 bln) of various assets, including corporate bonds, exchange traded funds, real estate investment trusts and government paper. On October 28, it provided a bit more detail and indicated it would lower the minimum rating of the corporate bonds it may buy to BBB. Proportionate to the size of its economy, this would be roughly equivalent to the Federal Reserve buying around $250 bln of securities.

Take Aways

The US dollar has recouped a good part of yesterday’s losses as the choppy range trading that has characterized recent trading continues. Despite a string of poor economic data, pointing to stronger deflation forces and weaker output in Japan, the yen is the strongest currency, posting across the board gains.

German retail sales were very disappointing, falling 2.3% in Sept (vs consensus forecast of +0.5%) and the Aug series was revised to -0.4% from -0.2%, but the euro’s retreat was well underway by then. Nearby support is seen near $1.3780, but the lower end of the recent range comes in nearer $1.3700.

More Thoughts about US Q3 GDP

The next string of US real sector reports are likely to solidify evidence that the economy is gradually recovering.

Tomorrow should kick of the string with the first look at Q3 GDP, but the string of data is likely to include auto sales in September, which appears to possibly be the strongest since the cash-for-clunker program ended last summer and next week should finish with the first rise (modest) in headline non-farm payrolls since May.

EU Summit: Two Big Issues

The EU is holding a two day summit. There are two issues that are of interest to the foreign exchange market.

First, the German-France condominium reached an agreement about tightening up the deficit rule and the stick that would be used. The absence of automaticity has been criticized. It will be recalled that in 2003 France and Germany had breached the deficit rules for three consecutive years, but managed to block the imposition of sanctions.

Dollar in Yesterday's Range

The US dollar is weaker across the board today, but largely confined to yesterday’s trading ranges. Short-term participants are getting chopped up while long-term investors seem to have adjusted their positions and awaiting the passing of the significant event risk next week. Japan’s poor Sept retail sales (-3% vs consensus of -0.5%), nor the BOJ’s downgrade of its growth forecasts nor bringing forward the next meeting to next week from mid-Nov able to stop the yen from rising today.

Indonesia's Samurai May be Attractive Alternative to JGB

Indonesia is planning to issue a 10-year samurai bond next month and for fund managers who for benchmark purposes need exposure, this issue may be an attractive alternative to Japanese government bonds.

First, Indonesia's credit rating by S&P is BB. Our analysis suggests Indonesia is a good candidate for a ratings upgrade over the next 3-6 months. We suspect it is on its way to investment grade status.

Euro-Dollar Update

My piece from last Friday suggested medium term investors begin cutting short dollar exposure. We identified three factors that should be tracked (moving averages, risk-reversal, and interest rate differentials).

1. The 5-day moving average of the euro is still poised to fall below the 20-day in the coming days. Sterling's moving averages turned late last week and the Swiss franc's turned at the start of this week. The Australian dollar's averages and the Dollar Index (DXY) averages are also about to cross. The cascading effect where all the moving averages in different sequence is not unusual as is consistent with our understanding of bottoms and tops being processes, they are carved out rather than precise moment. Other technical indictors (e.g. trend line violations, chart patterns, momentum) also warn of heightened risk of a dollar recovery after its recent slide.

FX Drivers

The US dollar is retaining its new found firm tone. Position adjusting ahead of next week’s key events continues to dominate, encouraged by the loss of the dollar’s downside momentum.

Softer Australian CPI (2.8% in Q3 from 3.1% in Q2 sent the Australian dollar down the most today, about 1.2% as rate hike ideas pulled back (scratched) or pushed out (into the future). The Wall Street Journal story today about a more restrained QEII and the greater take down at the ECB’s 3-month refi operations (42.47 bln euros allotted vs expected of nearer 34 bln) helped support the firmer dollar tone. Rising US yields and position-adjusting mode has seen the dollar rise to its best level against the yen since Oct 13, but offers near JPY82 seem formidable. Initial support now is seen near JPY81.20-40. The dollar is broadly higher against emerging market currencies today as well.

Euro Taking Another Leg Down

Into the European close, the euro has broken down further. A break below $1.3835 warns of the increased risk of a return to last week's low near $1.3700. The unwinding of long euro cross positions, especially against sterling seems to be a contributing factor. Yet, given the euro's strong gains against Swedish krona, Swiss francs some eastern and central European currencies, there is more than cross rate developments at work. The inability of the euro to maintain its move above $1.40 yesterday has soured the mood among dollar bears.

In a post last week, I noted that the 5- and 20-day moving averages for sterling crossed in a dollar positive direction and the Swiss franc's average were about to. They crossed yesterday. The euro's averages have not crossed, but they could in the coming days. Momentum traders and model traders are likely being forced to the sidelines. The euro has not closed once below its 20-day moving average since Sept 10. That average comes in near $1.3875 today.

Observations about the Yen Conundrum

The yen appears to simply trend higher regardless of the extension of the BOJ's QE and what happens in other markets. Neither the rising equity markets (risk-on) nor the widening on interest rate differentials (10-year) has been able to deter yen buying. The market appears to have turned cautious about pushing the dollar below JPY80. The G20 statement is understood not to necessarily stand in the way of further BOJ intervention under the principle of avoiding excessive fluctuations.

We continue to be struck by the strength of Japanese portfolio capital outflows during this fiscal year. Unlike Americans, who when investing offshore prefer equities, Japanese investors prefer fixed income. Using weekly MOF data, during the current fiscal year, Japanese investors have bought about JPY20 trillion of foreign bonds (~$245 bln) and about JPY1.2 trillion (~$15 bln) of foreign equities. At the same point in the last fiscal year, Japanese investors bought about JPY5.25 trillion of foreign bonds and about JPY1.06 trillion of foreign stocks.

Dollar Firm, but the Pound is Sterling

The US dollar is still consolidating/correcting its recent decline against most of the major currencies today. The notable exception is the British pound, where a considerably stronger than expected initial estimate of Q3 GDP (0.8% quarter-over-quarter vs 0.4% consensus) and an upgrade in its sovereign rating to stable from negative has bolstered the currency. The data would seem to undermine the prospects a new round of asset purchases this year.

After underperforming in recent weeks, sterling began playing a bit of catch-up yesterday is firmer across the board today. The euro found support ahead of $1.39 in early Asia, but after being turned back from the foray above $1.40 yesterday, continued range trading is the most likely scenario. Stops are thought to be below $1.3880 now.

Q3 US GDP Oct 29

The US reports Q3 GDP at the end of the week. Expectations appear to have crept up and now stand around 2%. This is after a disappointing 1.7% annualized growth in Q2.

Part of the improvement is expected to come from consumption, which is expected to tick up to 2.4% from 2.2%. This would be the strongest since before the crisis began. In the 2003-2006 period, consumption rose between 2-4% per quarter at an annualized rate. Given the high levels of unemployment and job insecurity and weak wage growth, the Q3 rise would be impressive.

Dollar Slumps Post G20

The US dollar is broadly weaker in the wake of the G20 statement that appeared to encourage flowing in emerging markets and risk assets in general. Leading the move is the Australian dollar and Swedish krona. The larger than expected rise in Q3 PPI (1.3% vs 0.5% consensus) and hawkish comments from RBA Governor Stevens, coupled with anticipation of M&A-related flows (Singapore SGX to buy Australia’s ASX for A$8.4 bln) helped lift the Australian dollar to near parity (~$0.9973).

Expectations that Sweden’s Riksbank will follow through with it recent hawkish signals and raise rate later this week has underpinned the krona. The euro is trying to establish a foothold above $1.40. Although it traded around there for the better part fo the past three weeks, only in one session (Oct 14) has it managed to finish the NY session above there.

Euro Dollar Outlook

Executive Summary: We suspect the dollar’s decline against the euro is reaching its final stages. US interest rates appear to have largely priced in some form of quantitative easing by the Federal Reserve (though headline risk remains in terms of the actual decision) and European rates have risen to a price in the risk of an ECB rate hike in Q1 11. Medium-term investors may want to consider reducing short dollar exposures. However, prudence suggests waiting for interest rate differentials to turn before taking on new long dollar exposure.

The ECB Trumps the Fed

The main accelerant fueling the dollar’s descent has been the anticipation of new long-term asset purchases by the Federal Reserve. Although investors are fairly certain that the Fed will announce this at the end of the next FOMC meeting (the day after the November 2 elections) there is much less certainty about the details. Nevertheless, given the decline in US yields -- the market appears to have gone a long way toward discounting some action.

Current Account Targets

US Treasury Secretary Geithner has proposing that G20 members restrain large current account imbalances. Over the last quarter of a century such ideas were mostly aimed against the US, however, like the currency war language, the US has coopted the issue and has managed to turn it around.

He is also turning on its head the traditional burden that is placed on the deficit countries not the surplus countries to bear the adjustment process. Geithner appears to want to limit current account imbalances to 4% of GDP.

Take Aways from This Week

The US dollar continues to trade choppily against the major foreign currencies as corrective pressures encounter the underlying bearish sentiment. The unexpected rise in the German IFO (107.6 vs consensus 106.5 and 106.8 in Sept) and talk of sovereign interest helped the euro recover after nearing $1.3850.

Sterling retested the week’s low near $1.5650, as both the UK Prime Minister and the Chancellor of the Exchequer have encouraged the Bank of England to ease monetary policy (QEII) if the recovery falters. It too recovered as the European session progressed. The yen is the only major currency that has gained on the dollar this week (~+0.34%) , but it remains confined to narrow trading ranges. It seems no matter what the dollar does against the other major currencies, it is bouncing along its trough against the yen.

Another Twist on Reserve Diversification

We have identified the interest rate differential theme as the major driver in the foreign exchange market. Another theme has also impacted the foreign exchange market is the diversification of new reserve accumulation. The focus here is primarily Asia. A number of central bank Asia are believed have intervened in the recent period. They buy dollars and sell their own currency. Some of the dollars are used to buy Treasuries and Agencies. This is evident in the Fed's custody holdings for foreign central banks, which rose nearly as much in Q3 ($132 bln) as in Q1 and Q2 put together. Already in the first half of October, custody holdings have risen about $38 bln. Some of the dollars are sold for other currencies and this helps keep the general allocation largely stable. New custody holding data will be released later today.

Strong Dollar Policy in Time for G20

The US dollar is mixed today and the real feature is the euro’s strength. Asian central bank reserve diversification and model-driven leveraged accounts appeared to help drive the euro higher. News that US Treasury Secretary Geithner suggested that the major currencies were in rough alignment sparked a short lived dollar bounce, with the greenback rising toward JPY81.85 and the euro slumping below $1.3900. Participants sold into that dollar bounce aggressively.

Sterling continues to be a laggard. Dollar weakness has concealed sterling’s soft underbelly. Speculation that the BOE is not far from its own version of QEII and the rise in European core interest rates has pushed sterling to six month lows against the euro. Ideas that the G20 can hammer out the basis for a truce in the so-called currency wars kept Asian regional currencies mostly bid.

Yuan in the Hong Kong: The Logic

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One of the surprises of the year has been the increased internationalization of the yuan, even though the capital account has not been liberated and the currency remains tightly managed.

We were skeptical of the significance of the yuan swap lines with other countries, primarily emerging markets. However,, more impressive has been the growth of a yuan market in Hong Kong. It is a bit confusing in the sense that Hong Kong is a part of China (special administrative region) and of course HK has its own currency (pegged to the dollar). However, the HK financial market is regarded by investors, and treated by Chinese officials, as offshore.

ForexTV: Dollar and Quantitative Easing in Japan

China Reducing Rare Earth Exports to US?

US-China trade tensions have intensified in recent days. At the end of last week, the US began an investigation into whether China is violating international trade rules by subsidizing its clean energy industries. This also involved whether its rare earth export quotas since 2005, with already high export taxes, are illegal.

The NY Times reports that in response, not only has Chinese officials taken to the media to criticize the US stance, but more important, appear to have blocked shipments of rare earth elements to the US and Europe. Although reports suggest there have been some delays in recent weeks, developments this week are more ominous. Industry officials quoted in the NYT report characterized it as a widening of the embargo first aimed at Japan.

Keeping the Eyes on the Prize

The US dollar is trading heavier today as Asia and Europe sold into the strong gains scored in North America yesterday following yesterday’s surprise Chinese rate hike. Of the majors, the euro and Australian dollar are leading the move, but given the magnitude of yesterday’s losses, these gains today are modest.

The dollar’s pullback after Asia initially managed to marginally extend yesterday’s gains, but has left short-term technical indicators over-extended. The price action in recent days has been exceptionally choppy and the underlying direction is not as clear as it had been in recent weeks. Today’s North American session could be pivotal. If North American participants take advantage of the foreign currency bounce to cut stale positions, it would point to a deeper correction of the dollar’s precipitous decline.

China Surprises with Hike

China has surprised the market with a 25 bp hike in the key 1-year deposit and lending rates. With the hike the deposit rate now stands at 2.5%. This is still below the inflation rate, which in Aug was 3.5%. This leave monetary policy very stimulative, even if not as much as previously. The lending rate now stands at 5.56%.

Choppy Correction Unfolding in FX

The US dollar is mixed in choppy turnover. The dollar initially saw late yesterday’s Geithner’s anti-devaluation talk inspired gains reverse in early Asia and the euro briefly pushed through the $1.40 level and sterling approached $1.5950.

However, Asian accounts sold into the foreign currency bounce. The better-than-rumored German ZEW survey saw the euro and Swiss franc turn better bid for a little. Sterling is the notable laggard today, especially after the weaker than expected CBI Trends Survey and ahead of BOE King’s speech and tomorrow’s the government’s spending review and MPC minutes (where there has been some speculation of a three-way split). The dollar is largely sidelined against the yen and has continued to remains largely within last Thursday’s JPY80.90-JPY81.85 range. The Bank of Canada meets today but is nearly universally expected to stand pat.

A Look at a Half Full Glass

Anticipation of QEII in the US remains among the most potent forces in the capital markets. Bernanke's pre-weekend speech and two dovish speeches since--Evans and Rosengren (both voting members of the FOMC).

The case the Fed has built for the public is based on inflation being too low and clearly officials are concerned about the contraction in bank credit too.

Us Industrial Production Disappoints

The US industrial production fell 0.2% in Sept. The market consensus was for a gain of the same magnitude. This is the first decline since June 2009. Manufacturing output fell 0.2%, utility output fell 1.9%, and mining rose 0.7%. The decline in utility output appears largely weather related and fell 1.4% in August. The auto industry stabilized (+0.5%) after the 6.3% drop in August and this volatility is seen related to the investor adjustment of earlier this summer. The output of consumer goods fell 0.4% and durable good goods output fell 0.9%.

Overall industrial output rose 0.5% Q3 after a 1.4% gain in Q2 and a 1.7% rise in Q1 (cumulative sum of monthly figures).

The data has seen the dollar continue to pare gains scored in Asia earlier today. US debt market is also recouping some of its pre-weekend losses.

Dollar Bounce, but Not Real Thing

The US dollar is broadly higher as the correction seen before the weekend was extended through the Asian session. In Europe, the greenback’s gains have been pared, but it remains above last Friday’s high against the major currencies. The exception is the yen, against which the dollar has been confined to roughly JPY81.00-JPY81.50.

The dollar’s bounce looks to be more a function of market positioning and a bout of profit-taking more than a fundamental-driven development. While we anticipate the dollar making low in the first half of Q4, as the Fed’s QE and the normalization of euro zone money market conditions are discounted, this dollar bounce is not being confirmed by interest rate developments and we are suspicious of its sustainability.

Data View

The US reported a slew of data and although there are some interesting nuggets, the data is unlikely to alter views on the state of the economy or the likelihood of QEII.

CPI was uninspiring, though the core rate slipped to 0.8%, which is the lowest level in nearly 50 years. Of note, the owners equivalent rent was unchanged for the second consecutive month. Apparel prices were unusually weak and medical prices were unusually strong.

The Broken Cash Register

Opinion seems nearly universal that what we are currently experiencing is not the typical business cycle with which we are familiar. Besides being the end of a long speculative bubble and the magnitudes involved, the significance of what is happening is difficult to fathom. To the extent that some have thought about the bigger picture, the discussion has tended to focus on things like the decline of America, Anglo-American capitalism, and the rise of China and emerging markets.

The tensions that are emphasized in such conceptualization have certain apocalyptic appeal, but really shed little light on the current challenges. However, it does seem as if the financial crisis has ended a historical period, leaving great anxiety and uncertainty over what is next. This short essay attempts to sketch out a different big picture view.

Waiting for Big Ben

The US dollar remains soft, but within yesterday’s trading ranges, as the market awaits Federal Reserve Chairman Bernanke’s speech early in the North American session (8:15 EST/12:15 GMT) on “Monetary Policy Objectives and Tools in Low Inflation Environment”. The market is hoping to glean more insight into the likely Fed actions.

Headline risk also stems from US economic data today with a string of reports and the possibility that the US Treasury releases its report on the currency market, which is due today, though is often late. The over-extended nature of the dollar’s decline, extreme sentiment readings, and the crowded nature of the trade in general, makes short-term participants reluctant to chase the market. However, but the negativity related to perceptions that rather than leading the recovery from the crisis, the US may now be lagging has not dissipated, encouraging selling into modest dollar bounces.

More Thoughts on China's Reserve

Yesterday China reported its reserves figures. In my note I mis-represented the increase in reserves. Chinese figures show the reserves jumped a massive $194 bln. This a huge number.

The trade surplus is Q3 was about $65 bln. Can the rest be hot money, direct investment flows being neutralized, and extra efforts to restrain the CNY's rise? One of the critical points we make when look at reserve figures is that there is a valuation component that is often significant but just as often overlooked by analysts as well as the media. China is one of the few countries that is highly secretive about their reserve allocation. However, an official let slip, perhaps in an effort to play down the significance of the jump in reserves, that $80 bln was due to the euro's appreciation.

Data Leaves Dollar Vulnerable

US headline PPI came in somewhat higher than expected at 0.4%. Weekly initial jobless claims were a bit stronger than expected and the US trade deficit was wider than expected. The trade balance, adjusted for inflation, is used to calculate GDP and there was a sharp widening of this deficit measure, which warns that, if anything, economists may have to revise Q3 GDP forecast down. The real deficit widened to $51.2 bln from $47.3 bln and an average of $47.9 bln in Q2. The wider trade deficit is not due to the stalling of exports. US exports hit a 2-year high. This includes the $1.7 bln slump in US commercial aircraft exports. Core PPI was tame with a 0.1% increase and is unlikely to stand in the way of new round of asset purchases.

The dollar remains vulnerable, but is over-extended after the overnight slide and players are more inclined to sell a bounce than chase it now.

Dollar Punished

The US dollar is getting punished; suffering steep broad based losses today. The spark that has driven the euro and sterling through their recent caps near $1.40 and $1.60 respectively, the Australian dollar, Swiss franc and Japanese yen to new highs and the Canadian dollar through parity, appears to have been initially triggered by unexpected tightening by the Monetary Authority of Singapore, which is achieved through the currency appreciation against an undisclosed basket.

With the US Treasury report on currency market manipulation expected tomorrow, and pressure mounting ahead of the G20 meeting next month, there is speculation that quicker Asian currency appreciation may be at hand. This hit the already fragile dollar. The beleaguered buck remains vulnerable to headline risk in North America if the PPI is lower than expected and/or the trade deficit larger than expected.

China Update

There are four developments in China to note today.

First, China reported that its reserves jumped to $2.65 trillion from $2.45 trillion in June. The $200 bln increase is more than the $7.1 bln in Q2 and the $48 bln in Q1 put together. The reserve growth poses a management problem for Chinese officials and an absorption problem for rest of the world. China's portfolio (and direct investment) flows can overwhelm developing and developed markets (see concern from Japan on Chinese bill purchases in the May-July period).

Contrasts Weigh on Dollar

The US dollar is mostly lower as shorts get re-established after yesterday’s squeeze. The contrast between The ECB’s continued commitment to an exit strategy, leading to firmer euro zone interest rates, while the FOMC minutes underscore the Fed’s willingness to ease further was brought into stark relief yesterday, cutting short what had appeared to be the beginnings of a corrective phase for the dollar.

At the same time, the combination of strong Chinese reserves figures ($2.65 trillion vs $2.45 trillion at the end of June) and the commitment not to raise interest rates this year means that the world’s three biggest economies will continue to be a source of liquidity and this is encouraging flows into equities, commodities and emerging markets. In the foreign exchange market this is reflected in the relative under-performance of the yen and Swiss franc.

Thailand Developments

Thailand has become the latest emerging market country to take action to slow capital inflows. As hinted yesterday, Thailand’s cabinet approved today to impose the 15% tax on interest income paid to foreign investors that domestic investors subject to. Previously, foreign investors were exempt for income earned from government or quasi-government bonds.

Reports indicate that foreign investors have bought a little more than $1 bln in Thai bonds this month after buying nearly $5 bln in Q3. Foreign investors have also stepped up their purchases of Thai equities. Data from the stock exchange indicates that of the $1.61 bln worth of Thai shares foreigners bought in the Jan-Sept period, almost $1.2 bln was bought last month alone. As is the case with many countries experimenting with measures to slow down capital inflows, Thailand is also looking at ways to encourage capital outflows.

Long Awaited Dollar Correction

The US dollar is enjoying a broad correction against most of the major and emerging market currencies. The Japanese yen is one of the few exceptions and it is largely sidelined with the greenback confined in a narrow range on either side of JPY82. Japanese officials continue to brandish the threat of intervention.

The market had struggled to maintain the downside momentum on the greenback, despite the disappointing jobs data before the weekend, heightened expectations of new long-term asset purchases by the Fed, and the continued rise in short-term euro zone rates (3-month Euribor at new 14-month high today). As we had noted at the end of last week, bearish sentiment toward the dollar had become extreme and the market had gone a long way toward discounting the dollar’s negatives.

Capital Market Overview

The US dollar is little changed against the major foreign currencies as the consolidation seen at the end of last week continue. Holidays in Japan, Canada and the United States contributes to the subdued tone. The euro made a brief run above the $1.40 level in early Asia, but it was not sustained. Support is seen in the $1.3880-$1.3900 area. A break would indicate the consolidation is morphing into a correction.

The dollar spiked down to JPY81.40 in thin early Asian activity, but snapped back quickly. The JPY82.20-40 band may cap upticks. Sterling continues to under-perform.

Currency War: A View from the Trenches

Recent weeks have seen much talk about "currency wars". This talk suggests that many countries are seeking the devaluation of their currencies in order to promote their exports, which in turn forces other countries to respond with similar efforts. It harkens back to the disastrous beggar-thy-neighbor policy that was seen between the two world wars. While the foreign exchange market is one of many arenas in which nation states compete for advantage, calling what is happening now a currency war is not only wrong, it is dangerous.

No Devaluations

It is factually wrong in the sense that there has been no recent currency devaluation in any country that is known or suspected to have intervened. In fact, the emerging Asian currencies (leaving aside the Hong Kong dollar) have all risen against the US dollar this year. The Thai baht is the strongest performer, advancing about 11.3% against the dollar, followed by the 10.8% climb of the Malaysian ringgit. The Taiwanese dollar is 4.2% higher and the Korean won 4.4% higher than they began the year.

Overview Ahead of US Employment Report

The US dollar is firmer amid last minute position agajust ahead of the employment data. With another round of asset purchases continues to seem probable, even though FOMC voting member Bullard and non-voting Dallas Fed’s Fisher indicated it is not yet a done deal.

Underlying sentiment is extremely dollar negative. In fact, the extreme sentiment readings and achievement of key levels, like $1.40 in the euro, $1.60 in sterling and JPY82 against the yen, is making the dollar bears uncomfortable going into the jobs report and the weekend G7/G20/IMF meetings.

Dollar Selling is Relentless

The US dollar remains under relentless pressure. Even though the ADP has tended to under under-estimate private sector job growth, the unexpected weakness reported yesterday is the latest catalyst for expectations of renewed asset purchases by the Federal Reserve. The euro approached the $1.40 level before the market paused in Europe. Slightly stronger than expected UK manufacturing output (0.3 vs 0.2) and the generally weak dollar environment is helping sterling edge toward $1.60, though as widely expected the BOE left policy unchanged. Comments from Vice Finance Minister Sakurai acknowledging that Japan must learn to live with a strong yen seemed to encourage yen buying and the dollar reached new multi-year lows near JPY82.25. Strong Australian jobs report sent the Australian dollar through $0.9900 as expectations for a rate hike build again.

Mexico Update: Century Bond and More

Mexico is taking advantage of the investment climate and the near insatiable demand for emerging market credits. The peso may also benefit from actions by other countries, from Brazil to South Korea taking actions to deter hot money inflows.

Yesterday. Mexico brought a 100-year bond to market, an unprecedented duration for Latam and a rare issue in general. Initially it was going to be a $500 mln issue but the demand was sufficiently strong that the government doubled the size and it was still over-subscribed. Reports indicate that demand came from institutional investors in the US, Europe and Asia.

Understanding the FX Price Action

The price action in the foreign exchange market stands in sharp contrast with yesterday’s key developments.

First, like they did earlier this year, the Reserve Bank of Australia surprised the market by apparently signaling the need to hike rates and then failed to deliver. This led to a wash out of some of the late buyers of Australian dollars. At one point the currency was off about 2%. It has now not only fully recovery but it is made new two-year highs today, just shy of the $0.98 level.

Did the MOF Signal No More BOJ Intervention (Near-Term)?

Japan's Finance Minister Noda has indicated that he will take advantage of the upcoming G7 and IMF meeting to explain its Sept 15 intervention. While US Fed and Treasury and the ECB did not comment on the intervention, several others did, including Eurogroup head Juncker, US House Ways and Means Committee Chairman Levin, and the heads of the IMF and WTO. Those comments were largely critical. The fact that he feels compelled to explain, would suggest that there won't be intervention until this explanation is delivered.

The basis for the explanation is clear. Contrary to conventional wisdom there are two pillars to G7 currency policy: flexibility and avoidance of excessive fluctuations. Japanese intervention was clearly an attempt to achieve the latter objective.

Capital Market Drivers

The RBA left rates steady, confounding market expectations and this led to a sharp sell-off in the Australian dollar, as one would expected. The RBA left the door open to additional easing. The next inflation report is due out Oct 27 and that will play a big role in shaping expectations for a Nov move.

The fundamental case for the Australian dollar may not be so much tied to higher rates--especially if the BOJ, and Fed and maybe the BOE are easing policy. Current high rates are attractive. The commodity story and the proximity to China theme also may continue to underpin the Australian dollar on a trend basis. The Australilan dollar fell to a low near $0.9540 and the high since has been about $0.9615. It looks likely to be capped near $0.9650.

FX in Nutshell

The US dollar rise yesterday looks like a one-day wonder, with the euro returning to the $1.38 area, sterling moving through yesterday’s highs and the Swiss franc at new record highs vs the greenback.

The Australian dollar is under-performing following the Reserve Bank of Australia’s decision not to hike rates as had been widely expected. The Bank of Japan also surprised the market by adopting zero-interest rate policy and expanding its balance sheet launching a fund to buy JPY5 trillion of government and corporate paper. This initially lifted the dollar initially about a half a yen to JPY84.00 before hitting offers thought to be leveraged accounts and Japanese exporters.

ECB Winding Down or Winding Up?

A couple of ECB officials have indicated that when the extraordinary liquidity provisions expire at the end of the end of the year, they will not be renewed. Officials drew comfort in the recent news that the stock of bank loans accelerated in August. That European banks are weaning themselves off the special liquidity provisions is likely reinforces the exit strategy, which Trichet will likely be questioned about after the ECB meeting Thursday.

Swiss Developments and a bit of Hungary

There are several developments in Switzerland that investors should be aware of today.

First, Germany and Switzerland appear to have struck the basis for an agreement on a new tax treaty. This generally seen as Swiss franc negative and was cited as a factor for euro gains against the Swiss franc before the weekend.

Euro Correction or Reversal?

The key question today is whether the setback in the euro, after a marginal new high was recorded in early Asia above $1.3800, or if it is the start of a more sustained correction. Since September 10, the euro has advanced more than 9%.

In the three weeks since then, the euro has fallen one day in each week. The Commitment of Traders data released late Friday showed a large jump in net speculative longs. Recall that since from December last year through most of September, the net speculative position at the IMM has been short euros. At the end of September, the net position had swung long and last week, it jumped from almost 5100 contracts to 35.3k, which is the highest since last October.

Corrective Pressures Grip the Start of the Week

The US dollar is enjoying a firmer tone, but has remained confined to its pre-weekend trading ranges. The euro is the hardest hit and although Nobel prize-winning economist Stiglitz pressed his pessimistic outlook for the euro zone and especially Spain, the market reaction outside of foreign exchange has been quite limited.

Rare Earths: The New Sputnik

The years of the Great Moderation had lulled us to sleep. The modern, dynamic, global economy has many vulnerabilities. The ongoing crisis demonstrates the fragility of the financial sector. High food and energy prices are also threats.

Another vulnerability has come to the forefront in recent weeks. Many goods that use modern technology, such as hybrid cars, computers, mobile phones, precision guided weapons, radar, fluorescent light bulbs, and wind turbines, require chemical elements that are scarce and expensive. The growing global dependence on these elements is not well appreciated by most, including many policy makers and investors.

The More Considered Take

The US’s dollar’s slide that began in earnest in early September is set to continue. The prospects of QEII are deeply engrained. Some observers are emphasizing the sell-off in US Treasuries after the stronger Chicago PMI, but it seems the recovery was just as impressive. There seem to be two elements capture the forces at work.

First, the euro continues to track the US-German two-year spread. The spread has moved from a about 9 bp in Germany’s favor as recently as Sept 7 to 47 bp today. This is a new wide read since the end of last year. The spread seems important not simply because one has to pay more for the “privilege” of holding dollars, but also because that spread appears to reflect and encapsulate the various forces at work.

FX in a Nut Shell

The US dollar is suffering broad losses. Signs that European growth are moderating or that an Australian rate hike next week is not as easy of a call as it appeared a few days ago has done nothing to dent the persistent appetite for the major foreign currencies. Even a sub-50 reading on South Africa’s PMI did not deter rand purchases against the dollar. Japanese officials meanwhile are voicing more concern about the yen as the dollar edges closer to the JPY83 level. Although the BOJ is widely expected to provide additional support next week, the idea that the Fed is close to resuming a long-term asset purchase program remains the key focus. The contrast with the ECB, which has signaled intentions to continue to exit from its crisis response is stark and continues to undermine dollar sentiment.