Dollar Bid, but Antipodeans Firm

There are three key developments today. After seemingly spending recent months pursuing a controversial political agenda, Japan's Abe has returned his attention to the economy to propose corporate tax cuts. This lifted the Nikkei a stunning 7.7%.  The UK industrial output and trade figures disappointed. Ideas a month ago that the BOE could hike rates later this year seems quite dated.  The UK economy appears to have lost momentum in late summer.  China's shares advanced for the second day, despite some reports that the government intervention has slackened.   

 

Abe indicated Japanese corporate tax schedule will by cut by at least 3.3 percentage points, but all of it is not clear water.  Some of this reduction has already taken place.  At the start of the new fiscal year, starting April 1, it has already been legislated that the corporate tax rate will fall to 31.33% from 34.62%.  Perhaps more importantly, Abe recommitted to continuing to bring the corporate tax rate down. 

 

It will likely boost corporate profitability, which has already been elevated by the decline in the yen.  Rather than seek to exploit the yen's decline to pick-up market share, Japanese businesses largely let the weaker yen flatter their bottom lines.  However, it seems misguided to expect a lower corporate tax rate to boost investment.  As we have seen repeatedly, lower interest rates, lower taxes do not boost capex.  What boosts capex is prospects for growth.  Changing depreciation allowances also may help encourage new investment. 

 

In addition to the corporate tax cuts, there is also momentum building for a supplemental budget that could be unveiled as early as next month.  One government advisor suggested a JPY3.5 trillion (~$28 bln package) could be sufficient.  One of the consequences of the tax cut and supplemental budget is that it would seem to reduce the chances of an increase in the BOJ's asset purchases, even though the BOJ is reportedly considering cutting its inflation forecasts again. 

 

UK industrial output unexpectedly fell in July.  The 0.4% decline contrasts with a consensus forecast for a 0.1% increase.  This understates the weakness.  Manufacturing slumped 0./8%, whereas the market expected a small rise.  Oil and gas extraction fell 0.4%.   More disturbing was the 9.2% decline in UK merchandise exports.  The deficit with non-EU countries widened sharply, as exports to the US, China and Switzerland slumped.

 

Since early August the implied yield of the June 2016 short-sterling futures contract has fallen by nearly 25 bp though the middle of last week.  The yield has firmed about 3 bp this week to 86 bp.  A month ago, the key talking point was how the dissents at the BOE would grow, culminating with a rate hike as early as November.  To the contrary, the one advocate of a rate hike at the last meeting likely remains alone this week.  There seems to be a greater risk that the hawk, McCafferty, re-joins the majority than some one else joins him. 

 

China's stocks appear to be stabilizing, even though many observers remain bearish, and some high profile calls for another 20% slide.  We suspect the demise of China is exaggerated.  There is scope for fiscal stimulus and more easing of monetary conditions.   China will reported expedite the construction of some infrastructure projects.  It will also remove fees and reduce some corporate taxes.  On a positive note, China reported that auto sales rose in August after declining in June and July.  Auto sales were at a 17-month low in July, and rebounded 11% in August, seemingly encouraged by various incentives, including subsidized insurance, zero-down financing and interest rate loans. 

 

China has succeeded in closing the gap between spot and the setting of the daily reference rate.  This is important operationally, for joining the SDR.  However, closing this gap has resulted in the widening of the gap between the onshore and offshore yuan.    By dampening ideas that officials are trying to engineer a larger yuan depreciation, the hope is that the gap between onshore and offshore rates will narrow.    We suspect the widening of the gap between the two was not intended, but it was not unexpected.  There is no immediate urgency for the gap to close.  It would be helpful for risk management that the gap is reduced, but it need not be critical that it is done quickly.  The withholding of 20% of banks' forward book starting next month is also seen to reduce some pressure on the onshore yuan.   

 

Meanwhile, the two-year premium the US pays over Germany has widened around 7 bp since the beginning of the month.  This seems to have weighed on the euro.  The euro has been pushed through yesterday's lows as it appears the market is rejecting the $1.12 handle.  Support is seen near $1.1120 and then last week's low just below $1.1090.   It appears that the low for the day is in place.  A close above $1.1160 today would likely confirm the continued range trading that we thought was the most likely scenario this week. 

 

The dollar is approaching its 20-day moving average against the yen, which comes in near JPY121.35.  However, the real key to the medium term outlook is the high made in late August near JPY121.75.  It would clear the charts for a return toward JPY124.00.  The rise in equities and US bond yields are supportive of the dollar against the yen. 

 

Sterling has found support near $1.5350.  It snapped a nine-day losing streak  by moving higher on Monday and Tuesday.  The disappointing data today gave short-term operators an excuse to take profits.   The risk of a less hawkish MPC tomorrow may also be encouraging some caution today.  Still, the market does not appear done with the upside.  The $1.5415 area represents a 38.2% of the nine-day slump.  The 50% retracement, which sterling appears fonder about comes just below $1.55, near the 20-day moving average. 

 

The New Zealand dollar is the strongest of the majors today.  It has gained about 1% against  the US dollar even though the RBNZ is widely expected to cut rates by 25 bp later today.  The idea is that it is priced in and there is some risk that after a series of cuts, it adopt a more neutral bias, like the RBA.  The next target is near $0.6460. 

 

The Australian dollar has been boosted by the stabilization of Chinese markets, but also the sharp rise in copper prices.  It is up about 1225% since August 24 contract lows and about 7% above Monday's lows.  The Aussie had been sold through a monthly trend line going back to 2001.  It comes in near $0.7025. It has now bounced back to about $0.7070, which corresponds to a 38.2% retracement of the decline since August 21.   Above here, there is potential toward $0.7130.  These gains look corrective in nature. 

 

 

 

 

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