A Few Developments to Note on Hump Day

Consolidative forces continue to grip the foreign exchange market. The Dollar Index recorded new three year highs yesterday, with the euro falling to its lowest level since April, and sterling setting new three year lows. However, there was no follow through. 

 The yen is actually the strongest of the major currencies today. A short squeeze ahead of the outcome of the two-day BOJ meeting is helping lift the yen. Previously polls indicated that additional easing by the BOJ was likely, but now sentiment has swung against it. The dollar found support in front of JPY99.80.

The IMF had revised its forecasts for Japanese growth yesterday and earlier today Japan reported domestic corporate prices (similar to PPI) rose 0.1% for a 1.2% year-over-year pace, up from a revised 0.5% pace in May. It suggests price pressures are building. Yesterday's report that the government was considering a new core/core measure of inflation that excludes both energy and fresh food would seem to make the BOJ's 2% inflation target more difficult to achieve if this is to be the new official metric. Separately, Japan reported its tertiary index rose 1.2% rather than the 0.7% the consensus expected. It suggests that the rebound in manufacturing and exports is helping lift the broader economy.

News of an unexpected slump in China's exports (and imports) rattled investors. Exports fell 3.1% in May on a year-over-year basis. It is the first outright decline in over a year and the largest drop since Oct 2009. The consensus expected a 3.7% increase. Imports slipped 0.7%. The consensus expected a 6.0% rise. The net result was a $27.1 bln surplus after a $20.4 bln surplus in May. 

 The impact of the report outside of China seemed muted, as most Asian currencies rose as did most of the regional equity markets. However, the news spurred speculation that the PBOC may consider a cut in the required reserves, which is a type of monetary easing.

In Europe, the impact of S&P's decision to cut Italy's credit rating to BBB from BBB+ yesterday has been minor. The bill sale did produce a small increase in yields and the benchmark 10-year Italian bond yield is up about 6 bp today. However, we note that the 10-year Spanish yield is up even more (~10 bp) and short-term Italian rates had already risen before the downgrade. 

The downgrade itself simply brings S&P in line with Moody's and hence it is a catch-up move. Fitch is still a notch above. That S&P cut its growth forecast for Italy to -1.9% this year from -1.4% also did not contain much new information as the IMF had already announced its new forecast of -1.8% (from its April forecast of 0.3%).

News that Italy's industrial production rose 0.1% in May, defying expectations for a 0.3% increase, fits into the pattern of disappointing reports. Separately, Italy reported that nonperforming loans rose 22.3% year-over-year in May, the same pace as April. Private deposits were up 7.1%, but loans to non-financial firms were off 3.6% (vs 3.5% previously).

Corrective forces are evident in the Australian dollar, which is trading at its best level in a little over a week. Last week and again on Monday, the Aussie built a base near $0.9040. Short-term momentum players appeared to cover shorts and this helped the Aussie climb toward $0.9230. Some position squaring ahead of tomorrow's Australian jobs data may also be contributing to the move. Still, we look for the $0.9250-60 area to provide more formidable resistance. We note that the OIS implies about a 60% chance now of a 25 bp rate cut next month.

The highlight of the North American session are the FOMC minutes and Bernanke's speech on the economic policy. The Chairman's speech is a couple of hours after the FOMC minutes and will begin just after the close of the equity markets. The FOMC minutes are likely to be seen as hawkish insofar as the broad exit strategy was discussed and Bernanke's press conference afterwards seemed to lay out a rough time frame. It was in subsequent remarks that officials tried to clarify the signal and reiterate that reduced purchases is not the same as tightening.

Indeed, even if the consensus is right and the Fed cuts back on the asset purchases by $20 bln starting in Oct, that means that the Fed will still be buying some $450 bln of long term assets before the end of the year. Bernanke, who has expressed some surprise at the extent of the increase in market rates, is expected to continue to try calming investors' nerves. This warns that while there may be some volatility around the headlines from the FOMC minutes, there may not be much follow through.