Dollar Mixed, Bonds And Stocks Under Pressure

The dollar is mostly weaker against the major currencies, except against the dollar-bloc, where the Australian dollar has fallen to new 20-month lows as the bearish sentiment and poor data continue to take a toll. On the other hand, the greenback is extending recent gains against most emerging market currencies.

News that the IMF cut this year's and next year's growth forecasts for China to 7.75% from 8% and 8.25% respectively did not help matters. The Chinese yuan which has been surprisingly strong, fell by 0.25% today, its largest loss of the year.

The euro and sterling briefly traded below yesterday's lows before recovering. Those lows ahead of $1.2820 and $1.5000 respectively marks the lower end of the recent range. A poor UK CBI sales report (-11 from -1 in April) saw sterling give up its gains and return toward the lows. This also turned the euro back from the test on $1.2900.

The continued contraction in euro area lending (-0.9% in April after a 0.8% decline in March) reported earlier today is worrisome. This is especially so in the context of the recent signs of resistance among key ECB members to take additional action. Asmussen and Weidmann for Germany, France's Noyer, and Austria's Nowotny all expressed doubts about the merits of another rate cut. Noyer's comments also indicated that the ECB was not on the verge of delivering a negative deposit rate. Luxembourg's Mersch weighed in against the suggestion that ECB purchases of ABS or relaxing the rules of collateral for the same, would promote lending to small and medium sized businesses.

If the trajectory of ECB monetary policy does not look particularly promising, even though the OECD in its annual report out today, recognizes more scope for unconventional policies, there is some movement on the fiscal side. The EC will give France, Spain and the Netherlands more time to bring in their deficits. Spain, which yesterday reported a wider central government deficit for the first four months of the year already appears to be taking advantage of the leeway. Italy will be released from the excessive deficit procedures and this will free up some 8 bln euro in investment funds.

Germany's Schaeuble appears to have changed tactics with a new initiative to get the government's KfW to help provide seed capital to its counterpart in Spain and Portugal to help spur lending to small and medium businesses. There may be two considerations here. First, the austerity agenda, high youth unemployment and the recession (the OECD forecasts a 0.6% contraction this year) requires some adjustment.

The poor showing of the Five-Star Movement in local elections and the implosion of the German Pirate Party shows provides an opportunity for the elite to steal some thunder and new interest in funds to address youth joblessness illustrated this move. Second, the German election is gradually moving into focus. Merkel and Schaeuble's shift may also be protecting a flank against the opposition SPD-Greens. The German economy appears to have moved into a somewhat lower gear and the number of unemployed rose for a fourth month in May (and has only fallen in one month--Jan '13--since March '12).

The Bank of Japan met with bankers for the second time in recent weeks to try to address the volatility of the JGB market. Currently, as was the case just yesterday, the BOJ buys JGBS in large size (~JPY1 trillion all told) several days a month and gives dealers a few hours warning. Dealers want the BOJ to make smaller and more frequent transactions, buy more short-term (1-5 year) bonds and not buy bonds on the same day the MOF is selling bonds. Tomorrow the BOJ will publish its purchase schedule for next month.

In addition to the contradiction between the BOJ trying to push up inflation (which the OECD forecasts will be -0.1% this year) and lower bond yields, another force that officials have to reckon with is the backing up of US Treasury yields, which is exerting upward pressure on long-term yields. The US 10-year is at it highest level for the year and many are talking about a test on the March '12 high near 2.4% as the next target. Even if the US economy is strong enough to withstand higher yields, of which we are not convinced, it is not clear that Japan or Europe can.

The BOJ is cognizant that a substantial rise in JGB yields before the economy truly strengthens will weaken the bank's capital ratios, hurt the financial system as well as the broader economy. The same of course goes for banks in other countries which have also been buying government bonds.

Lastly, we note the Bank of Canada meets today. No change in rates is expected, nor a significant change in the statement. Some recognition of a slowing economy and global risks are likely will not giving up the idea that the next move will be a hike. The timing seems to be further out than the Bank previously anticipated.