FX: Making Sense Of The Rise In Yields And Drop In VIX

EUR: Improvement in German Trade Masks Underlying Weakness
GBP: Hit by Weaker Christmas Spending
AUD: Worst Trade Deficit in Nearly 5 Years
CAD: Gold Prices Up Nearly 1%
NZD: Building Permits Fall 5.4%
JPY: Finance Minister Aso Expresses Interest in ESM Bonds

FX: Making Sense of Rise in Yields and Drop in VIX

With U.S. stocks falling for the second day in a row, the dollar traded higher against all of the major currencies yesterday, except for the yen, which continued to succumb to profit taking. Concerns about this quarter’s earnings season led to deleveraging in equities and high beta currencies. So far it has been extremely quiet in terms of U.S. data and with nothing on the calendar today, earnings and the performance of the stock market should continue to drive currency flows. Of the companies that have reported so far including Yum! Brands (YUM) and GameStop (GME), there have been more disappointments than positive surprises, explaining the weakness in the market – equities were also hit by the resignation of Sears' (SHLD) CEO and a downgrade of Boeing (BA).

What to Make of Rise in Bond Yields and Decline in VIX

While there hasn’t much movement in currencies, equities are beginning to roll over and that could keep the EUR/USD and other high beta pairs under pressure. Since the beginning of the year, we have seen 2 interesting developments – #1, bond yields have soared and #2, the VIX has plunged. Over the past 2 months, 10 year U.S. Treasury yields increased from 1.62% to 1.87% and right now yields are back where they started at the beginning of January 2012.

The increase in yields and decline in Treasury prices reflects worries that the Federal Reserve could end asset purchases in 2013. The Fiscal Cliff deal also removed some risk in the market, encouraging investors to dive back into riskier assets. The more than 35% decline in the VIX, or the “fear index” also reflects a decrease in uncertainty but it is hard to believe that Fiscal Cliff deal has brought forth a new sense of stability because the performance of the equity and currency market suggests that investors are still nervous. They know that the spending cuts and the debt ceiling will become bigger issues in the coming weeks which may feel far away right now but really isn’t. Any snag in the discussions could trigger a slide in equities. In the meantime, it's all about earnings and comments from Federal Reserve officials.

Fed President Lacker spoke yesterday afternoon and he said that the recession made many consumers more cautious but he expects the economy to grow by 2% this year. As the most hawkish member of the FOMC in 2012, Lacker also felt that too much stimulus would raise the risk of inflation even though “this economic expansion, while disappointing, may be the best we should expect given the large decline in the housing market.” Lacker will no longer be a voting member of the FOMC this year which means that on balance, the Fed will be more dovish and less inclined to end asset purchases prematurely.

EUR: Improvement in German Trade Masks Underlying Weakness

The euro ended the North American trading session lower against the U.S. dollar. The Japanese government’s interest in buying ESM bonds failed to lend support to the euro even though bond prices across the region benefited from the news. European stocks including the German DAX gave up its earlier gains to end the day lower as the S&P 500 declined for the second day in a row. Yesterday was a busy day for eurozone data, but mixed economic releases provided investors with little clarity. Germany’s trade and current account surpluses increased in the month of November but with exports and imports falling sharply, the improvement is not necessarily indicative of stronger economic activity. As a result of the decline in exports, factory orders dropped 1.8%. Eurozone confidence improved but retail sales also grew less than expected. This suggests that while consumers and businesses are slightly pessimistic, there’s still not enough improvement in the economy to turn everyone into optimists. This may be important to remember as we head into Thursday’s European Central Bank meeting because it could be a stance that the ECB adopts as well. In the meantime, the decline in factory orders points to a potential downside surprise in today’s German industrial production report. EUR/CHF ended the day unchanged despite an increase in Switzerland’s unadjusted unemployment rate. Joblessness rose to 3.3% from 3.1% but remained unchanged at 3% on a seasonally adjusted basis.

GBP: Hit by Weaker Christmas Spending

The British pound sold off against the U.S. dollar and held steady against the euro following a slowdown in annualized retail sales growth last month. According to the British Retail Consortium, the total value of goods sold rose 1.5% year over year and on a like-for-like basis, rose only 0.3%. This suggests that it has been a weak holiday shopping season in the U.K. with consumer spending held back by fears of softer growth in 2013. Retail analysts described it best by saying that it is “a flat end to a flat year.” Since the BRC report tends to have a strong correlation with the official retail sales release, we would not be surprised to see retail sales decline again in December. With consumer confidence falling, we do not anticipate a major recovery in demand in the first quarter. BRC shop prices are due for release followed by the visible trade balance report on Wednesday. The deficit is expected to narrow with the PMI manufacturing index increasing but even so, the U.K. economy is starting the New Year on soft footing.

AUD: Worst Trade Deficit in Nearly 5 Years

The Australian, New Zealand and Canadian dollars weakened against the greenback on the heels of lower equity prices and softer Australian data. The country’s trade deficit widened to –AUD 2637 million in the month of November from –AUD2443 million in October. This was the largest trade deficit reported in nearly 5 years and was caused by weaker Chinese growth, a stronger currency and lower commodity prices. While exports and imports both increased, the trade gap widened because imports rose 2% and exports increased a mere 1%. A number of Chinese economic reports are scheduled for release this week including the country’s trade figures. If Chinese imports are also pared, the AUD/USD could extend its slide as it would mean that Australia’s largest trade partner is reducing external demand. Construction activity ticked up slightly in December with the PMI index rising to 38.8 from 37.0. Australian retail sales are scheduled for release this evening and with the sharp increase in the sales component of service sector PMI in the month of November, we expect a rebound in Australian retail demand. The Canadian dollar continued to consolidate while the New Zealand dollar edged lower. Building permits dropped 5.4% in November, the steepest slide since May 2012.

JPY: Finance Minister Aso Expresses Interest in ESM Bonds

The Japanese yen traded higher against all of the major currencies yesterday despite Finance Minister Aso’s comment that Japan plans to weaken its currency by using its foreign exchange reserves to buy bonds issued by the European Stability Mechanism and euro-area sovereigns. He said in a briefing in Tokyo yesterday, “The financial stability of Europe will help the stability of foreign-exchange rates, including the yen.” He also said, “Japan considers ESM bonds a major investment tool just like euro-dominated sovereign bonds.” Aso faces a lot of scrutiny from trading partners such as the US for allowing its currency to weaken so quickly. Last month Aso said other countries had “no right” to criticize Japan’s currency policies saying the US should have a stronger dollar. The amount of bonds Japan plans to purchase is unknown for the time being. According to a draft of Japan’s emergency economic measures released yesterday, the Japanese government will watch the currency market “closely” and will strengthen cooperation with the Bank of Japan to counter deflation. The Japanese newspaper Mainichi reported that the Japanese government and BOJ are discussing forming a new policy to spark stable job growth. Although no specifics have been set, the BOJ is expected to elaborate on these plans in its upcoming central bank meeting on January 21-22.