Dollar Extends Rally As S&P 500 Breaks Critical 1,600 Support

Risk aversion – which the dollar craves – showed a significant escalation this past session. While we have seen pressure in Chinese funding, a surge in Euro-area sovereign yields and multi-asset volatility swell; what really marks fear is the S&P 500’s drop below 1,300. Aside from representing a simple measure of the standard investors’ ‘risk’ exposure, this benchmark is also the most prolific beneficiary of hope founded in Fed stimulus. Therefore, a 2.5 percent decline – the largest daily loss since November 9, 2011 – to break the index’s bull trend for this year is a serious development. Yet, we are still multiple levels below the extreme panic end of the sentiment scale. In a wholesale flight to quality, two critical capital currents will join the fray: an unwinding of carry trade (yen rally) and rally is US Treasuries. The dollar can advance and S&P 500 tumble without these elements, but a mere speculative reversal of Fed exposure is far easier to revert back to the bulls.

Japanese Yen: Why Isn’t the Carry Trade Unwinding?
The curious case of buoyant yen crosses is confusing many traders. Why, if risk aversion is indeed engaged, isn’t the carry trade behind pairs like AUD/JPY and EUR/JPY suffering? Looking at the yield differential (libor, sovereign bond rates, etc), the relative return on a long Aussie position is near historic lows. That contrasts severely with the current proximity to historic highs that so many of the yen-cross spot rates currently find themselves. For pairs like EUR/JPY, the differential is actually negative. There is a countervailing, fundamental wind that bears have to compete with: Japanese monetary policy. The stimulus program from the BoJ is a constant pressure on the yen. That said, Japan’s central bank and government have been overwhelmed by markets many times over the years. They could do so again now if fear builds.

Euro: PMI Improvement Doesn’t Offset Building Greece Fears
There were two very different perspectives of euro-based fundamentals. From the docket, the data was encouraging. The leading growth measure of the June PMI figures showed the Eurozone composite – the best proxy for GDP – advanced to its highest level since March 2012 (thought it was still in contractionary territory at 48.9). Furthermore, consumer confidence climbed to its highest balance in 22 months. A climb out of recession is important for Europe, but it will mean little in the short-term if financial crisis returns. Reports circulated that the IMF could suspend aid payments next month to Greece if the country didn’t enforce austerity to cover a shortfall in its plan. Pressure is nothing new and it usually works out. Yet, this fragile state may crack if rumors of the Greek coalition breaking down prove true. Traders should be on alert.

Swiss Franc Takes in US Tax Pressure, EUR/CHF Floor, Financial Warnings
The headlines from Switzerland continued to run heavy through this past session. Trade figures were the least influential headline. The 2.2 billion franc surplus was the largest in six months, but does little to change the landscape for growth. More interest was the Swiss National Bank (SNB) rate decision. Few were surprised by the central bank’s retention of the 1.2000 floor on EUR/CHF – increasingly important as Euro-area financial risks present themselves. A financial stability report from the group released separately says local banks have made strides but were still exposed to unfavorable international trends. And of course, we can’t forget the existential threat of the US pursuing Swiss banks.

British Pound Safe Haven Status for European Funds Seen in EUR/GBP
Is the sterling a safe haven currency? That depends on what you are comparing it to. Of course, the currency does not carry the same rank as a reserve as the US dollar; but for Europe, the pound is a haven that offers additional benefits of the country’s global financial status and connections to the European Union. We can see the appeal of stability in the EUR/GBP exchange rate. As risk has levitated, the pair posted its biggest drop in eight weeks. Meanwhile, data on the UK docket posted encouraging – if minimized – data. Retail sales matched its biggest monthly increase since April 2011 while the CBI manufacturing trends data posted its best reading (-18) in three months.

New Zealand Dollar Selling Outpaces Australian Dollar Ongoing Collapse
Surprisingly, the Australia dollar was not the worst performer over the past 24 hours. Yet it certainly wasn’t far behind the leader; and its two-month selloff is unrivaled in the majors. Plunging to levels not seen in three years and working on its worst week since September 23, 2011, selling pressure is well engrained. The same is true for the New Zealand dollar which topped the day for worst performer. Yet, with kiwi, the 8 percent drop against the greenback over the past two months puts it behind the curve on the Aussie’s 12 percent plunge. However, how intense the full unwind for each ultimately proves depends on what level of ‘diversification’ capital was injected to the respective financial systems. In the yield chase, FX traders were further assured of their carry trades on the assumption that the Aussie sported a dollar-level reserve status.

Gold Suffers Second Collapse in Two Months, Long-Term Trend Change
The hold out bulls behind battered gold were dealt a severe blow this past session. Recalling the extreme pain two months ago as the metal dropped nearly 15 percent in the span of just two days, the market dropped another 4.9 percent ($66) through the end of the New York session Thursday. That is the fifth largest notional drop on record and it easily drove us under $1,300. However, the one-day movement doesn’t encapsulate just how troubled conditions have grown. We are now trading at the lowest levels since September 2010 – and the bearish momentum that began back in October has clearly established its trend. In the span of eight months - not even a move from the record high in 2011 - gold has lost 30 percent of its value.

A shift of this magnitude should dispel the ‘gold can only go up’ mentality that many had assumed presumed for various reasons. The metal’s dominant three characteristics have been soundly undermined, and the commodity has clearly suffered for it. As a safe haven, the CBOE’s gold volatility index has surged back to 30 percent to reflect the level of oscillation we’ve seen these past three months. A shelter from risk does not experience this level of volatility. As an inflation hedge, there has been a remarkable lack of price growth in the world’s largest economies: US, Japan, Europe. Most prominent lately, the ‘alternative store of wealth’ appeal as offset for stimulus-distorted currency has clearly lost traction. With the US dollar – the benchmark reserve currency – rising in the wake of the Fed taper warning, there is little left.