Global Angst Roils FX Markets

The U.S. dollar continued to power higher against all of the major currencies, wreaking havoc across the financial markets. While we can't blame all of the volatility on the U.S. dollar (10-year bond yields spiked above 2.4%), the latest moves have unsettled investors around the world. The S&P 500 dropped 2.59%, European equities fell 3% and major indices in Asia lost anywhere between 1.5 to 3%. Most of this weakness can be attributed to the spike in global bond yields, which boosted the cost of borrowing around the world. This accelerated deleveraging in the forex market with dollar strength only adding to the pain. The rally in the U.S. dollar has driven the Australian dollar to a fresh 2.5-year low and the New Zealand dollar to a 1-year low but the biggest moves were in commodities. Gold prices fell over 5% and silver prices dropped a whopping 8%. These are the lowest levels that we have seen both commodities trade at since September 2010. Even oil prices fell 2.9%, closing in on $95 a barrel.

While the world may end up thanking the Federal Reserve for keeping inflation at bay and boosting their export sector by weakening their currencies, right now the focus is on volatility and its impact on confidence. Central banks around the world are not going to be happy with the pace of depreciation in their currencies, the spike in bond yields and decline in stocks. Unfortunately given the amount of re-pricing that needs to occur, the latest moves could extend further. However the sell-off in U.S. stocks and the panic in global markets are not completely justified. Investors should realize is that the Federal Reserve is planning to reduce asset purchases because they have grown more confident in the U.S. economy. The latest upside surprises in the Philadelphia Fed survey and existing home sales only supports their decision. The central bank would not be taking steps that would drive U.S. yields higher if they did not feel that the economy and U.S. corporations could handle it. So eventually the sell-off in U.S. stocks should stabilize, allowing U.S. yields and the dollar to hold onto their gains and grind slowly higher.

Meanwhile, the "cash crunch" in China has only made investors more nervous. Interbank overnight lending rates in China spiked to a record high of 13.44%, up from 7.66% the previous day. One month ago, the rate that banks borrowed from each other was less than 4%. The rise in the interbank rate began two weeks ago before a three-day holiday when demand for cash increases and rates follow. In the past, the central bank would inject money into the system to offset demand but when they refrained from doing so, rates started to climb higher and the situation was made worse by weakening economic data. Now China finds itself in a liquidity crunch begging for the central bank to step in. The central bank however refuses to do because they want to punish speculators and are in the midst of reforming the economy but the longer they hold off, the more disruption it will have on China's economy and the global financial markets.

EUR: Stronger Data Limits Losses
Stronger euro-zone PMI numbers failed to spare the euro from losses against the U.S. dollar. However compared to other currencies, the euro was surprisingly resilient. Improvements in the euro-zone manufacturing and service sectors drove the PMI composite index up to 48.9 from 47.7. While the index remains in contractionary territory, this was the third consecutive month of improvement for the euro zone, a sign that the recovery is gaining momentum. The only wrinkle was the decline in manufacturing activity in Germany. This is concerning because the manufacturing sector is the foundation of the euro-zone's largest economy and if manufacturing activity has slowed this suggests that exports may have suffered as well but some economists are attributing the decline to the temporary impact of recent floods. German producer prices also dropped -0.3% in May and lower inflationary pressures should keep monetary policy easy. According to the Financial Times, the IMF is set to suspend aid payments to Greece, a development that won't be received warmly by the markets. For the time being, we expect the euro to outperform the commodity currencies but remain under pressure against the greenback. Lost in the shuffle was the Swiss National Bank's monetary policy announcement. The SNB left interest rates unchanged and kept their monetary policy statement untouched. The main takeaway is that the central bank is committed to keeping EUR/CHF above 1.20.

GBP: Supported By Stronger Retail Sales
Of all the major currencies, the British pound held up the best against the U.S. dollar Thursday. In fact it was the only currency that did not fall victim to dollar strength. There was one point during the day when the GBP hit a low of 1.5414 but by the end of the North American session, it rebounded. The resilience of sterling was driven entirely by the upside surprise in U.K. retail sales. Consumer demand in the U.K. jumped 2.1% in the month of May with retail sales excluding autos rising by the same amount. Healthier consumer appetites will contribute positively to U.K. GDP growth in the second quarter and leave Mark Carney to inherit a stronger economy in July. A survey by the Confederation of British Industry also revealed that production levels of UK manufacturers expanded in June and firms continue to expect modest growth over the next three months. CBI Director of Economics Stephen Gifford said, "While an expected improvement in conditions at home and abroad should lead to better prospects for manufacturers, the business climate still remains quite fragile." The BOE's launch of Funding for Lending Scheme has shown to work as intended as mortgage lending in the UK increased notably in May according to a survey by Council of Mortgage Lenders. CML estimated that total gross mortgage lending increased by 21%, which is the highest monthly estimate for mortgage lending since October 2008. CML chief economists Bob Pannell said, "Funding conditions, helped by the funding for lending scheme, continue to look favorable and are supporting more competitive mortgage pricing and availability and a gradual resumption of lenders' risk appetite." Public sector finances are scheduled for release Friday.

NZD Drops 1.7% To Fresh 2.5-Year Lows
All three of the commodity currencies fell aggressively against the U.S. dollar Thursday as the combination of weaker economic data and lower commodity prices sent the AUD, NZD and CAD tumbling. The New Zealand dollar was hit the hardest first by softer GDP growth and then weaker Chinese PMI. New Zealand's GDP expanded by 0.3% in the first quarter, coming short of the market's 0.5% forecast. According to the government officials, there were improvements in construction and related services, "the rest of the economy was a mixed bag, but we are coming off very strong growth in the previous quarter." Construction increased by 5.5% due to residential building and associated construction services activity in Canterbury. Agriculture declined by 4.7% due to dry weather in the quarter. Attewell said, "The impact of the drought showed up as expected, with lower milk production and higher slaughter numbers for the first three months in 2013. New Zealand expects the drought will impact the economy for several quarters, as lower herd numbers and conception rates will affect future prices." The Australian dollar also fell aggressively but having already dropped 12% since April, it fell less than NZD but still hit a fresh 2.5-year low. The AUD received a triple blow from weaker Chinese PMI manufacturing numbers from HSBC, the Fed's plans to taper and fears of bond outflows. While the decline in the currency will eventually help the economy, before it does so, underlying concerns about demand from China and the shift in Fed policy could drive the AUD/USD to 90 cents. No economic data was released from Canada Thursday but that will change with Friday's CPI and retail sales report. Both inflation and spending is expected to tick higher which should lend support to the loonie.

JPY: Japanese Investors Continue To Sell Foreign Bonds
The Japanese Yen extended lower against all of the major currencies except for the New Zealand dollar. According to the Cabinet Office, leading indicator growth rose less than expected in the month of April. The leading index increased to 99 and was initially estimated to hit 99.3. The index that measured current economic situation increased to 95.3 in April from 94.6. Another index that measured the past performance of the economy dropped to 87.9 from 88, however, was anticipated to drop to 86.8. Japan's Liberal Democratic Party said its government is closely working with the Bank of Japan to help achieve its 2% inflation target. The party also said it would consider measures to help people and industries affected by the weakening of the yen. The LDP pledges to aim for 3% average nominal growth and 2% real growth over the next 10 years. Prime Minister Shinzo Abe and his ministers says the LDP's growth plan, based on monetary easing, fiscal stimulus and a strategy to encourage investment is working but we'll see how long that optimism can last with JGB yields soaring. The latest data from the Ministry of Finance shows Japanese investors continuing to sell foreign bonds. While the uptrend in USD/JPY has resumed, a new high would require a shift in demand for foreign bonds by the Japanese.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.