Risk aversion takes traditional safe-haven FX to top of table

USD: Risk aversion is mild so far but core G10 outperforms

We mentioned here that based on a lull in markets and low levels of volatility that rate spreads suggested the US dollar could strengthen further from here. The dollar did strengthen but more on risk aversion than yields although this has partially reversed today after the S&P 500 rallied into the close last night. Fed President Harker explicitly mentioned the prospect of rate cuts in 2024, which has helped bring 10yr yields back to 4.00%. After a period of yield curve steepening, the weakness in equities before the rally into the close was driven in part by bank stocks and in part by further evidence of economic weakness in China. The 2s10s curve re-inverted by about 8bps. 2s10s inversion remains at a substantial 75bps or so despite the recent period of steepening before yesterday. The sources of risk aversion now are not new for the markets – US regional banks being the key trigger in March of the most pronounced bout of risk aversion this year and the ongoing economic weakness in China has been a constant. In that sense, it is hard to see this bout of risk aversion suddenly escalating further from here. That’s not to sound dismissive of the US banking sector headwind. It is notable that approaching six months after the crisis sparked market turmoil, the support required at that time remains in place. Fed balance sheet data last week to Wednesday revealed the Bank Term Funding Program increased further to a new record high of USD 105.7bn. Coupled with still substantial loans to banks via the Federal Home Loan Bank it is clear that there remain weaknesses in the banking sector that could suddenly undermine investor confidence again. At a minimum it underlines the fact that credit flow to the real economy will remain impaired. If Moodys downgrades larger financial institutions it could certainly reinforce the tightening of financial conditions going forward as a wider array of banks focus on shoring up balance sheets.

 

FED’S BANK TERM FUNDING PROGRAM HITS A NEW RECORD

Source: Bloomberg & Macrobond

The US dollar was the top performing G10 currency yesterday and has been on a month-to-date basis with EUR, CHF and JPY the top three performing G10 currencies after the dollar. NZD, AUD and CAD are the three worst performing G10 currencies underlining the text-book risk-off G10 FX performance pattern.

China too is playing a role in this risk-off pattern and after weak trade data yesterday, the inflation data today confirmed that China is now in deflation. The YoY CPI rate fell from 0.0% to -0.3%. PPI YoY stands at -4.4%. Weak domestic demand as China deals with the property market continuing to struggle is a key factor here. Country Garden’s missed bond payments has raised concerns once again. The dollar strength has reversed somewhat today with the PBoC USD/CNY fixing stronger than expected but rate spreads not seen in over a decade will continue to weigh on CNY.

In this global backdrop, it is highly likely that the US dollar will remain well supported. If risk aversion intensifies again today and into the US CPI data tomorrow, a worst case scenario would be for a much higher than expected CPI print that would likely pressure global equity markets further lower. To us a much stronger CPI print seems unlikely with rental disinflation only just about to unfold.

JAPAN’S MERCHANDISE TRADE BALANCE RETURNS TO SURPLUS

Source: Macrobond & Bloomberg

JPY: BoJ caution last week justified by wage data

While the yen is one of the top performing G10 currencies so far in August it did still weaken yesterday with the risk aversion dynamic more than offset by the latest wage data released yesterday that was weaker than expected. It remains probably the key data release in Japan (certainly after CPI) given Governor Ueda has been explicit about the need to see sustainable wage inflation. He has specifically mentioned underlying wage growth being “a little over 2% or more” as being a requirement for achieving the 2% price stability goal.

But wage growth decelerated with full-time schedule wages slowing on an annual basis from 2.0% to 1.6%. Of course, the BoJ’s decision to alter the YCC framework was not related to the fundamental backdrop so we would argue that the BoJ’s thinking is more around the view that YCC is no longer a framework that is necessarily required and hence a step-by-step approach to ending it could still continue even coinciding with evidence that inflation is not reaching the required goal.

So we doubt the weaker wage data will result in further yen selling. There are other factors to consider too. While JGB yields are unlikely to drift higher if the current risk aversion persists, the MoF has become more resistant to yen weakness and further selling will likely soon be met by vocal opposition and threats of intervention. In addition, while the wage data got the focus yesterday, the current account data for June was notable in revealing the first merchandise goods trade surplus since October 2021 and the largest since July 2021. This is a crucial fundamental turnaround for the yen as the negative energy price shock fades. This was a big negative factor in 2022 that was part of the weak fundamental backdrop for the yen that has now ended. It adds to our belief that the upside for USD/JPY is limited from here.

KEY RELEASES AND EVENTS

Country	BST	Indicator/Event	Period	Consensus	Previous	Mkt Moving
UK	10:00	10-Year Treasury Gilt Auction	--	--	4.595%	!
US	12:00	MBA Mortgage Applications (WoW)	--	--	-3.0%	!
CA	13:30	Building Permits (MoM)	Jun	-3.5%	10.5%	!!
US	13:55	Redbook (YoY)	--	--	0.1%	!
US	17:00	Thomson Reuters IPSOS PCSI	Aug	--	54.41	!
CA	17:00	Thomson Reuters IPSOS PCSI (MoM)	Aug	--	49.55	!
US	18:00	10-Year Note Auction	--	--	3.857%	!!

Source: Bloomberg