Run on Dollar and Yen Continues

The main driver of the foreign exchange market is the continued
reassessment of the trajectory of monetary policy in the UK, EMU, and Canada. 
The OIS market does
not show that higher rates are discounted
for the next policy meeting (August, September,
and July respectively), but rather there is greater confidence that, outside of
Japan, peak monetary stimulus is behind us.  

We have argued that the interest rate differentials more than external
imbalances and politics explain movements in the foreign exchange market.
This still seems to be the case, but in
the opposite direction than we had envisioned.  The US 10 year premium
over Canada is the narrowest since Oct, over Germany since November and over
the UK since February.  

At the shorter end of the curve, the US two-year premium over German fell
to 191 bp earlier today, which is the smallest since February.
  The two-year premium over Canada was nearly halved to 31 bp from 63 bp last month.  It is the smallest
premium since last November.   The US offers 102 bp more than the UK
on the two-year money.  That is down
from 127 earlier this month and return the spread to its lowest level since

We are concerned that the many are exaggerating the extent to which the
ECB is truly mulling an exit from its extraordinary monetary stance, as one news
wires claimed. 
Draghi and Constancio were fairly clear on this
point.  Their focus is on inflation,
not growth, and they do not believe that inflation has yet reached a durable
and sustainable path toward its target.  Therefore, a high degree of
accommodation is still warranted.    Far from exiting its
negative deposit and asset purchase regime, we expect the buying to be extended into next year, at the September
meeting, and deposit hike from minus 40 bp over the year.  

Ahead of tomorrow’s EMU flash CPI, Germany and Spain are reporting their figures today.  Italy reported yesterday, and the headline fell more than
expected.  In Spain and Germany, prices appear a bit stickier.  In
Spain, the headline pace slowed from 2.0% to 1.6%.  The median result of
the Bloomberg survey was for a fall to 1.5%.  It appears to mostly the
base effect as last June’s rise housing and utilities were not repeated.    In  Germany, most of the
states the have reported have seen the year-over-year rate tick up.  This risks the aggregate figure, due out later
today, which is expected to decline to 1.3% from 1.4%. 

We recognize that the BOE decision earlier this week to raise the capital
buffer is one way the central bank is removing some accommodation proved last
year after the decision to leave the EU.
  However, despite the
apparent change in Carney’s tone, the Governor did not seem prepared to hike
rates at its next opportunity.   

Separately, though not totally
unrelated, auto output in the UK fell sharply in April (-18.2%) and May (-10%).
Roughly 13% of UK auto production is sold
domestically.  The rest is exported,
and roughly half goes to Europe.  At the same time, nearly 2/3 of the
components are outsourced with most
coming from Europe.  

The rally in stocks seen in the US yesterday carried into Asia but is struggling in Europe. 
News that all 34 of the US largest banks passed the second part of the Fed’s
stress test regarding their capital buffer excited investors.  The bank
quickly announced share buyback and dividend plans.  More than $100 bln
will be returned to investors.  It
is the first time since the financial crisis that the banks will return an
amount equal to their annual profits.  Last year, “only” 65% was

The MSCI Asia Pacific Index rally 0.6% to turn higher for the week. 
Financials and materials (the latter benefiting from a weaker dollar) are among
the strongest sectors.    Financials and materials are higher in
Europe, but not sufficiently to offset the drag from other sectors, including
utilities and consumer staples and consumer discretionary sectors.  The
Dow Jones Stoxx 600 is nursing a small loss in late morning turnover in

Asia-Pacific bond yields were mostly higher in the wake of yesterday’s
surge in Europe and the US.  However, we note that the 10-year JGB yield
was flat
.  European bond yields are rising today 2-3 bp, though UK
Gilts are underperforming and the 10-year yield is up five basis points to
1.20%.   The Us 10-year yield is holding just below yesterday’s high print
of 2.25%.  

A weak US dollar coupled with news yesterday that US output fell 100k
barrels a day in the latest week, the largest decline in a year, are helping to
support oil prices.
  Oil is
trading higher for the sixth session as it continues to recover the from the
recent slide.  The August contract has traded at its 20-day average
(~$45.15) for the first since the start of the month., and $46 a equates to a
38.2% retracement of the decline since
May 25 high near $52.20. 

Sterling briefly poked through $1.30, where it appears sellers were
  A break of $1.2950 could be the first sign that the
seven-day rally is over and a new consolidation/correction phase is at
hand.  The euro traded as high as $1.1435, the highest in the year. 
Although we did not expect the upside break this week, we recognized that a
break of the $1.11-$1.13 range would target $1.15 and then last year’s high
near $1.1615.  Support now is seen near $1.1350.   
Meanwhile, the dollar made new highs against the yen near JPY112.65.  It
his now flirting with a trendline drawn off the January and May highs and is
found today near JPY112.70.   

The Australian dollar has rallied a
cent from yesterday’s lows and is
approaching a key resistance area near $0.7700. 
The US dollar is
consolidating its losses against the Canadian dollar.  The CAD1.30 area is
giving the US dollar bears cause for pause, while a move above CAD1.3050 warns
of corrective upticks toward CAD1.3100-CAD1.3120.  



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