Market Overview

[Research]

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Market overview

The dollar was mixed overnight, holding well against the EUR in a tight 1.4216-1.4237 range, but weakening against the JPY in a range of 115.31-115.83 on the back of some repatriation to Japan. Risk trades performed well in general, led especially by equities. Both the S&P and DJIA registered strong gains, with the latter closing at a record high. Despite some more negative news from the financial sector, investors are becoming increasingly confident that the fallout from the summer's subprime crisis may be close to a nadir. As such, prospects of a swift move into reflation for the US economy are helping risk sentiment across the board. On the data front, manufacturing ISM for September fell slightly more than expected to 52.0, but remains above typical Fed easing territory. Investors are still looking for further Fed easing this year to consolidate a recovery, but if markets are close to reaching a turning point both in terms of outlook for credit conditions and economic performance, the dollar's recent decline will probably end sooner rather than later. Significant risks to this view remain in the short term; markets will need confirmation that the US economy is not weakening dramatically, based on key data releases this week, and surprises to the downside may eliminate some of the recent gains in risk appetite. In addition, despite the recent rise in policymaker rhetoric concerning the strength of the EUR, the market remains sceptical whether concerted action will be taken to implement the "strong dollar view" espoused by US Treasury Secretary Paulson and affirmed by ECB President Trichet. More important for the US dollar at this juncture is positioning risk given how short the speculative market is of USD presently. If payrolls on Friday were to surprise significantly on the upside then a short squeeze in the USD could help push EURUSD lower. Likewise, a consensus or softer-than-expected payrolls this Friday would probably help consolidate the USD at current low levels for now. Ahead today, Fed President Fisher speaks at 18.35 BST, on "Technological Innovation in a Knowledge Economy".

There was some focus yesterday on how the Japan postal savings system will restructure its balance sheet as it is being privatised. This was prompted by the launch of the first stage of privatisation on Sunday, with Japan Post renamed Japan Post Holdings Co. and divided into 4 separate entities, with the banking and insurance divisions the primary revenue generators. A comparison of the balance sheet of the insurance division with those of private-sector insurers suggests that the new entity will need to increase its exposure to foreign assets, in turn leading to yen selling. However, the impact on FX will depend on how quickly the balance sheet restructuring is done. If the restructuring is drawn out over a 10-year period then the outflows may be imperceptibly small. Prime Minister Fukuda gave his first speech on policy on Monday. Fukuda promised to maintain momentum on fiscal reform, targeting a balanced primary budget by 2011. However, any near-term hike in the consumption tax rate looks unlikely as the opposition DPJ, which won the recent upper house election, campaigned against such a move. As such fiscal reform should not be a catalyst for yen weakness at this juncture. Focus in the short-term will turn towards the upcoming BoJ two-day board meeting, which concludes on Oct 11. Economists believe the BoJ will lift rates, and their stance has been supported by recent data, including the Q3 Tankan report on Monday, which showed capex growth expectations improving. The market still does not expect a rate hike by year end. Economists think that global risk aversion and FX volatility will remain the dominant driver of the yen.

The GBP continues to be vulnerable to news reports voicing concern over the health of UK financials exposed to the recent credit squeeze. An article in a UK newspaper suggested today that British banks have accounted for a substantial portion of last week's EUR 190bln ECB tender. The reluctance of the BoE to provide liquidity in money markets until events moved beyond their control may have been the catalyst for banks to approach the ECB. However, the scale of the borrowing will lead to questions over the extent of liquidity problems UK lenders are currently facing. Recent credit-related events will dominate the agenda of this week's BoE rates decision. The market expects no change in interest rates, but the central bank may also choose to release another uncustomary accompanying statement to ally any concerns that money market conditions are not showing significant signs of improvement. A sharp decline in interest rate expectations against its high-yielding peers has put sterling on the back foot. The currency's gains against the EUR will likely be capped around current levels.

A string of European PMI numbers were released across the Eurozone yesterday and most nations registered falls, in line with market expectations. Italian and Spanish PMIs came in at 23 and 27-month lows respectively, French PMI fell to just above the key 50 level, while Germany's index also fell. The overall Eurozone PMI fell to 53.2 as expected, with new orders down to a two-year low of 52.2. The numbers continue to indicate weaker economic conditions ahead and consistent with economist views that the ECB will not hike ahead. However, the ECB has become firmer in recent weeks regarding its stance against pressures, and the EUR may yet benefit if a surprisingly hawkish signal is sent at this week's interest rate meeting. The currency is likely to hold well on the crosses in the short term as improving growth sentiment is driving regional asset markets higher. However, economists advise against chasing EURUSD moves higher at this stage as excessive currency strength will both ease inflationary concerns and caution policymakers against further hikes which may potentially be damaging to growth.




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