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US Dollar and Equities Recover but Bond Yields Continue to Sell Off : What Does this Mean?

Wednesday, 25 July 2007 21:20:00 GMT  |  Kathy Lien, Chief Strategist

• Euro Sees the Biggest Drop in 2 Months
• Reserve Bank of New Zealand Raises Interest Rates to 8.25 Percent

US Dollar and Equities Recover but Bond Yields Continue to Sell Off:  What Does this Mean?
It is earnings season and this appears to be cushioning the fall in both the US dollar and the Dow.  Stocks clawed their way back into positive territory in the late US trading session after the market digested the more optimistic Federal Reserve Beige Book report.  In contrast to the warnings and dour outlook given by Fed Chairman Ben Bernanke last week, the report from the 12 Fed districts provided a breath of fresh air. According to the report, economic growth continued at a modest pace for most districts.  Even though consumer spending for 4 out of the 12 districts was mixed or below expectations, business spending was strong.  The same could be said about the real estate market, which was weak on the retail level but more active on a commercial level.  At the same time however it leaves the market confused about who to believe since Bernanke’s comments could be a more current assessment of the economic situation and a more valid warning about the troubles ahead.  Existing home sales fell 3.8 percent in the month June to the weakest level in over 4 years (this is the lowest since Nov 2002).  The markets took the weaker numbers in stride because the previous collapse in the US dollar, bond yields and stocks essentially priced the disappointment in.  Also, the average sales price increased for the first time in a year while supply remained unchanged.  It is not time to get complacent just because house prices have increased.  Although possible, we think that it is highly unlikely that Bernanke will be shifting his tone at the bottom of the housing market.  The increasing number of late payments reported by American Express and Countrywide Financial is hardly the behavior of a healthy economy.  New home sales are due for release tomorrow along with durable goods.  The weak dollar could boost orders for big ticket items but new homes sales on the other hand could suffer the same fate as existing home sales.  Even though the stock market licked its wounds and the dollar rallied strongly, bond yields continued to sell-off.  Interest rate markets tend to be most accurate indicator of the overall market’s assessment of data.  The fact that yields are lower suggests that there may be more bad news to come. 

Euro Sees the Biggest Drop in 2 Months
The Euro fell by the largest amount in 2 months, putting an end to the currency pair’s month long uptrend.  Sentiment has shifted in the markets and it has done so with little fundamental support. French business confidence remained unchanged in July while Trichet continued to play down the significance of the currency’s ascent.  The fact that he only indicated that the recent market correction is healthy suggests that he is not willing to rock the boat days before he goes on his summer holiday.  Instead, he has sent the members of his monetary policy committee to do the job.  Yesterday Stark said the strong euro was hurting exporters.  Today, Quaden said that the central bank was against abrupt and excessive currency moves.  If Trichet were to say the same things, the market’s reaction would be far more severe, but now they have a nice and orderly correction.  Tomorrow we have the German IFO survey.  The deterioration in Eurozone manufacturing PMI and the drop in the Belgian manufacturing survey suggests that German business sentiment could deteriorate.  If that becomes true, the sell-off in the Euro could deepen.  A break below 1.3697, which is today’s low, would open the door for a move down to 1.3575. 

Reserve Bank of New Zealand Raises Interest Rates to 8.25 Percent and a Possible End to Rate Hikes
The Reserve Bank of New Zealand raised interest rates to 8.25 percent today, but hinted that they have done enough.  Central bank Governor Bollard said that rate rises are enough to contain inflation and the strong currency is hurting exporters.  He feels that the high NZD is not sustainable even though price pressures, the labor market and the overall economy remain strong.  Clearly, if it was not for the strength of the currency, Bollard would continue to raise rates.  But since that is not the case, there will be a nice long pause before rates are raised again.  Meanwhile, inflation is also a problem in Australia.  Consumer prices increased more than expected in the second quarter, taking the Australian dollar to a fresh 18 year high. This follows a similar rise in producer prices earlier this week.  The rise in inflationary pressures is only a mild concern for the Treasury at the moment.  Costello indicated that inflation is still consistent with their target but prices remained very constrained.   Meanwhile the Canadian dollar lost ground despite higher oil prices.  There is a great deal of two-way demand in the currency pair at current levels suggesting that a bottom could still be possible. 

Sharp Intraday Recovery Seen in Yen Crosses
The stronger than expected Japanese Merchandise Trade balance has helped rally the Yen, but the late US stock market recovery caused a massive reversal in all of the Yen crosses.  In fact, some of the pairs such as USD/JPY are back in positive territory.  Consumer prices are due out tomorrow night.  Any evidence of inflationary pressures could to a new wave of Yen strength.  Otherwise, the other big focus is the upcoming LDP elections.  If the LDP loses its majority, the Yen could weaken because future reforms would be difficult to be passed.
 
British Pound Tanks but Uptrend Not Broken Yet
With no economic data released today, like the Euro, the British pound saw its biggest drop in 2 months.  Unlike the Euro however, the uptrend in the GBP/USD is not broken until the currency pair slides below 2.0450, which is the July 18th low.  House prices and mortgage approvals are due for release tomorrow.  Disappointing numbers should only cause mild weakness in the pound.  Instead, the US dollar will probably drive the currency pair’s movements over the next 24 hours, unless there is another surprise cross border merger or acquisition announcement. 

Written by Kathy Lien, Chief Strategist of DailyFX.com

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