Risks to Financial Stability Fan Speculation of Emergency Rate Cuts

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Risks to Financial Stability Fan Speculation of Emergency Rate Cuts

Overview: The Black Monday talked about over the weekend has materialized. Japanese equity indices more than 12% today. The Nikkei is off around 26.5% form the high set on July 11. Taiwan and South Korean equities were tagged for more than 8% in a sea of red that spared no one. Europe's Stoxx 600 is off 2.4%, nearly matching its pre-weekend loss. It is back at levels last seen in February. The S&P 500 futures are off almost 3% and the Nasdaq futures are down about 4.5%. Haven flows into fixed income saw the 10-year JGB yield tumbled nearly 16 bp to 0.77%. European benchmark 10-year yields are down mostly 2-4 bp, with the 10-year German Bund yield off more than five basis points. The 10-year US Treasury yield is off 5 bp near 3.74% and the two-year yield is down 11 bp to almost 3.76%. Market talk is of an emergency cut by the Federal Reserve. Ahead of the weekend, there was heighted speculation of a 50 bp cut in September. 

The yen's surge is the main feature of the foreign exchange market. It is up about 3.25% on the day with the dollar slightly above JPY142. The unwinding of carry trades has also underpinned the Swiss franc, which is more than 1% stronger today. The other side of the carry trade, such as the Australian dollar, has been hit. The Aussie is off nearly 1%. The euro rose to $1.0975, a little shy of the year's high and is hovering above $1.0950. Sterling is chopping between roughly $1.2710 and $1.2815. The Canadian dollar is flattish. Among emerging market currencies, the Mexican peso, a favorite of carry-trade strategies is off nearly 3% followed by the South African range's 1.65% loss. Most emerging market currencies, including the Chinese yuan are firmer. Gold is trading heavier inside the pre-weekend range. September WTI extended its pre-weekend losses and is trading below $72 for the first time since February. 

Asia Pacific

With today's losses, the dollar has fallen by about 12.5% against the yen since the July 10 high (a day before the US June CPI). The greenback punched through the (61.8%) retracement of this year's rally (~JPY148.50) and through the trendline drawn off the 2023 lows (~JPY148) before the weekend. It has fallen to JPY141.70 today. While near JPY140.75, the dollar is about three standard deviations from the 20-day moving average, the next important chart area is JPY140. The speculative positioning in the futures market through July 30 showed it was overwhelmingly short covering of the yen as opposed to new longs. Specifically, the 33k short yen contracts were covered while the bull added only about 625 contracts (notional value is about $83k per contract). Speculators have a gross short yen position of about 138.5k contracts, back to February levels. At the end of last year, the gross short yen position was slightly less than 100k contracts. In the week ending July 26, foreign investors sold JPY1.56 trillion (~$10.7 bln) of Japanese cash equities and futures, according to Japan Exchange Group. Japan itself is the world's largest net creditor, with an around $4.4 trillion in foreign portfolio investments. The key issue is whether some of this is begin repatriated, not just speculative positioning. The unwinding of carry trades took the Australian dollar to $0.6350 (Friday's settlement was about $0.6510), a new low for the year, before snapping back to around $0.6450-60. The $0.6480-$0.6500 area offers nearby resistance. The low set in Q4 23 was near $0.6270. The Reserve Bank of Australia meets the first thing tomorrow. The market switched last week away from a tightening bias and has nearly a 50% chance of a rate cut next month and it is fully discounted in November. The offshore yuan soared by 1.2% ahead of the weekend, which is a particularly large move for the yuan, and easily the largest of the year. It is up another 0.50% today. It was not a change in China's policies that is driving the yuan, but the recovery of the yen, broad setback of the US dollar, and the sharp fall in US rates. The dollar fell to CNH7.1110 today before stabilizing. The dollar reached CNY7.1250. It had settled last week near CNY7.1720. The PBOC set the dollar's reference rate at CNY7.1345 (CNY71323 Friday). 

Europe

The euro gain about 1.1% before the weekend, the largest single-day advance since last November. To us, it is instructive that it took place not because of good news from Europe but poor news from the US. The week's gain was modest around 0.55%, but it offset the previous two weeks of losses in full. Today's gains carried the euro to $1.0975, slightly shy of the year's high set in March near $1.0980. The upper Bollinger Band is about $1.0955. The $1.10 area may pose more formidable psychological resistance. Initial support may be around $1.0925. Ahead of the weekend, sterling had fallen to almost $1.27, its lowest level in a month before recovering smartly on the back of the dollar's slump. It settled above $1.28 last week. It approached $1.27 today and again recovered through $1.28 where sellers capped in front of $1.2820. The $1.2875 area, which houses the (50%) of the decline since July 17 high for the year (~$1.3045) to the pre-weekend low, the 20-day moving average (~$1.2885), and recent price congestion is an important near-term hurdle. Still, it may take a move above the $1.2900-15 area to signal another run that the highs. 

America

The US data in the coming days simply does not have the heft to impact sentiment much. After a series of poor data from the labor market, including rising jobless claims, falling hiring, and quit rates, weak ISM survey results, cooling unit labor costs and Employment Cost Index, the US reported 114k rise in nonfarm payrolls, well below expectations and the fourth consecutive monthly rise in the unemployment rate. The destabilized capital markets have spurred speculation of an emergency Fed cut within a week. After nearing buy holdings below CAD1.39 in the last two sessions, the US dollar jumped to almost CAD1.3950 today before pulling back to almost CAD1.3860. It takes a move back below CAD1.38 to suggest a top is being formed, and our bias is to look for a topping formation. The Mexican peso has borne the brunt of the unwinding carry-trade strategies. The US dollar extended its gains since the middle of July against the Mexican peso. It soared to MXN20.2180 today, the highest in nearly two year. It traded beyond three standard deviations from the 20-day moving average (~MXN19.9350). It has steadied somewhat, but near midday in Europe, the greenback is still about 3% higher on the day. It had gained nearly 3% in the past two sessions combined. At today's peak, the dollar had risen by a little more than 15% from the mid-July low.  

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