Risk on, for now

The reaction of the dollar to the Friday’s US labour market report was instructive, with the US currency focusing on the more bullish reaction of equities rather than the diminished prospects of further QE from the Fed. But even though the headline number may have been stronger than expected, we don’t think it’s going to deter the US from looking at other possible options for boosting the economy.  

Markets are in tentative ‘risk-on’ mood, with the Aussie pushing for a sustained move above the 1.05 level vs. the US dollar.   The possibility of a rate cut here now looks to be slim after the recent run of strong data, which should at least offer some underlying support.

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Fed remains on easing course. The bigger reaction was on the yen, which has felt increasingly nervous just above the 78.00 level vs. the USD in the wake of the US jobs data. At face value the numbers were better than expected, with headline payrolls rising 163k during July, now just a shade above the 12mth average of 155k. The unemployment rate was higher, but only marginally so when taking into account the underlying numbers, so the move from 8.1% to 8.2% was mostly due to rounding (it rose 0.37%). We know that the Fed is keenly focused on the labour market because, whilst the economy has recovered the loss in output from the credit crisis, the labour market remains a long way behind, some 3% below the peak of early 2008. Furthermore, the participation rate (those either in work or actively looking for work) remains very close to the lows (at 63.7%), which is not encouraging for the longer-term health of the US economy. The market was a little more perplexed as to the implications for the Fed, but further policy measures are still likely. Both the BoE and the ECB have moved into new areas in recent weeks (or announced their intention to do so) and the Fed will likely do the same as the impact of both low rates and also bond-buying starts to fade.

The long and the short of FX moves. There were very interesting moves in both FX and bonds on Friday. The reason was the ECB’s statement the previous day, noting that any revised bond-buying on its part would be concentrated on shorter-dated bond maturities, the reasoning being that this fits more closely with its mandate. Traditionally 2yr yields correlate better with FX rates compared to 10yr bonds. Of course, for the eurozone, there is no such thing as a single bond market. If we use swap rates (i.e. money market rates) instead of bonds, the correlation between EUR/USD and 2yr rates (US vs. eurozone) has averaged around 0.33 compared to almost flat for the 10yr. That said, the inverse correlation between movements in peripheral yields and EUR/USD (euro rising as yields in Italy and Spain etc. fall) has been pretty strong, averaging -0.50 so far this year. If we do the same for the 2yr, the figure is -0.43. Not a massive difference, but notable that it is not as strong. What it means is that FX is more sensitive to interest rates at the short end of the curve (2yr), but more sensitive to sovereign risk at the longer end (10yr). This makes sense from the perspective that governments do issue a greater proportion nearer to 10yr maturity than 2yr on average. But it’s worth keeping an eye on, especially if governments shift to issuing more shorter-dated bonds as a result.

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