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Assets prices were not unlike a volcano yesterday – all quiet on top, but a bubbling cauldron of fire and friction underneath. Although most now accept that the end is nigh for Greece in terms of continuing participation in the eurozone, events in Spain are moving so incredibly quickly that the centre of global systemic risk has now shifted indelibly to Madrid.

Yesterday’s news that retail sales in Spain collapsed by 16% in real terms in the year to April confirmed that this is another European economy in freefall. Almost everywhere you look in southern Europe the news is disturbing. Unsurprisingly, confidence in the single currency continues to ebb away; the euro dropped to a new 2yr low of 1.2457 overnight. In the month of May alone, the euro has fallen by almost 6%.

Guest post by Forex Broker FxPro

Once more it is the dollar and the yen that are winning the forex popularity contest, while G4 bonds continue to set new record lows in yield. Gold is still really struggling (see below for a more detailed discussion) – it fell to USD 1,545 overnight. Oil prices are still plunging, providing further evidence that global demand has waned markedly in the current quarter. Brent crude fell below USD 107 last night, a fall of almost USD 20 in less than two months. That old investment adage ‘sell in May and go away’ has once again been remarkably prescient.

 

Commentary

A dollar drought. One of the major explanations for the dollar’s continuing outperformance vis-a-vis other major currencies is simply that the pool of high quality assets around the world is shrinking. The latter is especially the case in Europe, where only Germany, the Netherlands, Luxembourg and the Scandi countries enjoy the highest long-term foreign currency debt rating from the three major rating agencies. Only a handful of countries are in a position where the CDS on their debt trades under 100bp, with the United States being one of those. As such, for those real money managers who are constrained by their investment mandates to only invest in the highest-rated assets, the options beyond dollar-based assets are becoming increasingly limited. Indeed, the US accounts for three-quarters of the USD 14 trln of sovereign debt where 5yr CDS are trading beneath 100bp. Increasingly evident is that some sovereign wealth funds are reducing their euro exposure in favour of other reserve currencies such as the dollar, but also sterling and the Japanese yen. The former are conscious that a much lower proportion of eurozone sovereign debt securities meet their investment criteria, and as a result they are naturally inclined to reduce their currency exposure at the same time. Also, central banks in other safe haven countries such as Japan and Switzerland have been fighting a very determined rearguard action against local currency strength, diminishing the foreign appetite for their securities and currencies. In contrast, the Fed is completely relaxed by the gains in the currency, and the increased demand for treasuries being exhibited by foreign investors. This theme could continue to run in the dollar’s favour for a time, despite the fact that the single currency is incredibly oversold.

Gold less bold. The bullish trend in gold that emerged when the Fed first embarked on its QE program in late 2008 has been kicked into touch, at least as far as the charts are telling us, with the down-moves in the early part of May pushing below the longer-term trend-line support. But the fundamentals also appear to be shifting. The most notable shift on this front has been the undermining of the view that on-going quantitative easing (or very near to it in the eurozone) will ultimately lead to inflation, debasing currencies and supporting gold. This argument is looking weaker. Inflation for the G7 countries has been falling this year (currently 2.4% vs. 3.2% peak in September of last year) and inflation in the BRIC countries (Brazil, Russia, India, China) has fallen to 4.6%, from a 7% peak back in September of last year. Furthermore, the scope for those holding the monetary levers to generate inflation is diminishing through time as the impact from any further monetary stimulus will be limited, certainly in relation to the efforts taken early on in the crisis.
The other factor to note is that even with yields pushing record lows in the UK, US and German bond markets, investors are not being lured into gold, as has historically been the case when real interest rates have moved lower. Naturally, the move higher on the dollar has played its part on the gold price, but even taking this into account, the weaker tone to gold is evident on many of the gold crosses (India the notable exception here). You have to go back all the way to 2005 to find a time when gold was weaker at this point in the year, which is notable given it has risen every year for the past 11 years. The gold bulls are having a tough time of it and there’s little on the horizon to expect that this is going to change anytime soon.

The accelerating internationalisation of the renminbi. Beijing’s determination to internationalise the renminbi was in evidence again yesterday following the PBOC’s announcement that it had authorised direct trading between the yuan and the Japanese yen from this Friday. Policy officials recognise that the capital account must be opened up in order to increase the renminbi’s acceptance as a major international currency. This latest move follows last month’s decision to widen the daily trading band for the yuan, and to raise the quotas for global funds investing directly into Chinese securities from USD 30bn to USD 80bn. Direct yuan-yen trading will reduce the costs of currency transactions between the two countries and further reduce the dependence on the dollar, which has been a long term aim for Chinese policy-makers. It should also facilitate improved trading and investment opportunities between the two economies. Trade between the world’s second and third largest economies is huge, totalling USD 350bn in 2011. China is Japan’s largest trading partner.   Both London and Singapore will certainly sit up and take notice at this latest announcement. These centres have been urging China to allow yuan trading out of their respective financial centres, so the fact that Tokyo has essentially been selected represents a comparative advantage in terms of attracting business from those seeking to trade directly in the yuan/yen cross.