usd must

Churn Burn Continues

Wednesday, October 3, 2012, 7:20 AM

The US dollar is narrowly mixed as North American operators return to their posts. Initial gains were seen in Asia, as the market ostensibly reacted to reports that Spanish Prime Minister Rajoy denied earlier reports that a formal request was imminent. Color us skeptical. Such denials were seen near the US open yesterday.

It seems more likely a manufactured narrative to explain the choppy price action as the market remains torn between the dollar negativity of the open-ended QE and the dismal situation in Europe. In any event the dollar was better offered in the European morning, but is still not going anywhere quickly. We continue to detect an improvement in the dollar's technical tone and suggest that other fundamental forces besides the relative growth of central bank balance sheets will drive the foreign exchange market in general and the dollar in particular.

One of the main drivers we identified, global economic weakness, very much in evident today. China got the ball rolling with a drop in its official service PMI to 53.7 from 56.3 in August and 55.6 in July. Although we expect the Chinese economy to bottom Q3/Q4, it is still precarious.

The pan-euro zone service PMI was largely in line with the flash reading. It came in at 46.1 from the 46.0 flash and 47.2 in August. While the flash report prevents major surprises from Germany and France, we note a modest improvement in Italy. Its service PMI rose to 44.5 from 44.0 in August and bested expectations which looked for a decline of similar magnitude. However, the fact that new orders have now been below 50 for nearly a year and a half is worrisome.

That said, Spain's service PMI was horrific and plays on or fear that Spanish officials, like their French counterparts, were able to project hitting budget deficit targets with the help of overly optimistic growth assumptions. Spain's service PMI fell to 40.2 from 44.0. The market had looked for a more modest decline to 42.5.

The UK reported a disappointing CIPS service PMI. The 52.2 reading is down from 53.7 in August. Expectations centered around 53. Of note, the employment index fell for the first time since November 2011. Nevertheless, the British economy three-quarter contracting streak still seems over, even if just barely. The British Chamber of Commerce sees the economy expanding 0.5% in Q3, but NISER is at 0.3% and Markit is at 0.1%.

Negative news continued to pile up for the Australian dollar, which is the worst performing G10 currency thus far this week shedding almost 1.4% against the US dollar. The open door to additional rate cuts had taken a toll on a market leaning the wrong way.

Now the poor Chinese data and new of an Australian trade deficit nearly three-times larger than the consensus expected provided additional incentives for the longs to cut and run. The August trade deficit was reported at A$2.027 bln.

The Bloomberg consensus was for about a A$700 mln shortfall. Exports fell 3% on the month and imports slipped 1%. Economic weakness is taking a toll on world trade and we note that the Baltic Dry Index is off by nearly a third from the Q3 high.

US economic releases feature the ADP employment estimate and the service ISM. The ADP estimate has not offered helped clues into the national report in recent months and besides, we argue that the Fed's open-ended QE steals some of the thunder from near-term economic, and especially, jobs related reports. Meanwhile, unlike the euro area, the UK and Japan, there seems to be little doubt that the US economy is in fact expanding (and for the record, the net government contribution to GDP continues to be drag, even though a serious fiscal plan is still sorely missing). The service ISM is will likely confirm then what we already know.

Lastly we point out that the September US auto sales were strongest than expected and at 14.9 mln units at an annualized pace, was the best since March 2008. This year will be the third consecutive year that US auto sales rose by at least 10%. The relatively high price of gasoline is encouraging households and fleets to replace aging vehicles with smaller and more efficient ones. This remains a bright spot in an otherwise challenging economic period, even if it remains well off the 2000-2007 pace of closer to 16.8 mln units.