3 Economic Red Flags…and One False Alarm

DailyFX

The latest Chinese GDP data is yet another cause for concern about the health of the global economic recovery, but among the growing list of worries, recent selling seen in US Treasuries shouldn’t be one of them.

There are definite signs that the global economic recovery is losing momentum. Between this morning's softer US economic reports, last night's weaker-than-expected Chinese GDP data, and this month's disappointing US retail sales and jobs numbers, central banks have a lot more to worry about in Q2 than in Q1.

The US dollar (USD) is trading higher against all major currencies this morning except for the Japanese yen (JPY) on the back of weaker manufacturing activity in the New York region (the Empire State manufacturing index dropped to 3.05 from 9.24) and a decline in foreign purchases of US Treasuries.

According to the Treasury's international capital flow report, foreigners were net sellers of US dollars in February, which is bad news for the greenback. However, the outflows can be largely attributed to concerns about US budget cuts which have since abated, and we don't think foreigners will continue to be net sellers of Treasuries going forward for two reasons: 1) Because Bank of Japan (BoJ) policies have forced Japanese investors to go global, and 2) Because renewed concerns about sovereign risks in Europe, including the problems in Cyprus, have given investors good reasons to buy US dollars.

If you think about it, the US dollar and Japanese yen are traditionally the most popular safe-haven currencies, but BoJ policies are making the yen very unattractive, leaving the greenback as one of the few safe-haven options with the possibility of capital preservation. As a result, foreign sales of US Treasuries won't last for long.

Meanwhile, the simultaneous slowdown in the world's two largest economies could slow the normalization of monetary policies around the world. At this stage, we are almost certain that the Federal Reserve won't be able to taper asset purchases until September, at the earliest, and could even postpone monetary policy changes to December.

China Feeling the Pain of Overexpansion

China is beginning to feel the pain of economic overexpansion as slower growth in fixed capital investment, industrial production, and retail sales all start to weigh on GDP. China's economy expanded at an annualized rate of 7.7% in the first quarter, down from 7.9% in Q4.

Considering that most economists were looking for faster growth, this pullback caught everyone by surprise and explains why the Australian and New Zealand dollars were the worst-performing currencies in the wake of the latest data.

Despite strong credit growth, a higher luxury tax, smaller increase in disposable income, decline in government spending, and softer inflation all caused consumer spending growth to slow in the first three months of the year.

The question now is whether the weakness in Chinese data will prompt the People's Bank of China (PBoC) to consider shifting from neutral to easier monetary policy. We believe that the central bank will want to see if the slowdown is sustained in the second quarter before changing interest rates or the reserve requirement ratio, so AUD and NZD traders shouldn't expect any help from the PBoC in the interim.

USD/JPY Losses Continue Below 98

The USDJPY also extended its losses to trade below 98. The softer Chinese economic reports may have contributed to a general sense of risk aversion that has also hurt the currency pair, but short yen traders grew nervous after a report from the US Treasury was released late Friday.

In the semi-annual report on currencies," the Treasury said "We will continue to press Japan to adhere to the commitments agreed in the G-7 and G-20, to remain oriented towards meeting respective domestic objectives using domestic instruments and to refrain from competitive devaluation and targeting its exchange rate for competitive purposes."

Some investors interpreted this to mean that the US is critical of Japan's policies, but with the weaker yen being a byproduct of monetary policy and not currency intervention, it may be difficult for the US to accurately justify doing so.

By Kathy Lien of BK Asset Management

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