As USD sentiment hits the lowest level since May 2011 (only 5% of traders are bullish), we are now seeing the flows-related impact on the treasury market. Yesterday saw a very weak 1 year US government T-bill auction, where the bid to cover ratio, at 2.84, was the lowest since 2009. USDJPY may have rallied yesterday in response to longer end yields rising but we feel that for the USD to rally more broadly, you need to have the supporting capital inflows to the US. Lack of demand at a bond auction may naturally suggest less global USD asset demand. Recently, foreign investor participation in 10y bond auctions has fallen to 16% relative to a high of 28% in April. We see the USD weakening vs the EUR and tactically further vs NZD.

Political stability and increasing voices from core Eurozone countries to move towards a fiscal union have driven the EUR higher. The improved sentiment and growth outlook supports equity inflows. Helped further by Schauble and Merkel saying the EUR is too low for Germany, foreigners have been buying Eurozone equities on a currency unhedged basis (USD7bn since March via ETFs), in contrast with only a fraction with the FX hedge (USD0.9bn). In 2014, when inflows were with a currency hedge, stronger risk appetite drove EURUSD lower (the negative correlation). Today, stronger risk appetite should drive EURUSD higher (the positive correlation). We are already starting to see the EUR moving in line with positive economic data surprises (see Exhibit). Stronger growth means a stronger EUR.

But what about EUR bond flows? EURUSD is trading much higher than where the German-US 10y spread would suggest. Since August 2016, the correlation between the bond and FX market was close and using that relationship, the EUR should be trading close towards 1.10 (vs 1.1170 today). . The difference, we think, can be attributed to the equity inflows. Bond inflows may have not picked up as significantly due to the uncertainty that ECB tapering may bring for that market. We believe we need to see much higher yields before the equity inflow turns into a more sustained bond inflow. As of the last update of the balance of payments in March, Eurozone investors were still buying more foreign bonds than foreign investors were buying of theirs. Japan’s weekly security flow data is released overnight, where weakness in USDJPY would suggest Japanese had slowed bond purchases last week, but we don’t expect that to last.

As equity volatility has come down to close to its lows (VIX at 10.72),even China’s sovereign rating being downgraded by Moody’s to A1 from Aa3hasn’t dented risk appetite in the Asian market. China was put on negative watch in March 2016, therefore it is the timing of today’s announcement thathas come as a surprise. Moody’s cited an expectation that financial strength will erode somewhat over the coming years as debt increases and potential growth slows. AUDUSD has weakened 0.5% overnight, suggesting the technical uptrend is complete. We keep our bearish AUD bias driven more by domestic factors, such as the housing market. Construction activity fell by 0.7% in 1Q, leading to a 1Q GDP tracking estimate of -0.2% QoQ.

The market prices an 81% probability of a Fed rate hike in June, supported further by the Fed’s Harker saying that a June hike “is a distinct possibility”. The FOMC minutes will be watched to provide clues on the path for rates and how the committee views that tightening measure along with balance sheet reduction. Market expectations for the OPEC meeting tomorrow are for a 9-month extension to the production cut. Today US crude inventory data will be watched for NOK and CAD investors. The US budget proposed yesterday to sell 270 million barrels of oil from the Strategic Petroleum Reserve over the next decade.