02/27/2011 - US Dollar weaker on diverging policy expectations while safe havens surge

US Dollar weaker on diverging policy expectations while safe havens surge

The past week saw a decline in the greenback as expectations that the Fed will lag other major central banks in lifting interest rates mounted and as commodities surged amid continued turmoil in the Middle East. Tensions in Libya drove commodities higher led by rising oil prices and saw significant flows into the CHF, JPY, and gold as investors sought safety. CHF reached a record high against the US dollar, USD/JPY approached long term lows, and gold neared record highs against the buck as risk aversion took hold. Higher commodity prices due to supply shocks have fed into higher headline inflation which has prompted central banks to step up the hawkish rhetoric. MPC minutes from the Bank of England showed Spencer Dale joining Andrew Sentance and Martin Weale in voting for a rate hike, while ECB council members Axel Weber and Yves Mersch this week noted the need for the bank to be alert and ready to raise rates as inflationary pressures persist. Keep in mind that these hawks are still in the minority as other policy makers view inflation as temporary, however second round effects are a concern and the ECB and BOE have indicated their alertness. On the other hand, the Fed continues its asset purchase program as planned and the second estimate of 4Q GDP disappointed expectations with lower consumption and government spending than previously thought. The divergence in policy expectations has resulted in a weaker USD.

The elevated oil prices have also benefitted the Canadian dollar. USD/CAD fell to multi-year lows as it traded at levels that have not been seen since early 2008. The Bank of Canada, European Central Bank and Reserve Bank of Australia will meet in the week ahead to announce interest rates although we do not expect any change in policy rates. With several central bank meetings scheduled next week, we will gain valuable insight into policy expectations. Additionally, geopolitical events and developments in the Middle East will remain a focus as this has directly impacted the price of oil and the safe havens.

Key technical levels are coming into focus with a significant pivot in the USD index just below 77.00 where the lows of February can be found. While this may support the pair in the near term, a break below suggests further downside potential for the buck. EUR/USD sees a key level to the topside at the February highs of around 1.3860. A sustained break above this level is needed to see the rally continue. In cable (GBP/USD), the key level is around the 1.63 area which is resistance dating back to November. We would note that the dollar has weakened to multi year lows and record lows against the CAD and CHF respectively and appears vulnerable as it is testing key levels against the other majors.

Pricing in that the Bank of England won’t bite the bullet

Earlier this month the market thought that the UK would be the first major central bank to raise interest rates to stem the economy’s sticky inflation problem. But as we get close to month-end investors are scaling back their expectations of rate hikes. The 3-month sterling swap price, which moves closely with interest rate expectations, fell 5 basis points last week, and the June short sterling futures contract is also higher (yields lower).  Interestingly, this has happened even though we found out that another member of the Bank of England Spencer Dale, the Bank’s chief economist, voted for a 25 basis point rate hike at the MPC meeting early in February.

Interest rate expectations have fallen just as investors’ focus has shifted. Earlier this month inflation pressures dominated the headlines, but now the pendulum has swung back to growth. And the news was not good. Q4 2010 GDP was revised lower to -0.6 per cent and a CBI retail trade survey fell to its lowest level for 8-months suggesting that the UK’s economic recovery is extremely fragile and certainly wouldn’t be able to withstand a global oil price shock if the Middle East tensions escalate in the near-future.

This is negative for sterling especially versus the euro. Above 0.8550 we expect the pair to move back towards the 0.8650 highs from January, before embarking on the 0.8900 peak reached back in October 2010.

Flip-flopping Trichet may flip back to hawkish camp

The market gets another briefing from ECB President Trichet on Thursday after the ECB’s monthly rate-setting meeting. We do not expect the Bank to raise interest rates; however, there is growing expectation that Trichet will regain his hawkish tone after sounding more dovish at the February press conference. Inflation pressures have arguably increased in the last few weeks: Germany, the currency bloc’s largest economy, reported that prices were growing at an annualized 2 per cent rate in February – the top of the ECB’s price range. Also, the sharp appreciation in the oil price and the continued risks of a supply shock due to political tension in the Middle East are likely to be cited as factors by Trichet that “warrant much attention, to ensure price expectations remain well anchored.”

Traditionally the ECB has been tough to stamp out price pressures, more so than the Federal Reserve and the Bank of England. Although the economies in Europe’s periphery are weak and heavily indebted, the ECB has to consider the threat of a German economy growing at a 4 per cent quarterly rate causing price pressures to become entrenched. Currently the market is not expecting the ECB to hike rates until the summer, but euro-swap rates are back at their 4-week highs, suggesting that momentum is gathering in financial markets for the ECB to normalize monetary policy.

The risk is, of course, that Trichet is less hawkish than the market expects. This could weigh on EURUSD, which is currently trading at 1.3750-1.3800.  If the market perceives that Trichet is trying to tone down market expectations of rate hikes, then we could see back to the 1.3450 level (50-day moving average) extremely quickly. This is because much of the recent strength in the single currency has come from higher Eurozone yields. This also supported the euro during the recent bout of risk aversion caused by the violence in Libya.

But we still continue to believe that the ECB won’t hike rates unless the EU authorities come up with a credible long-term solution to sort out the peripheral nations’ debt woes. A solution should include bond buy-backs to reduce long-term interest rates, less erroneous interest rates for the countries that have already requested bailouts, possible fiscal transfers between the strong and weak nations, structural economic reforms and plan for an orderly mechanism for default. If the authorities can agree on this then it becomes far easier for the ECB to hike rates. We will find out more in mid-March at the next EU Summit, when the currency bloc’s leaders will debate the issue.  German voters may be the spanner in the works, however. They remain opposed to any further help to indebted nations and they go to the polls at the end of March. If Germany is not on board with a long-term solution we think the chance of its success and effectiveness are slim.

If no plan is formed, then EURUSD could dip back to the January lows sub of 1.3000. But if a harmonious plan is hatched at the upcoming summit then EURUSD at 1.4000 looks possible in the coming weeks.

Aussie, Aussie, Aussie, Oi! Oi! Oi!

Over the last few months the AUD/USD had every excuse to sell-off and yet it remained firm. Analysts cited everything, flooding and cyclones in Australia, significant overvaluation according to PPP, China raising interest rates, a pullback in commodities, and of late tensions in the Middle East; and while slight pullbacks have occurred along the way, their declines have lessened with each passing week. Even in the face of recent risk aversion, the Aussie has been able to attract foreign inflows due to the higher commodity prices. Furthermore, even if precious metals prices falter in the short-term we still believe iron ore and base metal prices will remain at elevated levels as continuing demand from Asia will sustain the need for Australia’s resources.

Since the turn of the year, AUD/USD has been trading within a triangle pattern. Currently resistance resides just above current levels near 1.0160/70, while support can be found just below parity at 0.9980/90. Technically speaking, since the trend prior to this consolidation pattern was higher and a triangle pattern is considered a continuation pattern, then it is reasonable to expect a breakout to the upside over the coming days. More specifically, it appears we have just completed wave-d within the triangle pattern, consequently the finally pullback towards 1.0050/1.0100(wave-e) should be viewed as a buying opportunity before a breakout higher. Keep in mind a direct move higher is still plausible and would not invalidate the pattern or our view as we still anticipate higher prices in the week(s) ahead. Depending upon the actual point of breakout, the measured move objective on a move higher is approximately 1.05 to 1.06.

Next week sees a plethora of high impact data in the land down under which could potentially spark such a move. On March 1st there is the Feb. PMI-Manufacturing, RBA meeting, Jan. Retails Sales and 4Q Current Account Balance, the 2nd sees 4Q GDP and Jan. New Home Sales and the 3rd sees Feb. PMI-Services, Jan. Building Approvals and Jan. Trade Balance (dates are local to Australia).

Higher commodity prices here to stay?

Risk aversion reared its ugly head this week as jitters of spreading turmoil in the MENA (Middle East and Africa) region jolted market participants. Flows poured towards safe haven assets which saw precious metals and US treasuries surge higher – XAG/USD made record nominal highs around $34.33/oz. this week. Crude oil was the biggest beneficiary of MENA unrest with close to +10% (WTI) weekly gains on heightened fears of supply disruptions out of Libya.

While safe haven flows have been noted as the main source to the recent commodity boom, accommodative monetary policy has played a more significant role in the broader uptrend. Low global policy rates have significantly accelerated commodity price gains in the last decade relative to the slower pace of acceleration witnessed in the decade prior when global policy rates were broadly higher.

Recent developments have seen a number of central banks consider tightening sooner rather than later, mainly the ECB and BOE. However, the efficacy of renewed hiking cycles in controlling global commodity prices is debatable. Global growth outlooks have been improving but remain hampered by rising geopolitical and economic uncertainties. The extent of monetary policy tightening that both the UK and Euro-zone would be able to absorb considering their respective situations – negative GDP prints in the UK and EZ periphery issues – is likely on the lower end of the spectrum. Furthermore, target rates in the U.S. and Japan are likely to remain near zero for the entirety of 2011 and will likely see depressed policy rates for developed economies for the remainder of the year. We think this may continue to support commodities with the pace of price acceleration to depend on external risk events. Judging from what we’ve seen with Egypt and now Libya in just a matter of weeks, the possibility for a continuation in rapid commodity price gains cannot be dismissed.

Key data and events to watch next week

United States: Monday – Jan. personal income & spending, Jan. PCE deflator, Feb. Chicago PMI, Feb, NAPM-Milwaukee, Jan pending home sales, Feb. Dallas Fed manufacturing activity index, Fed’s Dudley to speak Tuesday – Jan. construction spending, Feb. ISM manufacturing and prices paid, Fed Chairman Bernanke to give semiannual testimony at Senate Wednesday – Feb. ADP employment change, Fed’s Beige Book, Fed’s Bernanke to give semiannual testimony at House Thursday – Weekly initial jobless claims and continuing claims, 4Q F nonfarm productivity and unti labor costs, Feb ISM services, Fed’s Bernanke and Kocherlakota speaks Friday – Feb employment report, Jan. factory orders, Fed’s Yellen speaks

Euro-zone: Monday – German Jan. import price index, EZ Jan. CPI Tuesday – German Feb. unemployment change and rate, German Feb. final manufacturing PMI, EZ Jan. unemployment rate Wednesday – EZ Jan PPI Thursday – Feb final German and EC services PMI, 4Q prelim EZ GDP report, EZ Jan. retail sales, ECB announces interest rates & press conference Friday – ECB’s Noyer, Weber, Draghi & Orphanides speak in Paris

United Kingdom: Tuesday – Feb. Nationwide House prices, Feb. manufacturing PMI, Jan. net consumer credit, mortgage approvals Wednesday – Feb. construction PMI Thursday – Feb. hometrack housing survey, services PMI

Japan: Monday – Jan prelim industrial production, retail trade, large retailers’ sales, Feb. small business confidence, Jan. vehicle production, housing starts, construction orders Tuesday – Jan jobless rate, household spending Thursday –4Q capital spending

Canada: Monday – 4Q current account, Dec. and 4Q GDP Tuesday – Bank of Canada rate announcement Wednesday – Jan. industrial product price and raw materials price index Friday – Ivey PMI

Australia & New Zealand: Monday – NZ trade balance data, AU 4Q inventories, AU Jan private sector credit, Feb. NBNZ activity outlook and business confidence Tuesday – NZ 4Q terms of trade, AU Feb. AiG performance of mfg index, AU 4Q current account balance, net exports, AU Jan. retail sales, NZ ANZ commodity price, RBA announces cash target rate, RBA commodity price index Wednesday – AU Jan HIA new home sales, AU 4Q GDP Thursday – AU Jan building approvals, trade balance, AU Feb. AiG performance of service index

China: Tuesday – Feb. manufacturing PMI Thursday – Feb. services PMI

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04/17/2011 - USD consolidates, while metals shine

USD consolidates, while metals shine

The US dollar managed to hold its ground against most other major currencies, and it still remains vulnerable, essentially consolidating near recent lows. Incoming US data over the past week suggest the US recovery is continuing, with strength in manufacturing as the lead driver. Renewed concerns over debt restructuring in the Eurozone re-surfaced, adding pressure to the EUR against most other currencies, and preventing a break above the key 1.4500/30 resistance in EUR/USD (see below). The exception for USD stability was against the JPY, where it gave back some recent gains and posted a bearish engulfing line for the week, suggesting further downside potential ahead. Moreover, weakness in USD/JPY also hints at increasing risk aversion as seen in lower JPY-crosses, higher US Treasury prices and potential stalls in major stock indexes below highs for the year. The return of Eurozone debt fears has the potential to reignite overall market uncertainty, as a restructuring or default would lead to major losses in the Eurozone financial sector, where the banks are major holders of peripheral Eurozone government debt. While we don’t anticipate an announcement of a debt restructuring in coming weeks, we will be alert to markets pricing-in such a scenario. We would also note that it’s the week before Easter, when many investors take holiday, typically reducing liquidity and raising the potential for heightened volatility.

With the USD weak and the EUR being put back under the microscope, precious metals have surged higher as so-called currency alternatives. If there is a risk sell-off, especially if focused on EUR, the metals may find even greater demand in the weeks ahead. But if any risk retreat turns particularly ugly, metals may also end up being dumped, as speculative longs may be forced to exit positions to preserve margin for other trades. Gold prices appear on track to test the $1500/oz psychological/round number resistance level, but we would expect some profit-taking around that price and we’ll be on alert for any subsequent failure or rejection. We think XAU/USD has additional upside potential while above the $1445/50 area. Silver prices are also soaring, but face resistance at $43.05/10 (123.6% of primary wave higher), then 45.05 (138.2% of primary wave higher). XAG/USD has upside potential while above 40.90/41.00, in our view.

Could peripheral concerns disrupt the ECB?

Portugal’s bailout was expected to draw a line under the peripheral debt crisis as Spain was believed to be out of the woods. But last week the start of what could be the sovereign debt crisis v. 2.0 came to the fore.

The second phase of the crisis is likely to concentrate on the prospect of restructuring and haircuts on sovereign bonds. Greece, which has the worst debt position of all the peripheral nations and has the highest risk premium attached to its government debt, could impose haircuts of between 50 and 70 per cent, according to analysis from a major ratings agency.

This caused credit markets to shudder. Added to this, at the end of last week Moody’s credit rating agency downgraded Ireland yet again and Dublin is now clinging on to its investment grade credit status. Moody’s cited a deteriorating growth outlook made worse by the ECB rate hikes that could further depress consumer demand.

While we continue to believe that the ECB will embark on more rate hikes due to inflation pressures, there are currently three further hikes priced in to the European rates curve between now and the end of the year. If the pace of tightening accelerates, then we could easily see further ratings downgrades to Portugal, Ireland and even to Spain.

Protecting Spain from financial turmoil is pivotal for European asset markets and to keep the single currency supported. Over 80 per cent of homeowners in Spain have variable rate mortgages, so they get hit quickly from rising interest rates. Credit ratings agencies will be watching closely to see if this hurts growth going forward. If there are signs that the Iberian nation’s economy is faltering under the weight of increased mortgage payments, then Spain is at risk of a downgrade.

While ECB speakers have sounded increasingly hawkish in recent weeks, the ECB will be wary of Spain’s plight and further rate hikes beyond the three already priced in by the markets may not materialise. This could keep EURUSD trading in a range. 1.4530 is a key resistance level; if we get a convincing break above here then we may see 1.4600 first towards 1.4800.

The Bank of England to keep cool on rates over the summer

We have been non-consensus on the outlook for UK interest rates for a while and don’t think the Bank of England will hike until the fourth quarter of this year. This is due to three factors. The first is that growth signals, although volatile, have tended to point to another disappointing quarter for the UK economy. Although we don’t expect growth to be negative like it was in Q4 2010, a rate of about 0.5 per cent in Q1 is all we think the UK economy can muster at the present time.

Retail sales are weak, the manufacturing sector looks like it is coming off the boil, the housing market is under pressure and public sector spending cuts are only just starting to bite with any real force. Although the March PMI services sector survey surprised on the upside and reached its highest level in nearly a year, we think this was just an anomaly.

Likewise, the improvement in the unemployment rate to 7.8 per cent last month from 8 per cent February is unlikely to be the start of a trend as growth remains lacklustre and state jobs get cut later this year.

Although headline inflation moderated in March to a 4 per cent annual growth rate from 4.4 per cent in February, inflation remains elevated and continues to eat into households’ disposable income. Crucially, headline inflation pressures are not feeding into wage growth, and average weekly earnings in February actually fell to a 2 per cent annualised growth rate. Until we see the economy start to boost wages we think the Bank will be cautious about raising rates too soon.

One caveat is the Q1 2011 GDP report released on 27 April, which may be the game changer. If growth was strong in the first three months of the year then the Bank may choose to hike in May. We think this is unlikely.

Although in the long-term reduced support from yields should weigh on the pound, in the short-term the UK currency is benefiting from a weak dollar. We expect GBPUSD to remain well supported above 1.6000. We prefer a long position in EURGBP, which should benefit from the diverging interest rate stances of the ECB and the BOE. If we can break above this 0.8900 resistance level, then we may see back towards 0.9050 first and then 0.9350 next.

SEK firms as Riksbank tightening expected to continue

On Wednesday April 20, the Riksbank meets to decide on its key interest rate, the repo rate. We agree with the market consensus that the bank will increase rates by 25 bps to 1.75%. The bank’s monetary policy objective is to “maintain price stability” which the bank has interpreted to mean a low, stable rate of inflation of around 2% per year based on the CPI. Headline inflation accelerated to 2.9% in March up from 2.5% in February, exceeding the central bank’s 2% target for the fourth consecutive month. In response to the elevated inflation levels and tremendous growth, the bank has hiked rates 5 times since July. The first of the 6 yearly rate meetings occurred on February 15 and resulted in a 25 bps rate hike to 1.5%. The bank is expected to continue its tightening cycle and Riksbank Governor Stefan Ingves has said he can’t rule out raising rates at all five remaining policy meetings this year. First deputy governor Svante Oeberg went further saying, “it is quite possible that it will need to be raised by more than 0.25% at one or more meetings and that it will need to be increased to 4% already next year”. This suggests that the risks of a surprise from the Riksbank are that they hike more aggressively (50 bps), which the market has not factored in, potentially leading to outsized gains for the SEK.

The Swedish economy is Europe’s fastest recovering economy, which grew 5.5% in 2010 and is expected to expand at a pace of 4.6% this year according to a report released on Wednesday by the Swedish government. Not surprisingly the Swedish Krona has been the strongest performer of the G10 currencies against the US dollar year-to-date. USD/SEK is trading at lows that have not been seen since August 2008 as interest rate divergences widen. A break below the April lows of about 6.1800 is likely to see losses accelerate towards the 6.1200 pivot (mid-2008 resistance) initially ahead of the key psychological 6.0000 level. To the upside, the pair sees the 21-day SMA just under 6.3000 and the Kijun line above that at around 6.3500. In EUR/SEK, the 100-day SMA comes in around the 8.9300 level and a break below here may see towards the top of the daily ichimoku cloud which comes in around the 8.8600 area. The key level to the upside is the Tenkan line which comes in at about 9.0280.

The Aussie should continue to defy gravity

Last week Australia’s unemployment rate fell below 5%, to 4.9%, as the March employment figures surprised to the upside and climbed by 37.8K. Additionally, Westpac consumer confidence in April rose by 1.2% from -2.3% the month earlier and NAB March business conditions rose to 9 from -2 MoM. Bear in mind, Australia’s reconstruction efforts from the severe cyclone and floods are set to pick up in the second half of 2011 – consequently a rebound in growth should be expected.

Overall, stronger employment figures, rising consumer confidence, better business conditions and rebuilding efforts suggests future income growth is justifiable. Furthermore, as commodity prices continue to rise and exports to China remain robust, taken altogether this should stimulate the need for the RBA to react sooner rather than later. Presently the market implied expectations sees the RBA cash rate at 4.875% by the end of the year, from 4.75% currently. While a stronger AUD has reduced immediate inflationary fears, we believe the market has underpriced its severity and expect the RBA to hike rates at least twice before the end of the year. Watch the RBA minutes on Monday for any shift in current thinking.

The primary factor limiting the Aussie’s upside at the moment is positioning, as the IMM report earlier in the week showed the AUD is at record longs, and looks a little overextended. However, while the Fed continues to remain dovish and states that rising commodity prices are ‘transitory’, traders will continue to remain long commodities and thus commodity currencies. Moreover, the risk of further G7 intervention in the JPY should prevent a substantial sell-off in assets, which means a ‘buy on dips’ strategy should be the preferred plan going forward. Therefore, we would look to be a buyer of AUD/JPY on a dip towards 85.00/50 and for those seeking a relative commodity currency play – buying AUD/NZD on a dip towards 1.3125/75 could be a good idea in the week ahead.

Key data and events to watch in the week ahead

United States: Monday - APR NAHB Housing Market Index, Fed's Fisher, Lockhart to Discuss Globalization in Atlanta, Fed's Bullard to Speak on Banking Rules in Kentucky, Fed's Fisher to Speak on U.S. Economic Outlook in Atlanta Tuesday – MAR Building Permits, FEB Housing Starts, Wednesday - MBA Mortgage Applications (APR 15), MAR Existing Home Sales, DOE U.S. Crude Oil Inventories Thursday – Weekly Jobless Claims, FEB House Price Index, MAR Leading Indicators, APR Philadelphia Fed. Friday – U.S. equities closed in observance of Easter

Eurozone: Monday - APR EZ Consumer Confidence Tuesday - EZ APR PMI Manufacturing & Services, German APR PMI Manufacturing & Services Wednesday – MAR German Producer Prices, EU's Juncker Speaks on Euro Economic Governance in Brussels Thursday -APR German IFO Business Climate, Current Assessment, & Expectations

United Kingdom: Sunday – APR Rightmove House Prices Wednesday - Bank of England Minutes Thursday – MAR Public Finances (PSNCR), MAR Retail Sales

Japan: Tuesday – FEB Tertiary Industry Index (MoM), FEB Adjusted Merchandise Trade Bal., MAR Supermarket Sales Wednesday - BOJ Deputy Governor Nishimura to Speak in Yokohama City Thursday – FEB Coincident Index CI

Canada: Monday – FEB Int'l Securities Transactions Tuesday – MAR Consumer Price Index, MAR Bank Canada CPI Core, MAR Leading Indicators, FEB Wholesale Sales Thursday – FEB Retail Sales

Australia & New Zealand: Sunday – NZ 1Q Consumer Prices Monday – RBA’s Board April Minutes Tuesday – AU FEB Westpac Leading Index, 1Q Import and Export Price Index Wednesday – AU 1Q Producer Price Index, NZ MAR Credit Card Spending

China: Sunday – MAR Property Prices APR17/22 – MAR Actual FDI Monday – HSBC Flash China Manufacturing Tuesday – Conference Board Leading Economic Index

G20, IMF: Meetings start on Friday through the weekend

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