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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