The USD swoons; more weakness is likely
The Fed consigned the greenback to another bout of weakness, signalling that easy policy would remain in place for the foreseeable future, and markets were only too happy to oblige, sending the USD index to lows last seen in 2008. We see little on the fundamental horizon that could alter the dollar’s downtrend at the moment, with US rates on hold and other major central banks biased toward tightening. That leaves the market dynamic (meaning excessive USD-short positioning could lead to a short squeeze) as the only obvious catalyst to a bounce in the buck, which we would view as only temporary.
Although we anticipate further USD declines in the weeks ahead, we are in no rush to sell at current levels in light of the proximity of key technical and psychological levels, like 1.5000 in EUR/USD, 80.00 in USD/JPY and the series of 2008 lows in the USD index around 71.00-73.00 (last 72.92). Instead, we would urge patience and look for opportunities to re-enter USD shorts, looking to buy dips in EUR/USD around 1.4450/4500, AUD/USD near 1.0450/1.0500, and to sell USD/CHF near 0.9850/9900 and USD/CAD around 0.9800/9850. Finally, we would note that the current USD decline increasingly risks becoming disorderly, possibly leading to more concerted G7, possibly even G20, action to rescue the greenback. A disorderly decline in the USD risks sending commodity prices even higher, sparking even greater inflationary pressures, which we can all do without.
As an alternative to USD shorts, we observed that carry trades (JPY-crosses) failed to extend recent gains, despite the strong performance of other risk assets (stocks and commodities) during the past week overall. If risk sentiment remains buoyant, which we think will be the case going in to the start of a new month, then we would expect to see JPY-crosses resume gains and we prefer to be buyers of JPY-crosses on remaining pullbacks to recent lows seen early last week.
Commodities toy with key psychological levels
The sharp rise in commodities of late has been nothing short of spectacular. While silver has been the clear outperformer for the month of April, gaining over 31%, gold’s performance during the past week far surpassed the ‘poor-mans-gold’, as it rose from lows around $1495 to over $1560 at the time of this writing. This may partially be explained by those short the gold/silver ratio deciding to take profits into the end of the month. Meanwhile, crude oil came in last of the three as it rose a still highly respectable 7.8% in April. At the moment, commodities are toying with key psychological levels – Gold: $1550-1600, Silver: $50, and US Oil: $115-120. So, the overwhelming question we continue to hear is what’s causing this rise? And when will they peak?
As for what’s causing this rise, we believe a ‘perfect storm’ has been brewing for quite some time, but is now just coming to fruition. First and perhaps most importantly, has been the low global interest rate environment, especially in the US, leading to a renewed USD slump. This has led investors who believe ‘printing money’ will ultimately cause inflation to seek fiat money alternatives – hard assets (commodities). If that wasn’t enough, growing tensions in the MENA region saw traders flock to a ‘flight-to-safety’ trade. At the end of February we highlighted this potential in our Commodities Corner report, “with tensions in the Middle East unlikely to subside anytime soon, this flight-to-safety trade could be stronger and last longer than the market currently anticipates, subsequently traders are beginning to take action”. Lastly, commodities have benefitted from a strong technical outlook, especially silver which has made a true a parabolic move higher.
While some may believe buying at such elevated levels could be financial suicide, we actually consider it the prudent thing to do in the current environment – accordingly we do not foresee a peak yet. This week Bernanke, at his inaugural press conference after an FOMC announcement, made it abundantly clear that the uncertainty of the US economic recovery is likely to keep the Fed on the sidelines in 2H 2011 – thus remaining accommodative, until their hands are forced. Consequently, we believe the USD is likely to remain under pressure in the weeks and months ahead. While we are cautious of getting long at immediate levels next week, we would look to be rather opportunistic upon pullbacks as the fundamental backdrop is not going to change drastically overnight. Perhaps ADP on Wednesday or NFP on Friday will give us the opportunity we seek.
Tough decisions for the ECB
The Eurozone inflation report released on Friday would have made for some uncomfortable reading at the European Central Bank. Prices are rising in the currency bloc at a 2.8 per cent annual rate in April, up from 2.6 per cent in March. For a central bank that has a sole mandate of price stability then surely rates should rise to stub out inflationary pressure?
However, rising commodity prices are weighing on the inflation rate and this is starting to erode economic confidence. Consumer, economic, industrial and service sector confidence all moderated last month. Although confidence levels are coming off their highs it points to a slowdown in the recovery in the Eurozone, which may make some members of the ECB slightly wary about raising rates at too quick a pace.
On Thursday’s ECB meeting we will see what wins out between the inflation/ growth fight. Right now the market is looking for another rate hike late in the summer and Euribor rates and Eonia- euro swap rates remain at elevated levels.
If the ECB remains as committed to price stability as it says it is then we could hear ECB President Trichet use the code words “strong vigilance” to signal a rate hike slightly earlier at the next meeting in June.
This would sit alongside the fairly hawkish rhetoric coming from ECB members in recent weeks. Last week Luxembourg central bank chief Mersch said that policy has to be decided for the region as a whole rather than for individual countries. This suggests that the ECB may not consider the concerns that Greece may have to default on some of its giant debt load in the near-future.
Peripheral bond markets have come under heavy selling pressure this week with Portuguese and Greek bond yields reaching euro-era highs. Greek 2-year bond yields are now above 26 per cent and Italy and Spain have also had to pay a higher risk premium to investors at recent debt auctions.
A combination of high interest rates and an elevated euro are all likely to weigh on growth in the peripheral economies. EURUSD surged 2.5 per cent last week alone as the Federal Reserve sounded fairly committed to low interest rates at its meeting last week. 1.5000 is now in easy reach and possibly even 1.6000 next.
At these levels the euro could start to hurt exports at exactly the wrong time. The Spanish deputy finance minister spoke on Friday after the Spanish unemployment rate reached a 14-year high of 21.29 per cent in March and retail sales slumped by 7.9 per cent, saying that exports will be the key to the Spanish economic recovery. But this won’t be possible if European goods become less competitive on the global market.
While the EURUSD has surged 10 per cent since the start of this year, the single currency is up 9.5 per cent versus the Chinese renminbi, a major market for European exporters. Thus, the ECB also needs to weigh up the impact of an imminent rate hike on the already elevated exchange rate. So watch out on Thursday, firstly for the phrase “strong vigilance” and secondly, if Trichet makes any reference to the strength of the single currency.
UK recovery looks half-hearted
If members of the MPC were waiting for an update of the first quarter growth figures before making up their minds about hiking interest rates then the 0.5 per cent expansion was fairly lacklustre. At the start of the year a rate hike at this week’s meeting was nearly fully priced in, but that has been reversed. Signs of a flagging recovery, a negative growth reading at the end of 2010, and signs that BOE Gov. King remains intent on holding rates steady in the months ahead, have all dampened interest rate expectations.
Market watchers will now wait for economic signals about how growth progressed in the second quarter but the prolonged Easter/ Royal Wedding holiday is likely to ensure that growth remains erratic in the UK for some time to come. Interest rate expectations were pushed back further last week and the markets now expect a rate hike (based on Sonia inter-bank lending rates) in the last quarter of 2011.
This is weighing on the pound against the stronger currencies like the Aussie and the euro but GBPUSD remains very well supported, it is currently at its highest level since December 2009. We prefer short sterling positions against the Aussie and the euro in particular, as we believe that the dollar will remain under pressure for some time yet as the Fed remains committed to an ultra-loose monetary policy.
Loonie and kiwi grounded for now but may soon take flight
On Monday May 2nd, Canada will take to the polls in parliamentary elections as the minority Conservative party, headed by Prime Minister Harper, defends its run that started back in 2006. Opinion polls have shown a surge in support for the New Democrats (NDP), considered at one point to be a minor opposition party, over the Liberals, previously the leading opposition party. While both the NDP and the Liberals have pledged to reverse tax reductions of $6.3B annually for businesses, the NDP is viewed as favoring more stringent spending and tax hikes. As a result, growing NDP popularity has grounded the loonie relative to other commodity currencies – AUDCAD reached multi-year highs around 1.0440/45 this past week.
On Thursday, the RBNZ left its policy rate on hold at 2.5%. While an unchanged OCR was expected, the overall dovish tone of the accompanying statement took the market by surprise – the RBNZ noted ‘higher oil prices and the elevated level of the New Zealand dollar are both unwelcome’ and ‘current policy likely to be appropriate for some time’. The comments were interpreted as a signal that rates would remain low for an extended period of time and sent NZDUSD spiraling lower to below the 0.8000 big figure.
The loonie and kiwi have been grounded this week but both may be setting up to take-off again. While upcoming Canadian elections have weighed on the loonie, we think the ultimate impact is likely to be minimal. To start, the election is not likely to have any material effects on monetary policy as there has been no mention of exerting political pressure on the BoC in any campaigns. Furthermore, the most likely outcome is for another minority Conservative government despite the current cloud of uncertainty surrounding the elections. However, there is the risk for the surge in NDP support to translate into an increase in seats which would likely keep pressure on the loonie. Nevertheless, we think any CAD weakness may provide opportunities to jump on board a future ‘loonie’ flight fueled by prospects for BoC tightening on the back of a firm Canadian economic recovery, elevated commodities, and accelerating inflation.
Inflation is picking up pace in New Zealand as well evidenced by the rise in Q1 CPI to 4.5% from 4.0% y/y. Price gains may accelerate at an even faster pace on the back of earthquake reconstruction efforts which is likely to put pressure on the RBNZ to tighten sooner than expected. Accordingly, we think pullbacks in NZD may also be viewed as opportunities to take a cheaper seat on the flight to continued kiwi upside.
Key data and events to watch next week
United States: The slew of April sentiment data comes through this week along with the all-important payrolls figure on Friday. Monday sees ISM Manufacturing for April. Wednesday sees the ISM non-manufacturing report for April and ADP employment report. Thursday has unit labour costs and productivity from the first quarter. Friday’s Non- Farm payroll report (the market is looking for 180k), and the unemployment rate, expected to remain steady at 8.8 per cent in April, will be the highlights along with hours worked and average hourly earnings data.
Eurozone: The week will be dominated by the ECB meeting on Thursday (see above for preview). Other than that it’s a fairly light data week with PPI out on Tuesday and retail sales due for March out on Wednesday where the market is looking for another monthly contraction of 0.1 per cent.
United Kingdom: The Bank of England meeting on Thursday is the highlight; the Bank is expected to remain on hold. PMI manufacturing data is released on Tuesday along with the latest CBI sales report for April. The construction sector PMI along with the money supply is released on Wednesday with PMI services sector data released on Thursday prior to the BOE meeting. Rounding off the week on Friday is the PPI input and output price data for April.
Japan: It is Golden Week holidays so the data calendar is fairly light, but there are a few things to be aware of including labour cash earnings for March on Monday and the monetary base on Friday.
Canada: The week starts with Industrial product prices and raw materials prices for March that will be looked at closely for evidence of growing inflation pressure in the Canadian economy. Monday’s National elections will be watched closely for a potential change in government. Then on Thursday there is the Ivey Purchasing manager manufacturing survey for April. On Friday, Canada announces its labour market report also for April; the unemployment rate is also released, which is expected to remain steady at 7.7 per cent.
Australia and New Zealand: A busy data week for Australia with the highlight being Tuesday’s RBA meeting, the bank is expected to keep rates on hold. Prior to that on Monday TD Securities releases its inflation data for April then there is the house price index for Q1. On Wednesday there is housing market data including HIA New Home Sales for March. On Thursday we see building approvals data and retail sales for March that are expected to rise by 0.5 per cent over the month. In New Zealand the week gets started with ANZ Commodity Prices for April, along with labour market costs data for the first quarter. On Tuesday we get building permits for March. On Wednesday we get the unemployment rate for the first quarter, which is expected to edge lower to 6.7 per cent from 6.8 per cent in Q4.
China: It is a fairly light data week. PMI Manufacturing will be released on Sunday for April and the market is looking for the index to edge up to 53.9 from 53.4 in March. Non-manufacturing PMI is released on Tuesday with the China HSBC Services Sector PMI released on Thursday.
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