01/16/2011 - Range conditions persist, but a break may be building

Range conditions persist, but a break may be building

Another week sees another round trip between recent range highs and lows for the USD against many other major currencies. Since the beginning of December, EUR/USD has been effectively contained in a 1.30-1.35 range, with this week’s test below the range bottom having proved unsustainable. The Euro’s subsequent rebound to above 1.3400 looks similarly unsustainable in the short-term, but a further upside test of recent range highs and above 1.3500 seems likely as long as European credit markets continue to mend. We would note the regular monthly meeting of EU finance ministers next week has the potential to generate more positive news flow over the prospects for a permanent debt crisis resolution mechanism, potentially offering a fundamental catalyst to send the EUR higher (see more below). However, there is also potential for disappointment on this front and we would note comments from German Fin. Min. Schaeuble on Friday where he repeated Germany’s opposition to so-called Euro-bonds, the most viable long-term resolution to the debt crisis. For this reason, we would prefer to use EUR strength on a test and potential break of recent range highs as an opportunity to establish short EUR/USD positions in the 1.3450-1.3650 area for an expected medium-term decline. We still think additional bailouts will be required down the road and that sovereign debt restructuring (i.e. defaults) will ultimately come to pass for several of the peripheral countries.

Has Europe turned a corner?

The euro dominated action in the forex markets this week. But it was a week of two halves for the single currency: it started the week in sub-1.3000 region vs. the dollar and ended up heading toward 1.3400, now the single currency is on course to have its best weekly performance in 2 years. The turning point was the success of Portugal’s long-term debt auction. The auction was oversubscribed and the Iberian nation paid yield of 6.7 per cent, crucially this was below the 7 per cent threshold that is considered the rate at which Portugal would need to apply for funds from the EU/ECB/IMF rescue fund.

Even though Portugal could borrow at a cheaper rate from the lending facility, for now it can still borrow in the market, which is helping to restore reputational risk. Indeed, 10-year yields on Portuguese government debt has fallen 35 basis points since reaching a peak last week, and for now a bailout is off the table.

While this softened investors’ attitudes in the credit market, the rally in the euro was sparked by two factors: firstly, news that the EU authorities are discussing credible long-term solutions to the sovereign debt crisis, and secondly the perceived hawkish tone to ECB President Trichet’s press conference on Thursday.

After failing to agree on a long-term resolution to the debt crisis that has gripped peripheral Europe since the end of 2009, reports that the EU would look at possibly extending the size of the European Financial Stability Fund (EFSF) and extend its scope so that it could directly buy foreign bonds along with reducing the interest rate for rescue funds cheered the market. This fuelled the rally in the euro. It was given more gusto after ECB President Trichet was perceived as being hawkish during his monthly press conference. He noted that inflation had risen on the back of higher commodity prices and hinted that if it persisted it may warrant a rate rise. The market has rushed to re-evaluate its interest rate expectations for the ECB, and although a rate rise may not be imminent, it is too early to rule one out for the second half of 2011.

The widening differential in interest rate expectations between Europe and the US has fuelled EURUSD gains. As long as sovereign risk fears remain on the backburner and the ECB remains more likely to raise rates before the US, then EURUSD should be supported. If it can break above 1.3410, then we could see 1.3500, before the 1.42 November 2010 high comes back into view.

But there are some serious hurdles the market would have to clear first before we would be comfortable with EURUSD breaking back in the 1.40 territory. Firstly, EU officials need to come up with the goods and find a credible solution to the sovereign debt crisis. This will most likely require greater fiscal union between euro-area members, with a larger transfer of funds from the rich countries to the peripheral ones. This would hurt Germany as it is the largest economy in the Eurozone. Credit-default swaps on German bunds have been rising steadily higher in recent weeks as investors worry that Germany could get the rough end of the stick in any permanent resolution mechanism. This may make German officials reluctant to agree to expand the EFSF rescue fund, which would dent investor sentiment toward European assets in our view, as it would make a bailout of Portugal and Spain more likely.

Added to this, some large bond funds are still staying away from peripheral debt, and the ECB remains a large purchaser of this asset class. The markets are by no means robust, and a cocktail of German reluctance to extend funds for a rescue mechanism, weak economic data in the currency bloc and a less hawkish ECB/ less dovish Fed could spark a reversal in the single currency’s rally. So we are keeping in mind significant support levels for EURUSD including 1.2910 – recent lows, then 1.2650 – the low reached in August.

China’s continued tightening is a temporary setback in risk

The PBoC announced another hike to the reserve requirement ratio (RRR) today with the intent of managing liquidity and controlling the pace of bank lending. This is the fourth 50bps hike to the RRR in just over two months and will bring the rate for major banks to a record high of 19% when it takes effect next week on Jan. 20. Monthly new yuan loans data released on Tuesday came in at 480.7 billion yuan for December compared to expectations of 360 billion yuan which shows that lending remains at elevated levels. With inflation above 5% and rising from the prior reading, the central bank is also faced with the task of cooling upwards price pressures. The PBoC last raised benchmark rates by 25bps in late December and is now likely to shift towards using reserve requirements as a primary tool to rein in liquidity with several more RRR hikes expected throughout 2011.

The continued tightening in China – the world’s second largest economy – has added to the “risk off” sentiment and resulted in a knee-jerk reaction of firmer greenback and softer AUD and NZD. Commodities were also hit following the announcement of further tightening measures. China has allowed its currency to strengthen slightly as President Hu Jintao prepares to meet with President Barack Obama in Washington next week. Treasury Secretary Timothy Geithner was on the wires on Wednesday with his usual stance that China needs to strengthen the “substantially undervalued” yuan. We would expect the current decline in risk appetite to be a periodic setback and not to have a substantial impact on Chinese growth which was last reported at 9.6%. We would anticipate a rebound in sentiment coming from the tightening by the PBoC, although external factors (i.e. Europe) will remain a key driver of risk sentiment.

A long and winding road to BoC tightening

The Bank of Canada is set to release its interest rate decision on Tuesday, Jan. 18. With the target rate likely to remain unchanged at 1%, the market will home in on Wednesday’s release of the January Monetary Policy Report. In the October report, the BoC revised its 2012 year-end inflation outlook lower to 2% but highlighted upside risks from three principal factors: higher commodity prices, ‘a stronger-than-anticipated US recovery’, and the potential for ‘greater-than-expected momentum in the Canadian household sector’.

The first upside risk to the BoC’s revised inflation outlook has been fully realized as commodity prices have moved broadly higher since November (CRB Index is up about +10% since 11/1/10). The second risk, a ‘stronger-than-anticipated US recovery’, has also been set in motion and the BoC will likely note positive Canadian export growth on the back of improving US economic conditions.

However, the third upside inflation risk (‘greater-than-expected momentum in the Canadian household sector’) has not yet developed and will likely keep the BoC’s upcoming inflation outlook balanced. Household spending growth has been decelerating and signs of a rebound may be fleeting as household debt has been on the rise - household debt to disposable income was a record 148% in Q3 2010. The discouraging uptrend in households’ debt to income ratios dampens upside inflation risks as well as the possibility for a rate hike any time soon. A premature hike would weigh especially heavy on debt saddled households and subsequently Canada’s growth prospects - household spending accounts for about 60% of aggregate demand.

We believe that price gains in commodities alongside a quickening pace of recovery in the US may see the BoC acknowledge upside inflation pressures in the upcoming January Monetary Policy Report. However, we think that BoC tightening is still much further down the road. Although domestic conditions are showing signs of improvement, worse than expected housing data (Dec. Housing Starts 171.5k vs. expected 180k, Nov. Building Permits -11.2% vs. expected +1.5%) and high debt to income ratios suggest a Canadian economy unable to absorb rate hikes in the near future, not to mention the risk for the US recovery to stall. BoC policy direction, however, is moving down the road to tightening - albeit a long and winding one.

Key data and events to watch next week

Unites States:

Monday – Fed's Plosser Speaks

Tuesday – Jan. Empire Manufacturing, Nov. Total Net TIC Flows, Jan. NAHB Housing Market Index, Weekly ABC Consumer Confidence

Wednesday – Dec. Housing Starts & Building Permits

Thursday – Weekly Initial Jobless & Continuing Claims, Dec. Existing Home Sales, Dec. Leading Indicators, Jan. Philadelphia Fed, Weekly DOE U.S. Crude Oil Inventories

Euro-zone:

Monday – EU Finance Ministers Meet in Brussels

Tuesday – EU-27 Finance Ministers Meet in Brussels, German Jan. ZEW Survey, EU Jan. ZEW Survey

Wednesday – Nov. Euro-Zone Current Account, EU Nov. Construction Output, ECB's Stark Speaks

Thursday – German Producer Prices, Jan. Euro-Zone Consumer Confidence

Friday – French Jan. Own-Company Production Outlook, French Jan. Business Confidence Indicator, German Jan. IFO

United Kingdom:

Monday – Jan. Rightmove House Prices

Tuesday – Dec. Nationwide Consumer Confidence, Dec. RICS House Price Balance, Nov. DCLG UK House Prices, Dec. CPI, Dec. Retail Price Index

Wednesday – Dec. Claimant Count Rate & Jobless Claims Change

Thursday – Jan. CBI Business Optimism, Jan. CBI Trends Total Orders

Friday – Dec. Retail Sales

Japan:

Monday – Dec. Consumer Confidence

Tuesday – Nov. Industrial Production, Nov. Capacity Utilization, Dec. Nationwide Dept. Sales, Dec. Tokyo Dept. Store Sales, Dec. Machine Tool Orders

Wednesday – Nov. Tertiary Industry Index

Thursday – Nov. Coincident & Leading Index

Friday – Nov. All Industry Activity Index, Cabinet Office Monthly Economic Report

Canada:

Monday – Nov. Int'l Securities Transactions

Tuesday – BoC Interest Rate Announcement

Wednesday – Nov. Manufacturing Sales, BoC Publishes Monetary Policy Report

Thursday – Dec. Leading Indicators, Nov. Wholesale Sales

Friday – Nov. Retail Sales

Australia & New Zealand:

Monday – NZ Dec. REINZ Housing Price Index & Sales, NZ Dec. Food Prices, AU Dec. TD Securities Inflation

Wednesday – AU Jan. Westpac Consumer Confidence, AU Jan. DEWR Skilled Vacancies

Thursday – NZ Dec. Business PMI, NZ 4Q Consumer Prices, AU Jan. Consumer Inflation Expectation, NZ Jan. ANZ Consumer Confidence Index

Friday – NZ Nov. Retail Sales, AU 4Q Import/Export price index

China:

Tuesday – Dec. Actual FDI

Thursday – 4Q Real GDP, Dec. CPI, PPI, Industrial Production & Retail Sales, Dec. Fixed Assets Inv. Urban

Friday – President Hu Jintao's State Visit to United States

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02/20/2011 - US Dollar rally fizzles; ranges hold for now, but a break may be building

US Dollar rally fizzles; ranges hold for now, but a break may be building

The past week began with the greenback testing higher, only to fail and reverse course by the end of the week. The proximate cause for the reversal came following news that a pair of Iranian warships would transit the Suez Canal en route to Syria, a move which Israel labeled a ‘provocation,’ suggesting it might respond in some fashion. Geopolitical tensions ratcheted higher, and the JPY, CHF, gold and oil all registered sharp gains as investors sought havens. The USD failed to attract any safe have demand, presumably on fears that any confrontation between Israel and Iran would then draw the US into the conflict. However, we think those concerns are overblown and will eventually recede. Still, the USD reversal has done some technical damage, and with a potential US government shutdown looming when the temporary budget expires on March 3, there are plenty of reasons to shun the USD.

Another way of looking at it, and one that ignores the geo-political themes we find suspect, is that the USD simply tested key technical resistance levels at recent range highs and failed. In EUR/USD, the key 1.3450/3500 support zone we highlighted last week was tested, but ultimately held on a daily closing basis. Reports of reserve managers buying in that area also surfaced. In USD/JPY, the 84.00/50 recent high was also approached and has capped gains for the time being. Similarly, GBP/USD, USD/CHF, AUD/USD all tested range boundaries and have all reverted back into the ranges.

On the USD index, though, we see signs of a potentially more ominous USD development. The US dollar index closed last week inside the Ichimoku cloud, but ultimately was rejected from the Kijun line and has fallen back out of the cloud to finish this past week. Also, since the beginning of February, the US dollar index formed a likely bear flag consolidation. Dollar weakness at the end of this past week broke below the base of the flag, suggesting a new leg lower in the buck may be unfolding. A daily close below 77.50 Feb. 9 lows would suggest further weakness. A similar pattern appears in EUR/USD, with the flag top at about 1.3720/25, just below recent 1.3745/50 highs. A break above that 1.3725/50 level would signal to us a potentially much larger USD decline and EUR/USD gains well beyond the 1.3860/70 highs for the year. There are certainly enough Eurozone issues to restrain further gains in the single currency, but we would conclude they are being ignored or papered over on a daily close above 1.3750. Finally, we would highlight the US holiday on Monday (President’s Day) and the tendency for breakouts to occur around US-only holidays.

Mixed messages from the Bank of England

Last week's Inflation Report was expected to give the markets a steer on how close the Bank of England is to raising interest rates. However, although inflation expectations for the next two years were revised up, the Bank revised down its growth profile. This reinforces the difficult path for monetary policy over the coming months: inflation could rise to 5 per cent this year, while the most likely outcome for growth is a fairly tepid 1.5-2 per cent, and the Bank hasn't ruled out a return to recession. Bank governor Mervyn King dampened expectations for a rate hike when he said that some people were running ahead of themselves and the Bank wasn't "pre-announcing or laying the ground for a rate rise." This caused a sell-off in sterling and UK Gilts. However, once the dust had settled, sterling closed around the 1.6050 mark versus the dollar and gilt yields had only come off moderately by the end of Wednesday.

While King, who has voted to keep rates on hold, sounded dovish when he presented the Inflation Report, it is worth remembering that he is only one member and if the majority of the MPC want to hike then rates will rise. King did highlight the wide range of views on the Committee and this was in force the day after the Inflation Report when arch-hawk Andrew Sentance said that rates need to rise to stop inflation from taking hold. This sent GBPUSD soaring 100 points. But it is worth remembering that Sentance will be leaving the MPC in May. We don't know who his replacement will be yet, but if they don't share his views then the Bank will lose its most hawkish element. We will get an update on the range of views at the MPC in the minutes from the February meeting on Wednesday.

As we close the week the market is still looking for more than 50 basis points of rate hikes by the Bank by year-end. So, although the prospect of a rate hike in the next couple of months is looking less likely post the Report, the rate curve (based on short-sterling interest rate futures) is still steep for the second half of the year. Above 1.6000 the pound is still in a technical uptrend, but the outlook for sterling is extremely volatile. Austerity cuts don't start with gusto until April this year, so we won't know until late summer what the initial impact on growth will be. But, worryingly, there are signs that the labor market is already deteriorating and the number of people claiming jobless benefit rose unexpectedly in January. This highlights the deeply uncertain outlook for UK growth as the UK embarks on a massive fiscal retrenchment, and in the coming months there is a risk that the market will reassess its expectations of any rate hikes at all for this year.

Emerging market outflows here to stay?

Capital outflows from emerging market to developed economies continued this week driven by inflationary concerns, fears of growth impacts from EM policy tightening, and improving growth outlooks in developed economies. However, of more significance than the why is the when - are these flow shifts the underpinnings of a larger scale rotation or merely a temporary correction? Improving activity in the U.S. (Feb. Philli Fed registered 35.9 vs. expected 21.0) and Euro-zone ( Jan. F PMI Manufacturing printed 57.3 vs. expected 56.9) seem to support the prior but uncertainty concerning the U.S. labor market outlook (Initial Jobless Claims 2.12 was 410k vs. expected 400k) and Euro-zone periphery are supportive of the latter. Further supporting the latter has been the commodity market reaction to EM outflows. Commodities have traded broadly higher - silver hit record nominal highs around 32.88 on Friday - which contrasts from the expected reaction for lower commodities as result of weakening EM demand. We think that the recent correction in EM-DM flows is just that – a correction and that resilient growth despite capital controls may see EM equities and inflows return to trend. Ultimately, this would be a positive for commodities and related currencies (AUD, CAD, and NZD).

Scandies surge, Norges Bank indicates higher rates

The Scandinavian currencies have been exceptional performers of late with the Swedish krona as the top performer of the G10 currencies. It has experienced a year-to-date gain of 4.24% against the U.S. dollar. The Norwegian krone, or “Nocky” as it is sometimes referred to, has also seen strong gains reaching highs against the greenback which have not been seen since January of 2010. This is largely due to higher rate expectations and relatively strong GDP growth. Additionally, Norway boasts Europe’s lowest unemployment.

The Norges Bank was the first in Europe to raise rates following the financial crisis and noted that it will increase rates again in mid-2011. Rates have been on hold at 2% since May as inflation has stayed below the 2.5% target. The pause in rates has also been attributed European austerity concerns and the potential negative impact on Norway’s exports. Exports fell 1.3% last year while the krone gained.

Newly appointed Governor Oeystein Olsen, who took office last month after the departure of Svein Gjedrem, delivered his first annual address yesterday and said that “we don’t want to take responsibility for the currency level nor the overall competitiveness of the manufacturing industry”. He went on to say, “at Norges Bank we have no specific view on any equilibrium target or views on a specific level for the exchange rate.” The central bank provided guidance through the end of 2014 and expects its benchmark rate to average 2.25% this year and 3.25% next year. This indicates an expected 25bps hike each quarter from June 2011 until the end of 2014. The policy board will meet on March 16 to discuss interest rates publish its monetary policy report which will contain an updated interest rate path.

Technically, USD/NOK has broken below key support just below the 5.7000 level and sees the 2010 lows of around 5.56000 ahead of the 2009 lows of about 5.5100 as the next significant levels of support. Key resistance may be found around 5.7800 where the daily Tenkan and Kijun lines converge. The 21-week sma, currently around 5.8730, looks to have capped the upside over the past several weeks.

Key data and events to watch next week

United States:

Tuesday – Dec. S&P/CaseShiller Home Price Index, Feb. Consumer Confidence, Feb. Richmond Fed Manufacturing Index, Fed's Kocherlakota Speaks

Wednesday – Jan. Existing Home Sales, Fed's Hoenig & Plosser Speak

Thursday – Fed's Bullard Speaks, Jan. Chicago Fed Nat Activity Index, Weekly Initial Jobless & Continuing Claims, Jan. Durable Goods Orders, Jan. New Home Sales, Weekly DOE U.S. Crude Oil Inventories

Friday – 4Q second GDP & PCE, Feb. Univ. of Michigan Confidence, Fed's Yellen Speaks

Euro-zone:

Monday –EZ Feb. preliminary PMI Composite, Manufacturing & Services

Tuesday – German Mar. Consumer Confidence

Wednesday – French Jan. CPI, EZ Dec. Industrial New Orders, German Committee Discusses Euro Crisis, ECB's Trichet & Quaden Speak

Thursday – German final 4Q GDP, EZ Feb. Confidence Indicators, German Finance Minister Schaeuble Speaks

Friday – German Feb. preliminary CPI, ECB's Constancio Speaks

United Kingdom:

Monday – Feb. Rightmove House Prices

Tuesday – Jan. Public Finances

Wednesday – BoE Feb. Meeting Minutes, Jan. BBA Loans for House Purchase

Thursday – Feb. CBI Reported Sales

Friday – Feb. GfK Consumer Confidence, 4Q GDP, BOE's Bean Speaks

Japan:

Monday – Monthly Economic Report, Dec. All Industry Activity Index

Wednesday – Jan. Corporate Service Price Index, Jan. Merchandise Trade Balance, Feb. Small Business Confidence

Friday – Feb. Tokyo CPI, Jan. National CPI

Canada:

Tuesday – Dec. Retail Sales

Australia & New Zealand:

Monday – NZ Jan. Performance Services Index, NZ Jan. Credit Card Spending

Tuesday – NZ Q1 RBNZ 2yr Inflation Expectation,

Wednesday – RBA's Stevens Speaks, NZ Finance Minister English Speaks, AU 4Q Construction Work Done & Wage Cost Index

Thursday – AU Dec. Conference Board Leading Index, AU 4Q Private Capital Expenditure, AU Nov. Average Weekly Wages

China:

Friday – Feb. MNI Business Condition Survey

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