01/23/2011 - EUR rebound is fundamentally suspect

EUR rebound is fundamentally suspect

The EUR finished out the past week at two month highs against the USD and posted strong rebounds on the crosses as well. The EUR recovered even after EU finance ministers failed to deliver a concrete long-term debt resolution mechanism (see more below), postponing a likely plan to late March. While there has been some movement on the part of Germany to show greater willingness to provide assistance to the periphery, the German government remains insistent that other EU countries will need to shoulder more of the cost as well. This raises the question of how highly indebted countries like Belgium, Italy and Spain will be able to come up with their shares of any support package, and this is the source of our skepticism on the sustainability of the EUR recovery. German data has continued to surprise to the upside with ZEW and IFO surveys all pointing to further strength in the core, and this has also provided the Euro with support.

But core Eurozone strength was never really the issue, but rather how the periphery will muddle through. On that count we still have serious doubts that major debt restructurings (i.e. defaults) can be avoided in several of the peripheral nations. In that sense, we view the recent unwinding of bearish EU bets (e.g. short EUR, long sovereign CDS, short peripheral bonds) as a temporary position adjustment, rather than the end to the European debt crisis. Similarly, we think the fears of an ECB tightening phase are overblown and that even ueber-hawk and potential next ECB president Axel Weber this week downplayed the risks from inflation and called current policy appropriate. We prefer to use current EUR strength as an opportunity to establish more fundamental short EUR positions for an expected decline in the weeks ahead (see the Weekly Strategy).

Has Europe’s sovereign crisis turned a corner?

This time last week the market was looking forward to Eurozone officials taking decisive steps towards creating a permanent solution to the sovereign debt crisis. However, two meetings of EU officials passed with no resolutions agreed. In fact, the German Finance Minister Wolfgang Schaeuble said that the calm that has descended on the peripheral bond markets in recent weeks meant there was less urgency to make changes to the current European Financial Stability Facility (EFSF).

It seems likely that there will be no progress on a permanent solution until the EU council meeting scheduled for 24-25 March. Then officials may agree to an extension of the EFSF fund, which currently stands at EUR440bn. The timing of this meeting is important since it comes just before a state election in Germany on 27 March. Only after this can the German Parliament debate proposals for a permanent bailout facility. 

Even though it may seem like Europe’s debt problems have been pushed down the road, the market has given Europe the benefit of the doubt. The euro has extended its rally this week and looks fairly comfortable above 1.3500. Investment flows into the safety of German bunds has also fallen, which has pushed up bond yields. The spread between German and US 2-year government debt has widened to its highest level since November 2009, which could fuel EURUSD gains back up to 1.4000. 

The single currency may have yield on its side, but the path to 1.4000 could be bumpy. There has been a shift in the discussion of Europe’s sovereign debt crisis away from bailouts and towards default in Greece’s case and bank sector nationalization in Spain.

Reports that Germany was working on a plan to provide Greece with a loan to buy back its bonds in a restructuring that could apply haircuts to senior bond holders was swiftly denied. If this is true, it would suggest that the EU is taking the first steps towards fiscal unity, which flaunts the fiscal sovereignty rule in the European constitution. However, officials may not be willing to take such drastic action yet, even if it does sound like a sensible long-term solution to Greece’s problems. The cost to insure Greek debt for five years has fallen this week, suggesting that restructuring could bring some certainty to investors and actually reduce risk for investors holding Greek debt. If you know for certain that you could be subject to a haircut then you can price Greek debt accordingly. 

Spain meanwhile is working on recapitalizing its troubled Caja banks. The financial position of the 17 domestic lenders is precarious at best. They are scheduled to report all of their non-performing loans and property holdings by 31 January. This could cause market jitters, especially if their liabilities are larger than the approximately EUR50bn the market is expecting.

Fears of aggressive China tightening may unwind soon

China’s pace of economic growth accelerated above expectations (Q4 Real GDP y/y printed +9.8% vs. expected +9.4% in Dec.) which was also reciprocated in Dec. Industrial Production (+13.5% y/y vs. expected +13.4%) and Dec. Retail Sales (+19.1% vs. expected +18.7%). The markets’ reaction to positive China data surprises, however, was negative. Fears of a potential ramp up in PBOC tightening measures gripped financial markets with the brunt of the impact hitting commodities – gold declined -1.7%, WTI crude oil fell -2%, and silver lost around -4% post data release. Commodity currencies experienced concurrent declines as AUD/USD fell sharply below parity to lows around 0.9835 and USD/CAD soared to highs around 1.0030. However, the commodity market selloff should be taken with a grain of salt as speculation for more aggressive PBOC rate hikes are likely to be just that – speculation. Steadying inflation - December consumer prices y/y declined to 4.6% from a prior 5.1% as did producer prices to 5.9 % from a prior 6.1% - may balance out added tightening pressures from faster than expected growth and is likely to see policy direction stay the path of a moderate tightening cycle.

Accordingly, we think the post data commodity currency selloff may be overextended. AUD/USD fell off a proverbial cliff from highs around 1.0075 but was met by strong demand ahead of the 0.9825 range lows – the pair has been consolidating within a 0.9800/1.0025 range since 1/6/11. Above 0.9825 may provide good value for longs on persistent sideways price action. Aussie crosses have also corrected lower on the back of China tightening speculation. AUD/CHF is currently testing key support into 0.9450 highlighted in the Jan. 4th Weekly Strategy and warrants bringing stops to cost as protection against a sharp upside correction as we believe this to be a possibility when rate realities begin to set in over rate expectations.

A chilly fourth quarter for the UK

The strength of the UK’s economic recovery faces its most severe test on25 January when GDP data is released for the fourth quarter of 2010. Market analysts expect the quarterly growth rate to dip to 0.5 per cent from 0.7 per cent in the third quarter and a whopping 1.2 per cent in the second quarter. But the risks are to the downside. 

The trade deficit increased over the quarter, which will hit growth; also economic data released so far has shown a divergence between different sectors of the UK economy. The manufacturing sector has come back with a bang, and the PMI manufacturing index reached a multi-year high of 58.3 in December. In itself, this is good news. However, the manufacturing sector is only a small portion of the UK’s economy, a far more important sector is consumption, and there the figures are looking grim. 

Retail sales have been on a downward trajectory since October culminating in a dismal 0.8 per cent monthly decline in sales in December, a record drop. Although part of the decline was due to the coldest weather in a century hitting the UK, the hike in sales tax on January 1 suggests that retail sales will not pick up anytime soon. On another note, rising fuel and food costs also depressed retail sales at the end of 2010, which puts more pressure on the Bank of England. The minutes of the latest Bank of England meeting will be released on 26 January, which should give us some idea of where the debate is heading within the Monetary Policy Committee: to hike or not to hike? 

As mentioned, there is a chance that expectations for the UK’s economic growth are overdone. If we get a weak GDP reading next week then we could see a sharp reversal in long sterling positions. We were wary about the sustainability of growth in the UK, and wrote in our Q1 2011 outlook that we thought 1.6000 would be a tough resistance level for GBPUSD to break through; so far it looks that way.

Precious Metals may enter Q1 2011 predicted “Buy zones” next week

While the correction in gold and silver has taken a few weeks longer than predicated in our 1Q 2011 Precious Metals Outlook, it has still come nonetheless. The unwind since the turn of the year has been treacherous, especially for the “poor man’s gold”, but ultimately little has changed fundamentally. Much of this price action can be attributed to a reduction of long positioning since the “doomsday” scenario appears to be off the table. In the short-term, the market believes troubles in both the U.S. and E.U. have abated, primarily due to rising U.S. 2011 GDP estimates – based on the 2% reduction of the Social Security tax and EU official’s willingness to discuss a permanent solution and/or changes to the European Financial Stability Facility (EFSF). However, this euphoria is unlikely to last forever and Wednesday’s FOMC interest rate decision may provide a spark in renewed interest for precious metals – Fed is likely to reaffirm their view to keep interest rates “low for an extended period of time”. We believe gold and silver may trade down into the $1300-25 and $26-27 regions next week and could be an attractive area to establish a bullish bias over the coming weeks and months. Alternatively, buying a dip in XAU/EUR between €970-80, for those who prefer to remove the USD variable, could also be an idea.

Key data and events to watch next week

Unites States:

Tuesday – Nov. S&P/CaseShiller Home Price Index, Jan. Consumer Confidence, Nov. House Price Index, Jan. Richmond Fed Manufacturing Index, Weekly ABC Consumer Confidence

Wednesday – Weekly MBA Mortgage Applications, Dec. New Home Sales, FOMC Interest Rate Decision

Thursday – Dec. Chicago Fed Nat Activity Index, Dec. Durable Goods Orders, Weekly Initial Jobless & Continuing Claims, Dec. Pending Home Sales

Friday – 4Q Employment Cost Index, 4Q advance GDP, Jan. Univ. of Mich. Confidence

Euro-zone:

Monday – EZ, French and German Jan. Advance PMI, EZ Nov. Industrial New Orders

Tuesday – French Dec. Consumer Spending, French Jan. Business Survey Overall Demand, German Feb. GfK Consumer Confidence Survey, EU's Barroso and Van Rompuy Speak

Wednesday – French Dec. Jobseekers, ECB's Stark Speaks

Thursday – EZ Jan. Business Climate Indicator, EZ Jan. Confidence Readings, German Jan. preliminary CPI, ECB's Bini Smaghi and Tumpel Gugerell Speak, EU's Van Rompuy Speaks

Friday – EZ Dec. M3, German Chancellor Angela Merkel Speaks

United Kingdom:

Tuesday – 4Q advance GDP, Nov. Index of Services, Dec. Public Finances

Wednesday – BOE Minutes, Dec. BBA Loans for House Purchase, Jan. Hometrack Housing Survey

Thursday – Jan. CBI Reported Sales

Japan:

Monday – Dec. Supermarket Sales

Tuesday – Jan. BOJ Interest Rate Announcement

Wednesday – Dec. Corp Service Price Index, Jan. Small Business Confidence, BOJ Monthly Economic Report

Thursday – Dec. Merchandise Trade Balance

Friday – Dec. Jobless Rate, Jan. Tokyo CPI, Dec. National CPI, Dec. Retail Trade

Canada:

Tuesday – Dec. Consumer Price Index

Wednesday – Nov. Teranet/National Bank HPI

Australia & New Zealand:

Monday – AU 4Q Producer Price Index

Tuesday – AU Nov. Conference Board Leading Index, AU 4Q Consumer Prices, NZ Dec. Performance Services Index

Wednesday – NZ Dec. Credit Card Spending

Thursday – AU Nov. Westpac Leading Index, RBNZ Interest Rate Announcement, RBNZ’s Governor Bollard Speaks

China:

Friday – Jan. MNI Business Condition Survey

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02/6/2011 - Rates, data support USD rebound

Rates, data support USD rebound

US data this past week pointed to a further gain in momentum for the US recovery, with personal spending, Chicago PMI, both ISM surveys, factory orders and chain store sales all rising and beating estimates. Even the heavily distorted January US jobs report held some good news. Buried in the data, and driven by census adjustments, nearly 600K jobs were created in December, papering over the weaker Jan. job gains. US Treasury yields rose on the back of the improving outlook, with 10-year yields breaking higher out of the nearly 2-month consolidation range and reaching levels last seen before last summer’s slowdown. More importantly, US rates reversed recent spread widening against the USD, suggesting an important USD low may have been seen. A week that began with risk being embraced and the USD being shunned saw a sharp reversal for the greenback, though most of the gains were against the EUR. For the week, however, the US dollar index posted a large ‘hammer’ on weekly candlesticks, a bullish reversal pattern after a decline. We look for the USD to gain further ground in the weeks ahead, especially against EUR and JPY. If the dollar recovery proves more substantial, we may see commodities and commodity currencies lose some further ground.

In contrast, the Euro witnessed a sharp reversal after making new highs for the year after ECB Pres. Trichet indicated rates were appropriate and that inflation risks remained balanced. That view effectively quashed market speculation of a near-term ECB rate hike and sent the Euro reeling. Trichet also avoided responding to questions on the timing of the ECB’s exit strategy, suggesting a greater likelihood that unlimited ECB lending to beleaguered Eurozone banks would be extended beyond the previously indicated March expiration. At the end of the week, EU leaders were unable to reach agreement on the so-called “competitiveness package’ put forward by Germany, suggesting that significant divisions remain within the union. Also, earlier in the week, Germany rejected the idea of allowing the EFSF (European Financial Stabilization Facility) to buy peripheral nations’ bonds in secondary markets. Such a move was seen to provide the best hope for high-deficit countries to retain access to capital markets, and without it the risk of those countries needing a bailout is back in the picture. EUR/USD has managed to hold above the break level of 1.3520/40, but has dropped back into the daily Ichimoku cloud (top at 1.3626), suggesting a downside bias now prevails. Once below 1.3520, we would look for additional weakness to the 1.3365 daily Kijun line initially.

Aussie stays strong despite floods and cyclone

Despite being hit with another natural disaster as Cyclone Yasi reached north Queensland, the Australian dollar remained close to its post-float highs as the Aussie was given a boost this past week following the release of the RBA’s Quarterly Monetary Policy Statement. The bank is looking past the short term impact of recent force majeure and noted that the overall level of growth in the Q2 is “likely to be back close to the level it would have been in the absence of the floods”. With the forecasted growth for 2011 raised to 4.25% from the previous prediction of 3.75% the longer term outlook for the economy and currency remains positive; however the Aussie remains vulnerable to risk aversion possible negative surprises in next week’s economic data out of Australia and China.

On Thursday, Australia is set to release employment data which is expected to show 20.0k jobs added in January from 2.3K in December. The RBA report noted, “continued solid employment growth over coming months, though most likely at a slower pace”. The risk is for a weaker than anticipated print as weather disruptions have reduced consumption and have rendered a significant portion of mines inoperable. China trade balance is also due out on Thursday and is expected to show a decline to $10.2B from the prior $13.1B. Additionally, imports are anticipated to slow to 21.9% from 25.6%. This is likely to have an effect on the Australian dollar as China imports a large amount of natural resources from Australia. Indications of a slowing economic activity in China may weigh on the Aussie. Lastly, the sovereign debt problems in Europe and tensions in the Middle East remain a concern to risk sentiment in the near term.

Near term corrections can be viewed as buying opportunities as the longer term outlook remains bullish. Key levels to the downside include the daily Kijun and Tenkan lines currently converge around 1.0030 with the daily ichimoku cloud top and 21-day sma below at about 0.9990. A break below these levels may see towards the 21-week sma and 100-day sma which converge around 0.9875/85. Key levels to the upside are the 1.02 figure and post-float highs of around 1.0260.

The UK economic pendulum swings the other way

 Opposing economic signals from the UK are clouding the outlook for growth and becoming a headache for policy makers at the Bank of England. Firstly, GDP for the fourth quarter was negative, shocking the market and causing sterling to tumble. But within a few days manufacturing and services survey data came in at multi-year highs for January, sending GBPUSD back above 1.60.

Making the economic picture even more complex is inflation, which is running well above the Bank’s 2 per cent target at 3.7 per cent on an annualized basis; and then there is the government’s largest fiscal retrenchment in the post-war era. So trying to predict the future trajectory of interest rates has become incredibly difficult.

One way to get a grip on UK growth dynamics is by looking at the facts: manufacturing is strong, although there are signs of improvement in the services and construction sectors this is from a very low base, housing looks weak and the labor market is expected to deteriorate as public sector job cuts take effect. 

The voting pattern of the Monetary Policy Committee at the Bank of England reflects the divergence in the economic data. Last month there were two members who voted for a rate hike to stem inflation with one member voting for more quantitative easing. The MPC meet next week and the market expects another month of no change in policy. However rate hikes are looking more and more likely in the absence of sustained weakness in economic data and the market is currently pricing in a hike by the middle of the year. Rising bond yields are lending support to sterling. 

Indeed, the National Institute of Economic and Social Research, a think tank, urged the Bank to raise rates to stem inflation and the government to scale back its deficit reduction plans. The Bank and the government have to balance their actions going forward. If rates are rising at the same time as public spending is slashed, this would be disastrous for growth. We will have to wait for the 16 February when Mervyn King presents the latest inflation report to find out if the Bank sees inflation as a big enough threat to price stability to hike rates. 

Sterling is still in a technical uptrend above 1.5822 – the top of the Ichimoku cloud. However, investors don’t seem happy to hold sterling longs above 1.6200, which has become the level to beat if we are to see further gains in GBPUSD. Until the Inflation Report is released later this month we believe that sterling will remain range bound.

Gold and silver may be unable to stay aloft

As noted two weeks ago, the FOMC’s Jan. interest rate decision ended up providing the spark needed to see renewed interest in precious metals as the Fed reaffirmed their view to keep interest rates “low for an extended period of time”. What’s more, both gold and silver traded into their highlighted “buy zones” at $1300-25 and $26-27 respectively. While in the end these could prove to be great longer-term holdings, something just doesn’t quite “feel” right since they were unable to rally during the heightened Egyptian riots.

Additionally, after precious metals bottomed towards the end of January their advance has been suspect since they rose and fell in conjunction with the U.S. dollar on an intraday basis. Ultimately, it’s not a matter of if this relationship will end, but rather when. After the release of the U.S. Employment Report earlier today it appears these metals may have made a medium term top. Gold ran into the 38.2% retracement around $1355 – using the December All-time high to January 28th low, fell just shy of the 100-day sma at $1360 and formed an RSI negative divergence on hourly charts. Meanwhile, Silver has retraced a larger part of the Jan. 3rd to 28th decline – nearly reaching the 61.8% retracement at $29.35/40, however it too has seen an hourly negative divergence (but this is with Stochastics). Therefore, it may be in our best interest to take some profit while we still have it, and look to re-establish our bullish bias over the coming weeks at better levels. Be on the lookout for our bi-weekly “The Commodities Corner” updates under the latest research tab for more immediate precious metals updates.

U.S. growth outpacing Canadian growth

Following last week’s softer inflation data (BoC Dec. CPI Core printed -0.3% vs. expected -0.1%), USD/CAD rebounded from lows around 0.9900 to test above parity. The buck failed to hang on to gains against the Loonie, however, as Monday’s Nov. GDP release (+0.4% vs. expected +0.3%) suggested a Canadian economy continuing down the path of recovery. USD/CAD fell sharply from above parity but stalled just ahead of the 0.9800 figure (the lower end of our expected 0.9800/1.0800 Q1 2011 range) as the pair found decent demand around 0.9860 but remained range bound prior to Friday morning’s Canadian and U.S. employment data.

The release of Canada’s labor figures were quite confounding as the unemployment rate rose more than expected (+7.8% vs. consensus +7.6%)while the net change in employment for January printed higher (+69.2k vs. expected 15k). The Loonie made immediate strides against the buck which saw USD/CAD test lows around 0.9830. U.S. employment data paralleled Canadian data in terms of complexity but in reverse fashion – US unemployment declined more than expected while payrolls printed much worse. Later, the Ivey PMI for January came in at 41.4, well below forecasts of 53.2 and below the expansion/contraction level of 50. USD/CAD has been well bid since and is currently testing a weekly close back above the 0.9900 figure.

We think the failure to trade below key 0.9800 support may be constructive for USD/CAD for a number of reasons. Recent positive US data surprises suggest the US economic recovery is accelerating more rapidly than most had expected. The Canadian recovery, however, has seemingly stalled despite the slightly better than expected Nov. GDP print as export growth has been dampened by the relatively firm Loonie - ‘the cumulative effects of the persistent strength in the Canadian dollar and Canada’s poor relative productivity performance are restraining this recovery in net exports’ – BoC January Monetary Policy Report. Taking a look at yields, the Canada 2yr overnight curve is only 20 bps steeper than the US compared to spread highs around 100bps in 2010. This reflects the pessimistic outlook for Canada’s growth prospects relative to the U.S. which is also confirmed by the BoC - the Bank projects 2011 Canada GDP growth of +2.4% and U.S. growth around +3.3%. We agree with the central bank’s assessment and think a more rapid pace of U.S. growth relative to Canadian growth to likely lend support to USD/CAD above the 0.9800 figure.

Key data and events to watch next week

United States: Monday – Dec. Consumer Credit Tuesday – Jan. NFIB Small Business Consumer Confidence, Feb. IBD/TIPP Economic Optimism Wednesday – weekly ABC Consumer Confidence – Feb 4 MBA Mortgage Applications, Bernanke testifies at House Budget Committee Thursday – Weekly Jobless Claims, Dec. Wholesale Inventories, Jan. Monthly Budget Statement Friday – Jan. Monthly Budget Statement, Dec. Trade Balance, Feb Prelim. U. of Michigan Confidence

Euro-zone: Monday – Sentix Investor Confidence, ECB’s Weber speaks in Tallinn, ECB’s Mersch speaks at Luxembourg Event, German Dec. Factory Order Tuesday – German Dec. Industrial Production Wednesday – German Dec. Current Account, German Dec. Trade Balance Thursday– ECB Feb. Monthly Report, European Financial Services Conference in Brussels Friday – German Jan. Final CPI

United Kingdom: Monday – Jan. RICS House Price Balance Wednesday – Dec. Total Trade Balance Thursday – BOE Rate Decision, Dec. Industrial Production, Dec. Manufacturing Production, Jan NIESR GDP Estimate Friday – Jan. PPI Input & Output

Japan: Monday – Dec. preliminary coincident and leading index CI Tuesday – Dec. current account total, Dec. trade balance Wednesday – Jan. consumer confidence, Jan preliminary machine tool orders Thursday – Dec. machine orders, Jan. domestic CGPI

Canada: Monday – Dec. building permits Tuesday – Jan. housing starts Thursday – Dec. new housing price index Friday – Dec. international merchandise trade

Australia & New Zealand: Tuesday – Australia AiG performance of construction index for Jan., Jan. ANZ job advertisements, Dec. and 4Q retail sales Wednesday – Jan NZ card spending, Australia’s Westpac Consumer Confidence index Thursday – Jan employment change, unemployment rate Friday – NZ Jan food prices, RBA’s Stevens speaks before Parliament

China: Tuesday – Jan. HSBC Services PMI Wednesday – Jan. Trade Balance

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