Friday, June 27, 2008

Bob's Currency Focus

Negative sentiment against the dollar hit fever pitch again over the past few days as the Fed’s rather indifferent approach to rising inflation in their monetary policy deliberations this week led futures markets to pare back expectations for future interest rate rises in the US. The dollar has got it in the neck and oil has risen to a fresh lifetime high, close to $142 a barrel. Bernanke’s credibility has been seriously undermined by recent events with the Fed Chairman seen as talking tough but lacking the conviction to follow through on his words. US stock markets are plunging in recent weeks, primarily thanks to the rash policy decisions taken by the Fed over the course of the past 9 months. If the Fed hadn’t handed the ammunition to commodity traders to more than double the price of oil over the 9 month period of its aggressive rate easing cycle, the US industrial averages might not now be facing their worst monthly performance since the age of the Great Depression. While the Fed may be dithering on inflation, the ECB’s bold determination to signal an imminent rate hike a few weeks back, could come back to haunt the Governing Council. Since that statement from ECB President, Jean Claude Trichet, euro zone economic data has pointed to a marked slowdown, with both the manufacturing and services sectors falling into contraction in June and with consumer and business confidence plummeting across the entire euro area. Add to this the fact euro equity bourses have nosedived, a euro which is rising on ECB rate expectations rather than growth fundamentals and all in all you have a situation where one would believe it is the least opportune time for Mr Trichet to announce a rate hike. However, the ECB is likely to be true to its word and we should expect euro zone interest rates to rise 0.25% to 4.25% next Thursday.

The euro is close to the recent resistance line of 1.5840 and barring some sudden reversal, this should come under threat, possibly by as early as Monday. There are some data risks for the euro next week, but on Monday, we have the CPI flash estimate, which is likely to come in at or above June’s record 3.7% rate. If it does, it will more or less seal a rate hike from the ECB next Thursday. If we see further deterioration in the manufacturing PMI (Tuesday) and Services PMI (Thursday), both of which contracted in June according to the preliminary readings, it will put added pressure on the ECB to soften its approach on Thursday. This ECB is particularly hawkish though and it is difficult to see them swaying too much from their recent tough stance, given repeated references by members of the committee to the fact the ECB’s sole mandate is to stem inflation, not to stimulate growth, as is the dual mandate of the Fed and the Bank of England. Traders need to be on the lookout for comments on currencies next week, because of the dollar’s fragile market status and runaway oil prices. Central Bank intervention is most unlikely while the Fed and the ECB are adopting opposing strategies in their respective battles with rising inflation and declining growth. The euro will be vulnerable to a sell-off on EUR/JPY if risk aversion levels remain elevated, while a ‘done and dusted’ policy statement from the ECB would also undermine the single currency, given the extent of gains achieved on the back of a very tough ECB stance. It is dangerous to buy the euro on levels close to 1.58, given all the risks, even if there is a chance of a short-term rally higher. Weak economic data out of the euro zone, some of it very significant, has failed to hold the euro back over the past 10 days, but eventually it will come home to roost, particularly if followed by further soft data next week.

Sterling has got a timely boost over the past week, just at time when it was being written off. The pound has benefited from a broader collapse of the dollar this week, as well as uncertainty about the euro economy, which has helped fuel a flow of funds into the UK currency. While GDP for quarter 1 was revised down to 0.3% from 0.4%, the current account deficit narrowed sharply during the same period, surprising analysts. The principal reason for sterling’s recovery however has been the Bank of England’s shift in emphasis from growth to inflation, which has markets anticipating the next move by the MPC may be to hike rates. This has helped to attract a new wave of investors that are seeking higher yields, with the 5%-earning pound a favourite once again, if just for the short-term. Ongoing stresses in the housing sector and concerns over activity in the manufacturing and services sectors is likely to prevent frantic buying, although cable now has every chance of hitting the 2 dollar line, ahead of the big-hitting economic releases from Tuesday of next week. It is almost certain UK interest rates will be held at 5% when the MPC delivers its latest policy announcement on Thursday, and the pound’s immediate fate will depend on the fate of the dollar and what the ECB does next week. As long as cable remains above 1.98, an upside bias remains, for now, but that could revert very quickly and cable could find itself back in the middle of the recent trading range (1.94 – 1.98) before the Bank of England even delivers its statement next week.

The yen broke down several price barriers over the past 24 hours as the Japanese currency has been a principal benefactor of the sudden rise in risk aversion and the market attack on the US dollar. The USD/JPY pair has fallen as low as 106.10, down from the 108.20 it was trading at early Thursday. With the Dow plunging 3% on Thursday evening and oil rocketing to record prices, traders are beginning to offload short yen positions. If the unease continues, the yen could gain appreciably, given the exaggerated price levels which still exist on the EUR/JPY and AUD/JPY carry pairs. News out overnight reveals inflation rose the highest in 10 years in May and while an annualised rate of 1.5% is unlikely to frighten too many traders, it does leave options open for the bank of Japan, if the Bank wished to hike interest rates later in the year. Trading on the yen will continue to be volatile and any sign of a return to stability in stock markets will see the yen quickly fall out of favour. It is dangerous to sell down EUR/JPY ahead of the ECB meeting next Thursday, while there may be some value in buying USD/JPY on dips, when US stocks show evidence of a recovery. The wise move may be to wait until the current downside probe has run its course, however long that might take.

The loonie has hit fresh highs against the dollar on Friday, taking advantage of a weak dollar and spiralling out of control oil prices. All of the commodity currencies have performed remarkably well, despite the rise in risk aversion over the past few days, but there is an ever-growing opinion that the oil price spike is primarily a bubble and were it to prick at any time, the loonie would have most to lose of all the major commodity currencies. We could see the Canadian currency try to take out the parity line later today, especially as the USD/CAD pair has looked decidedly bearish over the past 2 weeks. Oil prices will continue to form an important support for the loonie, even in the wake of soft economic data. A break through parity could see the pair fall to take on support at 0.9970, where a further break could trigger a sharp retreat to 0.9920. The dollar needs to reclaim the 1.01 line quickly and push the pair past Thursday’s high of 1.0140, if it is to regain any sort of upside momentum.

Bob B - Jun 27

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