Monday, July 7, 2008

Bob's Currency Focus

The euro fell to 1.5610 early Monday as the knock-on impact of the ECB’s more dovish than expected statement last Thursday rolled into Monday, leading to a further liquidation of euro long positions. Monday’s economic releases did not help the euro with Germany’s Industrial Production declining by 2.4% in May, the steepest decline in 9 years, against a consensus rise of 0.5%. Recent economic data out of the euro area has been very poor and the only reason the euro has held up is because of the hawkish stance of the ECB. If euro zone economic data continues to reflect a sharpening slowdown in economic activity, the ECB’s rate hike last Thursday could begin to look like a serious error of judgement and could lead to a longer run sell-off in the single currency. In fact with commodity prices at risk of a sharp decline owing to the global economic slowdown and US interest rates almost certainly at their nadir, the medium to long-term outlook for the euro over the next 6-9 months does not look particularly bright. The euro may have peaked at 1.6016 and current prices around 1.5650 would appear to offer very good medium term value, even if the euro has come off sharply in the past few days. There looks to be no reason why EUR/USD will not now retreat to test key support levels around 1.53. This is a data light week on both sides of the Atlantic and direction will be influenced more by scheduled statements from the G8 and Fed Chief Ben Bernanke than by economic data. Oil prices will continue to play a dominant role and any further rise in oil prices will be seen as a reason to sell the US currency. The G8 has been pretty much ineffective in the past in dealing with the oil/dollar crisis and it may be wishful thinking to expect anything from the Japan summit of the leaders of the 8 largest economies. Indeed a return to the usual mantra of the requirement for oil producing nations to support increased oil production will likely be laughed off by financial markets and rather than leading to support for the dollar, it may well undermine it. There is value in selling down the pair on prices close to 1.57, with the potential for a return to 1.55 or even 1.54 over the next week. Watch out for Bernanke’s speeches on Tuesday and Thursday as these are likely to be the most important events of the week. Unless the Fed Chief signals an intention to raise interest rates to offset rising inflation, the dollar will not be aided.

Sterling is coming off the worst 2 weeks of economic data we have seen in years, with one report after another signalling a sharp downturn in the performance of the UK economy. Soft data has not been restricted to the housing sector, with economic activity in the manufacturing and services sectors entering contraction in June while the retail sector also comes under pressure. Sterling rose to 2 dollars against the dollar last week as traders speculated the Bank of England might raise interest rates to stave off the rising threat of inflation. This inflation however is commodity-driven and is outside the influence of the Bank of England and there is zero chance the MPC will move to raise rates when they meet later this week. This realisation has finally sunk in with markets and this morning the pound slid to below 1.97 against the greenback while the euro rose to above 79.5 pence. The Bank of England would normally be rushing to cut interest rates in an environment where growth is flat or negative but feel constrained by inflation concerns. In this environment the UK slowdown is only likely to become more pronounced and the medium term outlook for sterling is bleak. The Bank of England may feel forced into cutting rates, even while inflation is rising, as the Fed has done in the US, gambling that commodity prices are likely to retreat in the medium term. Mervyn King has not sown the inclination to be so creative in his policy thinking, so expect a wait and see approach this week and the Bank of England to stand pat on rates. Cable should be heading back to test the lower end of the trading range at 1.94, so it is still worth selling down on prices close to 1.97. There could be a lot of volatility this week, while any retreat in commodity prices will prove to be negative for sterling as it will relieve inflation pressures and make it easier for the Bank of England to cut UK interest rates. The euro will struggle to climb much above 80 pence against the pound, in the absence of any signal from the Bank of England to ease rates.

The yen is the worst performing of all the major currencies Monday as markets use the pick-up in stocks and rumours of a G8 reference to the need for a strong dollar as a reason to offload the low-yielding Japanese currency. The yen may struggle in the short-term in a situation where G8 leaders might issue some coordinated statement on the dollar and commodity prices, as the impact could lead to a rise in stocks and risk tolerance that would undermine the yen. However, expectations from the G8 summit are probably exaggerated, particularly with respect to any direct reference being made to the dollar, and any resultant disappointment in markets could see risk aversion rise again and lead to the yen recovering somewhat against the dollar and the euro. Domestic data will not have any significant impact on the direction of the yen during this week. The euro is clearly massively over-valued against the yen at prices over Y168 but it is difficult to see the trend being reversed in the immediate term unless there is some sustained downward move against the single European currency. The only currency offering value against the yen at the present time is the US dollar and that is only on dips back towards the Y105 price level. Stock market performance will need to be monitored closely over the coming days as will the scheduled speeches from Fed Chairman Ben Bernanke.

The loonie has continued its see-saw battle against the greenback over the past week and the pair remains pinned in a 1.0050 to 1.0250 price range, offering the most lucrative range-trading pair of all the majors. Soft economic data and concerns over the country’s sagging growth are preventing the loonie from getting away while equally soft economic data from the US and rising commodity prices continue to prevent the greenback from making a decisive move. The medium term outlook would tend to favour the US currency given the risk of a sharp correction in commodity prices, while any signal from Ben Bernanke that US interest rates are destined to rise could see the upside gain in the short run. Next Friday’s employment data out of Canada will be important although only a sharp decline in the employment total is likely to lead to any meaningful rally on either side, to the upside in this case for USD/CAD. In the unlikely event the G8 meeting results in some coordinated effort that sees in a retreat in commodity prices, then the loonie would also come under selling pressure. For now, expect the loonie to range between 1.01 and 1.03, with the value trades being bids on prices nearer to 1.01. The loonie could extend its rally this week against the euro, given the ECB has signalled a pause in interest rates and the euro could retreat to 1.58 at least against the Canadian currency.

Bob B - 7th July 2008

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