Wednesday, February 27, 2008

Market Watch: US Inflation and Growth Disconnect

In recent days we have seen oil hit $102 a barrel or 100% higher than what it traded at this time last year, gold hit a record $964 an ounce Wednesday and copper rose to $387 a pound, up close to 30% this year alone. At the same time the US dollar index has hit a record low of 74.30, down almost 11% from the same time last year. One might legitimately ask why oil is twice the price it was last year if the world is gripped by an economic slowdown and why are copper prices shooting through the roof when new home sales in the US are at a 2-decade low? The US economy grew a paltry 0.6% year-on-year in quarter 4 and is probably close to negative growth this quarter, yet US headline inflation is running at 4.3% and yesterday US producer prices recorded their highest year-on-year increase since 1981. Normally if the economy slows, prices cool and inflation should soften. So what’s so different now?

1) Investors believe the global economy is sufficiently decoupled from the US economy that economic growth can prosper in Europe, Asia and the emerging economies, even in the face of a US recession. Investors have poured masses of speculative funds into hard and soft commodities which sent the prices of base metals, energy and food soaring over recent months, fuelling inflation.

2) The US Federal Reserve is largely acting in isolation in its aggressive attempts to ease credit tightening and stimulate economic growth. The resultant shift in interest rate differentials between the US and in particular Europe has seen the dollar plummet, meaning the cost of US imports has surged, pushing US domestic inflation higher.

3) Monetary policy easing (cutting interest rates) has the effect of stoking inflation and it is noticeable that the sharp run-up in commodity prices over the past 6 months has coincided with a new cycle of monetary easing on the part of the Fed.

4) There is no evidence yet of dampening demand in the US for oil or for food commodities despite the sharp increase in prices. The market seems determined to push prices to breaking point limit. The relationship between supply and demand has little bearing in establishing an equilibrium price in today’s commodity market. In the short to medium term, commodity prices are being driven by speculative interests.

What’s next?
1) Stagflation. The US is currently in a period of zero growth and increasing prices. The most worrying aspect is that this stagflation is widening - inflation continues to rise and growth stagnates. It could be the second half of this year before the US can breathe again. A ‘decoupled’ global economy would make it more difficult for the US economy to recover, because this would keep commodity prices elevated and make it more difficult for the Fed to cut interest rates further. In a decoupled scenario, were the Fed to ignore price stability and continue to cut rates, it could tip the economy over a more precarious edge.

2) The euro. US inflation is being driven by a weak dollar and unless the greenback stabilises or strengthens against the euro, this situation is likely to get worse. The ECB’s view of the world is different to that of the Fed and the ECB is against cutting interest rates in the current environment. As long as the euro is appreciating against the dollar, investors will feel justified in pouring more speculative funds into commodities, thus pushing up the dollar price of oil, copper, corn etc. and forcing higher inflation, particularly in the US. We are close to the point where direct market intervention on the part of Central Banks to prop up the dollar is close to being on the agenda. The level of dollar depreciation seen in recent days is not sustainable in the longer run and while the sell-off continues, the disproportionate rise in commodity prices is compounding the inflation risks in every major economy, not just the US.

3) The flu. The decoupling theory may not hold true and it may well be the case that the US is simply at the front-end of a severe global-wide economic slowdown. There is plenty of soft data emanating from Europe, the UK and Japan to back up this theory. The US has sneezed and while officials elsewhere have been slow to react, it is only a matter of time before we see a sharper deterioration in the health of other major economies. This will cause a serious rethink and lead to a cooling in commodity prices, which will ease US inflation. In this situation look for a strong bounce in the dollar.

Ted B - Feb 27

Tuesday, February 26, 2008

Bob's Currency Focus - 19:00 GMT

The dollar tanked across the board Tuesday and the euro is now within reach of the lifetime high at 1.4966. The pair currently trades above the key 1.49 line. So what has changed to bring about this situation? The euro got a boost from Germany’s Ifo business survey for February which surprised to the upside and suggests the German economy at least remains resilient in the face of a US slowdown. Stock markets appear to have grown immune to bad news and are ready to rally on any hint of a positive. This increase in risk tolerance is resonating through currency markets with the dollar being targeted because of its negative rate outlook, versus the euro in particular. A rate cut by the ECB is off the agenda for the foreseeable future, following today’s Ifo report. US data again disappoints with consumer confidence hitting a 5-year low in February, producer prices increasing by twice the forecast in January and house prices falling by the most in 2 decades in December according to the most recent Case Shiller report. The euro looks poised to once again take on 1.4966 and attempt to vault the 1.50 price handle. Its chance may come on Wednesday, if Fed Chief Bernanke, in his testimony to the House Monetary Policy Panel, signals further aggressive rate cuts may be on the way. There is no value in buying the euro at present prices, given it is at a price level from where it had failed to progress on 3 previous occasions. Dollar sentiment is so negative right now it is difficult to see where a downside rally is going to come from. It will most likely take a rise in risk aversion and a downturn in stock prices to trigger it. Strategy: Sell down on prices close to 1.4930, but place a stop loss above 1.4966. Hold other short positions, in anticipation of a reversal.

Cable has advanced to 1.9850 as the pound seized on broad-based dollar weakness to push the pair close to the year’s highs, which are around 1.9957. UK economic data printed weak though it got lost in a cloud of dollar gloom. Total Business Investment in Quarter 4 was a negative 0.5%, against a 0.9% gain in quarter 3. The CBI Retail survey for February posts a sharp decline in confidence by retailers and signals there are difficult months ahead for the retail trade. Cable’s ability to reach 1.9957 may be dependent on the euro hitting 1.50 against the dollar. If the euro prevails it will spark a fresh bout of dollar-selling which will benefit the pound and should see cable return to the 2 dollar mark. I remain bearish on sterling but prefer to see the current dollar sell-spree pass before getting too involved in the market. Cable has now rallied 5 cents from last week’s low and it is difficult to see it going much higher on fundamental grounds. Comments today from the Bank of England’s Rachel Lomax were generally supportive of sterling – she intimated the Bank’s hands may be tied because of rising inflation. However if data continues to disappoint, markets will price in expectations of further rate cuts. The rise in risk tolerance is protecting sterling against the euro, as traders pour money into the higher-yielding pound and EUR/GBP should be able to slide to 0.75 in the short-term, so long as the interest in carry trades persist. Cable should be able to hold below 1.9957 bar another dollar collapse and a sell down on prices near this price would seem to offer the best value. Other short positions should be held in anticipation of resumption to the downside. Strategy: Sell cable on prices close to 1.9957 with downside price targets of 1.9730, 1.9670, 1.9605, 1.9550 and 1.95.

The yen has held up remarkably well Tuesday as currency markets have been dictated by dollar weakness rather than preference for riskier assets. The yen has gained over 70 pips against the dollar and has held its own against the euro, though the single currency is again trading above the key Y160 price line. The only major currencies the yen has lost ground against today are sterling and the Canadian dollar. Stocks have now rallied strongly over most of the past week and may be due a reality check, i.e. correct downwards, something which would benefit the yen. Wednesday will be an important day for the immediate direction for the yen, because if stock markets react negatively to Ben Bernanke’s semi-annual testimony on monetary policy, the yen will be the principal benefactor. It is not worth selling the yen ahead of tomorrow’s speech, particularly as a capitulation by the dollar against the euro (to 1.50) will also trigger a sharp pullback in USD/JPY. I recommend avoiding the yen for the present, because we are at a critical juncture across currency markets and the yen’s direction will very much depend on the immediate fate of the dollar.

Every USD/CAD bull on earth is wondering what has hit them in the past 36 hours. It was not outlandish to have expected a rise to 1.03 this week as we look ahead to an expected rate cut from the Bank of Canada next Tuesday. Instead we have seen as sharp a reversal as the market has ever witnessed with the loonie soaring by 3% and 3 cents in under 2 days. We cannot put it down to US dollar weakness because the loonie has also surged by over 2% against every other major currency, including the other commodity currencies. There was no economic data out of Canada and the Bank of Canada members due to speak today had not even uttered a word before USD/CAD had collapsed to 0.9850. Would day traders really buy the loonie in such volumes in the absence of data and days before an expected rate cut? No! It is a very curious market move and borders on the ridiculous. We have witnessed similar moves in the recent past of course, something which makes shorting the loonie an occupational hazard. Liquidity involving the loonie poses very serious questions at times like this and logic is very much out the window. A return to over $100 oil prices will help justify a strong loonie, but the currency is trading well above its real value. Wait for a bottom in USD/CAD to form before entering the market again. There may be an attempt to take out the December low at 0.9855. Strategy: Wait!

Bob B - Feb 26

Monday, February 25, 2008

Bob's Currency Focus - 18:00 GMT

The pair continues to trade within a narrow range Monday as the market is uncertain about price direction. There is a reluctance to push the euro towards the lifetime highs in the absence of major economic data or Central Bank policy updates, while by the same token the dollar is failing to attract any meaningful support and the negative sentiment that dogged the currency from the middle of last week still remains. We will need to see a break out of the current 1.4760 to 1.4860 price range to get an idea of where the pair may be headed through the remainder of this week. There are several speeches from Fed officials this week, including the Fed Chief’s semi-annual testimony in front of the Monetary Policy Committee on Wednesday. This will need to be monitored closely. US January existing home sales came in slightly higher than expected, 4.89 million Vs a forecast 4.80 million, and it has raised some hopes the housing crisis may be near a bottom. Stocks rallied in the immediate period following the news. A sustained rally in stocks this week will tend to support the euro in the short-term, as traders focus on interest rate differentials and yield. Germany’s February Ifo Business Survey is a risk for the euro Tuesday, but only if the index falls well below expectations. I still do not see any value in buying the euro at present levels and believe there is good value in selling down on prices close to 1.4850. Strategy: Sell on prices near 1.4850 with limit targets of 1.4780, 1.4755, 1.4730, 1.47 and 1.4660.

Cable has held firm Monday, the pound holding onto the 3 cent gain it made since last Wednesday. 1.97 is proving difficult to break and unless we see broader deterioration in the dollar over the next few days, the pound will struggle from here. Direction this week will be determined by sentiment towards the US currency and the pound will find it difficult to attract strong support, with traders having one eye on the Bank of England meeting next week. There are no genuine market-moving economic releases in the UK this week, although any decline in house prices from the Nationwide survey or a fall-off in the Gfk consumer confidence index, both released later in the week, will undermine the UK currency. There is definite value in selling cable down on prices above 1.97, with a distinct chance of a quick return to 1.95 over the coming days, especially if risk aversion levels are elevated. Meanwhile a poor Ifo survey result from Germany Tuesday could plunge EUR/GBP back below 0.75. Strategy: Sell cable on prices around 1.97 with downside price targets of 1.9605, 1.9555, 1.95 and 1.9460.

The yen sold off sharply from the moment markets opened Sunday night with risk-taking and the carry trade back in vogue, thanks to Wall Street’s strong reversal to the upside late Friday. The euro has gone above Y160 Monday, while the dollar briefly returned to above Y108, having gone as low as 106.70 Friday evening. There is a high degree of complacency creeping back into the market, with traders determined to back currencies on the basis of yield, but traders need to be alert to a sudden shift in risk, which could trigger a sharp rally for the yen, particularly against the euro. The euro does not offer any value at Y160, even if it manages to consolidate above this in the short-term. The dollar is very well supported below Y107 and offers a good buy opportunity on prices below this level. Strategy: Buy USD/CAD on dips to 106.80 with upside price targets of 107.50, 108 and 108.30.

If anyone truly knows the reason for the loonie’s monumental rally today, against every other currency, then you might share your insight with us please. It is totally inexplicable from a logical perspective. There was no economic data out of Canada and commodity prices are generally softer today. There must have been a single movement of funds somewhere to explain today’s move, because based on the recent trend and on economic events, both recent and future, the loonie should be in retreat this week. The Bank of Canada is expected to cut rates when it meets next week on Mar 4. There is no domestic data of influence ahead of Friday, when the Qtr 4 current account balance is released. The best way to look at today’s downside move in USD/CAD is that it represents a buy opportunity. It is difficult to see the loonie staying on the right side of parity against the greenback with a rate cut imminent within the next week. There are two speakers from the Bank of Canada tomorrow testifying on the impact of the Canadian dollar on the Canadian economy and this represents immediate downside risk for the loonie. Strategy: Buy USD/CAD on dips to 0.9960 with upside price targets of 1.0050, 1.0120, 1.0170, 1.0190 and 1.0250.

Bob B - Feb 25