Wednesday, May 7, 2008

Bob's Currency Focus

This week is relatively quiet in terms of key data and the main event is Thursday’s ECB meeting. While rates are certain to be kept on hold, markets will be looking for any shift in tone from the Bank’s monetary policy committee in the accompanying release. We have witnessed deterioration in the performance of the euro economy in the past month and while the Committee may point to further downside risks to growth, any such reference is likely to be offset by a hawkish statement on inflation. The ECB is not likely to let its guard down at a time when oil prices are trading at $122 a barrel and Euro zone inflation remains elevated at 3.3%. Euro area retail sales in March disappointed yet again coming in negative both on the month and on the year, while German factory orders also declined surprisingly in March. The euro has dipped sharply back to 1.5410 from the high of 1.5595 hit on Tuesday and the dollar looks poised to test key support at 1.5350, unless Thursday’s ECB statement is seen as providing additional hawkish bias. The euro is currently capped around the 1.56 price mark and the downtrend looks set to continue as long as the pair remains below this key price level. The catalyst for a further leg down in the pair could be oil prices. If crude oil sells off sharply, it will renew interest in the dollar and this could trigger a move to 1.5280 in EUR/USD. It is best to sell on prices close to 1.56 at present, with target prices of 1.5430, 1.54, 1.5360, 1.5341 and 1.53. Traders need to be cautious on Thursday because recent history has shown us that hawkish ECB statements tend to trigger strong short-term rallies for the euro.

I called it last week when looking for a sell-off on cable and today the pair fell below the critical 1.96 support line, a price level which has held for the past 2 months. With the Bank of England meeting Thursday and sterling coming off the back of a string of weak economic indicators, the pound could dip to 1.94 against the US currency over the next 2 days. Tuesday’s services PMI signalled the UK services sector grew at its slowest pact in over 5 years and on Wednesday there was the print of negative industrial and manufacturing output numbers for March. Sterling has been protected to some degree in the past few weeks by fresh concerns over the euro economy and a revival in stock markets, something that has drawn temporary funds into the high-yielding pound. On Wednesday however the euro rose back above 79 pence, although it has since dipped below this level once again. There is an outside chance of a rate cut from the Bank of England on Thursday and sterling will struggle to attract buying support between now and 12 noon tomorrow. With 1.96 support having given way on cable, the bias certainly favours the downside and cable should be sold down on any rallies towards 1.98. Sterling risks a retreat to 80 pence against the euro this week.

The yen retreated across against the dollar Wednesday as a pick-up in stock markets led to a sell-off of the low yielding yen and Swiss franc. The carry trade has moved with a vengeance in recent weeks and today AUD/JPY is trading just below Y100, having been as low as Y87 just 6 weeks ago. Weak economic data is failing to put a dent in risk appetite as investors believe the worst in the financial market crisis is behind us. A slowing global economy has failed to dampen investor demand for commodities and it is this which is driving the current wave of support in the carry trade. There is a major disconnection however between the economic fundamentals and the prices of many asset classes and the current move away from the Japanese yen could prove to be premature. The yen will need a significant downturn in global stock indices to trigger a sustainable rally, but until this happens the currency will remain vulnerable. The US dollar will struggle to break above Y106, but the best value in terms of buying the yen remains against the euro, with any advances towards Y165 offering medium term sell-down value.

The loonie has been the strongest currency amongst all the principals this week, making significant advances against all the major currencies. The move has been primarily driven by runaway oil prices, although Tuesday’s IVEY PMI reading, which printed higher than expected, was also a welcome boost. It is difficult to see the loonie sustaining any break below the parity level against the greenback, particularly as the Fed signalled a pause in US interest rates last week. Any falloff in the price of oil could trigger a sharp reversal and see the greenback rise back towards 102 in the next day or two. The loonie is also vulnerable to a sharp correction against the euro, with the ECB meeting on Thursday likely to see the Bank’s monetary policy committee reiterate its hawkish stance on euro zone inflation and interest rates. There is definitely value in buying EUR/CAD around the current price of 1.5450, while the greenback offers real value on prices close to parity against the Canadian currency. Oil prices will be the principal driver of the loonie through the remainder of this week.

Bob B - May 7