Wednesday, June 11, 2008

Bob's Currency Focus

The dollar rallied to its biggest 2 day gain over the euro since 2005, thanks to dollar defensive comments on Monday from Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke. Paulson stated the US Administration had not ruled out intervention in currency markets to help halt the dollar’s slide, while Fed Chairman Bernanke, speaking in Boston on Monday night, upped his hawkish tone on inflation, leading futures markets to price in higher US interest rates for later this year. US economic data has yet to point to any justification for a rise in interest rates and the timing of Bernanke’s comments may simply be an attempt to halt the surge in oil prices, by way of encouraging a stronger US dollar. Thus far markets have taken him at his word, but we saw a similar move on Tuesday of last week after Bernanke stated the Fed was ‘attentive’ to the dollar, only for the Chairman to be upstaged by ECB President Jean Claude Trichet on Thursday, who dropped a bombshell about an imminent rise in euro area interest rates. Markets will be looking ever closer at economic data for an indication of which way the market should lean and tomorrow’s retail sales out of the US will be an important barometer, but of more importance will be Friday’s consumer price inflation numbers. Oil prices too need to be watched closely and if commodity markets push the price of crude higher, it will undermine dollar confidence and potentially lead to another sudden sharp decline in the US currency, almost without warning. US crude inventory data released on Wednesday afternoon will have a significant impact for the direction of oil prices for the remainder of this week. Range trading between 1.54 and 1.5550 is likely in the lead up to Thursday’s US retail sales data and if economic data, particularly the CPI numbers on Friday, favours the US currency, we could witness a test of key support levels below 1.53 before the end of the week. If oil prices soar, traders need to be on guard for possible market intervention (vocal at first), if EUR/USD returns back above 1.58. Aggressive dollar selling is dangerous in this environment, particularly with a G8 summit this coming weekend.

Cable took something of a battering on Tuesday, sterling losing a full 2 cents, as the UK currency retreated against a broadly stronger dollar. UK data has remained soft and the medium to longer term outlook for sterling is bleak, especially against the dollar. Sterling has held its own against the euro this week, but this is due to the fact the euro was sold off more aggressively against the US currency than sterling, rather than any shift in fundamentals. In fact the fundamental outlook for sterling against the euro has worsened for the UK currency, since last week’s ECB announcement of a pending rate hike in the euro area. Today’s labour data out of the UK revealed the claimant count rose for the 4th consecutive month in May and the unemployment rate ticked up 0.1% to 5.3%. Of more immediate significance is the GDP number for the 3 months to the end of May from the NIESR think tank group, which reveals a sharp slowdown in growth in the UK economy over the past month - GDP slowed to 0.2% from the 0.4% reported in the 3 months to the end of April. Sterling’s only real form of protection right now is high commodity costs, something which is keeping UK inflation rates elevated and preventing the Bank of England from cutting interest rates. But any sharp falloff in commodity prices will probably see sterling fall sharply against the dollar, as markets start to raise bets on pending rate cuts in the UK. Cable offers good sell down value on any prices over 1.9750 against the dollar, with the prospect of a challenge of the year’s lows around 1.9330 over the next week, while there is every likelihood the euro will return to over 80 pence sterling, although this is a more dangerous trade, given the potential for growing weakness in the euro economy.

Complacency has returned in major fashion as witnessed by a virtual collapse of the Japanese yen in recent weeks, at a time when equity markets have been slumping. Although Japan’s economy grew faster than any of the other G7 economies in the first quarter, the low-yielding yen has found itself out of favour as Central Banks notch up their hawkish rhetoric and threaten higher interest rates. The yen has fallen to a year’s low against the euro and to a 14-week low against the dollar with traders anxious to place bets on a widening of interest rate differentials on USD/JPY and EUR/JPY. A weakening yen is unlikely to deter Japanese authorities and it is most unlikely the Bank of Japan will follow the Fed and the ECB and threaten higher rates in the world’s second largest economy. The Bank of Japan deliberate on monetary policy this Thursday and while rates are certain to remain on hold, if the Bank’s Governor delivers a passive statement on the rate outlook, the yen will likely come under further selling pressure. However traders need to be very attentive to what is happening on equity markets and given the extent to which the yen has been sold off recently, there is every chance of a sharp correction higher if credit woes intensify. The G8 meeting this coming weekend could also destabilise currency markets, but it is certain the yen will not come in for any direct comment. If anything is said at the G8, it will probably be a call for a stronger dollar and this should push USD/JPY even higher in the short term. The yen is out of favour right now, but because of the danger of a reversal, it may be wise to avoid trading it. Buying on sharp dips on USD/JPY probably offers the best value trade currently, given the calls for a stronger dollar.

The decision to stand pat on rates surprised markets, although the switch to a more hawkish line by many of the world’s central banks over the past week meant holding rates steady was a safer play for Bank of Canada on Tuesday. The loonie got a timely boost and prevented the dollar from rallying towards the year’s highs at 103.70, while the Canadian dollar also gained a tidy 2 cents against the euro. It is difficult to see the loonie extending its gains much further, particularly against the greenback, because the rate outlook has shifted in the US currency’s favour following Bernanke’s comments earlier in the week. Commodity currencies have taken on a softer tone this week, with the Aussie and New Zealand dollars in retreat and falling below key support levels, so the loonie’s reprieve could be short-lived. Oil prices will remain a dominant factor in influencing direction and elevated prices will offer important protection, although any collapse in the price of crude will encourage a sell-off in the loonie, given the weak economic fundamentals emanating from Canada in recent weeks. We should range trade between 1.0120 and 1.0320 for now, but the risks are for a breakout to the upside, given the broader and firmer tone earned by the greenback in recent days. The loonie should be able to trade below 1.60 against the euro, with the possibility of a pullback to 1.56 before the end of the week. The value trade is to buy USD/CAD on dips towards 1.0130, with target prices of 1.0210, 1.0240 and 1.03.

Bob B - Jun 11

Monday, June 9, 2008

Woeful error of judgment questions credibility of the ECB

On June 5th last, Jean Claude Trichet shook the world’s financial markets when he made what now looks like being his bravest statement since becoming ECB President, when he boldly signalled to the world’s media the ECB may raise interest rates when they meet again in July. To be fair to Trichet his statement was merely echoing the sentiment of the ECB’s Governing Council which had just deliberated on monetary policy for the 15-nation euro economic block. Markets were taken completely by surprise by the remarks as most Central Bank analysts had expected the next move in ECB interest rates to be down, albeit much later in the year. While inflation is running at a 16-year high in the euro zone, the recent surge in consumer price inflation is not because of excess consumption or demand from a slowing economy and an increasing cash-strapped euro area population, but rather because of a spike in global oil and commodity prices. These commodities are priced in dollars and only a rebound in the US dollar or some major global demand destruction is going to curb commodity price inflation. As to how the ECB believed a direct threat to raise euro zone interest rates exactly at the time the US Dollar was attempting to steer a tentative path to recovery is a mystery, but the record jump in crude oil prices witnessed in the 31 hours following Mr Trichet’s bombshell, would suggest the ECB’s strategy has backfired rather spectacularly already. Oil prices jumped a staggering $16.50 during this 31-hour period, or 13.5%, with oil futures posting lifetime gains on both Thursday and Friday’s sessions. The euro jumped 4 cents against the dollar over the same period and rose to its highest level against the yen in a year and this on a week when eurozone economic data added to growing evidence of a sharpening downturn in the euro area economy.

Spain’s Prime Minister, this past weekend, was correct to question the wisdom of Mr Trichet’s remarks and he essentially blamed the ECB President for the spike in oil prices seen at the end of last week. The nature in which the ECB ignored and steamrolled comments made by Fed Chairman Ben Bernanke earlier in the week, about the benefits of a stronger US dollar, does not augur well for a coordinated effort by the World’s Central Banks to solve the global inflation problem, a problem which is fast becoming a crisis. The ECB’s glaring lack of insight begs one to question the relevance and comprehensiveness of the data models used by ECB staff in making projections used in advising the Governing Council in its decision making process. A rate rise now by the ECB means higher inflation for the euro area, given trends and the driving factors behind the recent rally in commodity prices and this should have been known in advance of last week’s ECB meeting. As evidenced last Thursday and Friday, monetary policy which translates into a weaker dollar in the current climate means a disproportionate increase in fuel and food commodity prices for everyone, including all euro zone citizens. Why did the ECB Governing Council ignore this in its deliberation? The second round inflation effects that so concern the ECB is certain to become a self-fulfilling prophecy, if first round inflation is merely being fuelled by calamitous ECB monetary policy. This policy could trigger a vicious cycle that sees the ECB having to hike again and ultimately not only send the euro economy into a damaging recession, but it could lead to a major divergence in performance of the constituent states of the euro area. A divergence in performance will lead to greater political sniping and undermine not just the ECB’s credibility, but its very independence.

The ECB may feel it will lose face if it now fails to follow through with a July rate hike, having quite clearly signalled its new-found ‘heightened alertness’ last week. However, in light of the rapid evidence we have seen of how commodity traders have shown their willingness to translate this ‘heightened alertness’ into ‘heightened price inflation’, it means if the ECB is to follow through with this ill-timed threat, it may well constitute the most serious ‘dearth of alertness’ ever displayed by an ECB Governing Council, one for which all euro area inhabitants could pay very dearly, for some considerable time to come. Many would ague they are already paying too much.

Ted B