Thursday, July 10, 2008

Bob's Currency Focus

The euro has performed remarkably well since last Thursday, when it shed 2 cents against the dollar after a less hawkish than expected monetary policy statement from the ECB. The pair has moved within a 1.5610 to 1.5750 trading range since Friday and if anything, the euro has looked the more bullish, with the market seemingly ready to jump on any reason to offload the dollar. An Iranian missile test Wednesday morning saw oil prices stall their recent decline and this has given a bearish tone to the greenback. Poor trade and industrial data out of Germany and France was ignored by markets. German exports fell a sharp 3.2% in May, from April, the 3rd month in 5 that exports have contracted, while the French trade deficit for May was wider than forecast and industrial production came off by a whopping 2.5% in May. The euro’s ability to shake off poor economic data is becoming too much of a habit of late and it is a classic case of nervous currency markets favouring directional trends over economic facts. The US dollar has been unable to sustain any rally it has undergone all year for very long and dollar bulls are proving themselves to be fear-driven creatures, jumping off the train at the slightest hint of weakness or price stalling. The G8 concluded in Japan with leaders failing to make any mention of the weak dollar, something else which has in essence given license to traders to sell the US currency without fear of market intervention. ECB President Jean Claude Trichet, in his address to the European Parliament on Wednesday, sounded much more hawkish than he did last Thursday after the rate setting meeting, and this encouraged further euro buying. The euro currently stands at 1.5710 and while there is little value in buying the single currency at these prices, any rally above that sees price go above 1.5760 might generate greater momentum and send the pair back up to 1.5820. The pair is due a retreat back to 1.55 at least, but the dollar needs something to spark the move. Bernanke addresses Congress on Thursday and any hint of a future rate hike in his testimony will fuel a strong dollar rally. There is very good medium term value in selling down EUR/USD on prices near 1.5750, because of the significant downside risks for the euro economy in the months ahead and the fact the ECB’s growth forecasts may prove to be over-optimistic.

Sterling has bounced off a low of 1.9672 Wednesday to rally to 1.9836 against the dollar early Thursday, before retracing back to 1.9750. UK economic data disappointed again this week and sterling’s rise has more to do with a broadly weaker dollar than a stronger pound. The Nationwide consumer confidence survey for June reported another dip in consumer sentiment, the index falling to 61 from 65 the previous month, while HBOS reported house prices fell 2.0% alone in June. In addition the UK trade deficit was reported to have widened to £7.5B in May, marginally above expectations. Data out of the UK over the past 3 weeks has been depressing and points to an economy that is teetering on recession. However, sterling has hardly budged during this time and if anything it is now trading higher as traders bet the BoE will not cut rates while inflation is a threat and markets have priced in an actual hike in the coming months. In a normal economic cycle, the pound would now be pummelled, but the currency is currently evading collapse because the Bank of England’s hands are tied and traders are opting to persist with sterling because of its attractive yield of 5.0%. The MPC on Thursday, as expected, left rates unchanged and the Committee refrained from issuing an accompanying statement. Markets are currently rewarding higher yielding currencies, regardless of economic data and outlook and in this scenario sterling is likely to hold within current ranges, although there remains the risk of speculators going after the currency in the near future, because of the dismal economic picture in the UK. The dollar must break below 1.9650 to have any chance of pushing the pair back to the lower end of the range and the year’s lows under 1.94, otherwise the pair may well move between 1.97 and 2.00. The value trades are selling down on prices above 1.98. Sterling should be able to hold the euro below 80 pence, unless there is some hint of monetary policy easing from the Bank of England.

The yen is lower against every major currency on Thursday even though equity markets plunged in New York on Wednesday evening and the European bourses are trading between 1% and 2 % lower on Thursday. This apparent disconnect is the strongest evidence available that investors are now more concerned about yield than they are about growth and currency risk. The euro is trading close to its lifetime high against the yen even though European equities have collapsed over the past 6 weeks and economic data out of the euro area has been significantly sifter than that out of Japan. The carry trade seems determined to march on and the only event that might undermine it at the moment is if there is a sustained and convincing retreat in commodity prices, or evidence of a another major bank failure. It is fruitless buying the yen in this environment and the value trade is to buy the dollar against the Japanese currency on dips towards 105 and below 106. If Ben Bernanke’s testimony in front of Congress on Thursday gets the thumbs up from US stock markets, expect the yen to face another sell-off later today.

The loonie had one of its best days in weeks against the greenback on Wednesday, gaining almost a cent, although it failed to penetrate below the 1.01 line. Broad dollar weakness and a bounce in commodity prices helped the loonie gain some impetus. Housing Starts in Canada came off slightly in June, but were I line with forecasts and the data underscores that Canada’s housing sector is essentially free of the financial crisis currently ravaging the US housing sector. The loonie is likely to remain contained within a 1.0070 to 1.02 price range until Friday’s employment report. Another positive employment report could help push the loonie higher against all other currencies, especially if oil prices continue to trade at elevated levels, while a negative employment number could spark a significant sell-off and see USD/CAD return to 102.50 at least. If data is in Canada’s favour, look for the euro to drop to 1.58 by week’s end.

Bob B - Jul 10

Tuesday, July 8, 2008

The BoE is in the horns of a dilemma

The Bank of England is meeting this week to deliberate on monetary policy, at a time when the UK economy looks to be slipping into a steeper downturn, while inflation is rising to new highs thanks to rocketing oil and commodity costs. It is only a few months since markets had been pricing in up to 3 further rate cuts this year, but that position was reversed when inflation bubbled back above 3% in April, then hitting 3.3% in May. The inflation rate is likely to register higher again for June when the numbers come out later in the month. Markets suddenly began pricing in rate hikes over the past month with many analysts predicting it would come as soon as this week. But in the past fortnight economic data has revealed an acceleration in the downturn of the UK economy, with the manufacturing, services and construction sectors all contracting in June, while confidence amongst consumers and businesses alike are at rock bottom. It is difficult to see how the Bank of England can raise interest rates against this backdrop, unless they wish to push the economy into an even sharper downturn and into recession.

The Governor Mervyn King has recently admitted that rising inflation is owing to spiralling costs of imported oil and commodities and short-term adjustments in interest rates is not going to alleviate this problem. What the Bank will need to determine is if an interest rate hike would be successful in anchoring inflation expectations and might ward off potential second round effects, where unions are demanding higher wages from employers. But with economic growth grinding to a halt, it is likely the labour market will soften over the next 2 quarters and wage inflation should not be an issue. Also, while inflation may rise higher in the coming months until such time as there is a stabilisation or a decline in commodity costs, inflation should moderate accordingly from the middle of next year. Indeed there is every prospect that commodity prices could collapse, given the stagnant state of the global economy and in this situation inflation could begin to decline sharply from the middle of next year. It would be totally irresponsible of the MPC of the Bank of England to raise interest rates to combat an inflation threat they largely have no control over. Indeed the MPC would be better served to coordinate actions with other major Central banks who find themselves in exactly the same dilemma. The diversification in polices of the ECB and the Fed serves to remind us no coordination currently exists.

The ECB went it alone and decided to raise interest rates last week, but economic data from the euro zone in the coming months could indicate that the ECB’s decision to tighten now was a huge mistake. In any event recent economic data out of the euro area has not been as soft as that out of the UK, while the euro economy significantly outperformed the UK economy in the first quarter of 2008, the last period for which comparative GDP data is available. Therefore, the Bank of England is not under undue pressure to follow the precedent set by the ECB.

The Bank of England is clearly not in a position to raise interest rates in the current climate and in fact there should be considerable more airing for an argument to cut them this week, than there was a month ago, even allowing for the subsequent rise in consumer price inflation. It seems certain rates will be kept on hold, given all of the risk and uncertainty currently surrounding growth and inflation. A brave decision would be to take a leaf out of the Fed’s book and to cut rates, to help stimulate growth at a crucial time for the economy, on the assumption that longer run inflation will be forced to moderate anyhow as the economy slows. Either way, markets should be on the lookout for comments from Bank of England committee members in the days after the meeting, because business and consumers alike will be looking to the Central Bank for some words of wisdom or reassurance, at a time when economic growth is deteriorating at an alarming pace. It is not beyond the bounds of possibility the MPC will break with normal tradition and issue a more detailed statement this week, even if rates are kept on hold, in an attempt to more promptly address growing fears about the state of the economy.

Sterling should continue to hold its own against the euro and the dollar, trading within recent ranges, while markets continue to rule out the possibility of rate cuts. But any sustained move against commodities will tend to undermine the pound because a relaxation in energy and food costs would make the Bank of England a certain candidate to then ease its monetary policy in the months ahead. This week’s MPC meeting could prove to be a non-event for the currency, if, as expected, rates are left on hold and the Bank does not issue any detailed statement. There is serious downside risk for the currency over the medium to longer term.

Ted B - Jul 8

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