Tuesday, August 12, 2008

Bob's Currency Focus

EUR/USD Review
We have witnessed one of the most remarkable dollar rallies in recent times over the past couple of weeks, as the greenback has made record gains against most of the other major currencies. There has been virtual meltdown in GBP/USD and AUD/USD in the past 10 days, while the euro itself is now trading over 11 cents below the high it hit against the dollar in early July. The euro shed 4 cents alone in a 24 hour period into last Friday. The sharpness of the move has taken many in that market by surprise, but what is even more surprising is the fact that it does not appear to be justified by any major shift in economic fundamentals. There are a number of reasons for the strong rally at this time:

1) Liquidity seems to have been drained from the currency market at the moment (August holiday factor) and it does not take big volumes to shift currencies. With the trend already having shifted to the greenback a fortnight ago, the drop in liquidity is allowing exaggerated market moves, which is disproportionably benefiting the dollar. The dollar is so significantly overbought that a corrective reversal could easily manifest in a 5 cent rally in the other direction.

2) The sustained drop in commodity prices is resulting in a direct flip of trades that had worked for major funds in the first half of the year, with oil, gold, commodity currencies and EUR/USD being the big losers. Those who believed oil prices were a simple consequence of supply/demand issues are now nowhere to be seen as the speculative bubble that oil prices had become bursts spectacularly, with a barrel of crude plunging by $34 in the last 4 weeks. Depending on how far the decline in commodity prices has to go, this may determine how far the dollar’s rally might go.

3) Jean Claude Trichet’s monetary policy statement on August 7. The ECB President did make several references to an increase in the downside risks to growth in the euro area when delivering his policy statement on August 7 last. In reality, the ECB, rightly or wrongly, has not changed its policy stance as its primary concern remains the upside risks to price stability and Trichet again stated the ECB had ‘no bias’ with respect to monetary policy. However the markets responded to Trichet’s statement as if it were surprisingly dovish and sent the euro decidedly lower.

4) Eurozone economic data has pointed to a troubled euro economy for a few months but markets chose to ignore that data, preferring instead to focus on a struggling US economy and a detached from reality ECB that kept telling markets that the euro area economic fundamentals were sound. The ECB’s rate hike in July could go down as a gigantic faux-pas by a Governing Council that is clearly lacking economic foresight. Markets are now reassessing the outlook for the euro area economy and interest rate differentials going forward, which is weighing on the euro. The Fed’s policy of trying to stimulate economic growth in the US is now being rewarded by currency markets that don’t like what they see elsewhere. Of course the aggressive nature of the Fed’s rate cutting is largely responsible for the sudden run-up in commodity prices that in turn made inflation shoot up across the globe, but it now looks that this inflation spike was also a bubble and Central Banks like the ECB and Bank of England have been found wanting because they continue to fail to recognise this fact.

5) Carry Trade unwind. With some Central Banks, notably the RBA and RBNZ moving towards easing interest rates, the narrowing in rate differentials has resulted in a significant liquidation of carry trade positions in the past week. EUR/JPY is the most loaded carry trade currency pair in the basket and it has come off by over 5 yen in the past week, hurting the euro against the dollar, which has advanced against the Japanese currency. EUR/JPY is still very much over-valued in a historical context and if the carry trade comes under increased pressure, this would mean a greater sell off in EUR/JPY would pit the euro even lower against the US dollar.

6) Technical considerations. When EUR/USD broke below 1.5283 on Friday morning last, the pair went below a key technical support that had held since last March and this essentially opened the floor underneath the pair, with the next key line of support not seen until 1.4615. The pair also went below the 200 day moving average and the dip below this level has many traders now believing the longer run trend has reversed in favour of the dollar. The technical breakout has led to a loss of confidence in the euro and in some part explains the extended decline we have seen.

7) Russia and Georgia. On Friday the euro had its worst day ever against the dollar, since becoming a hard currency and while there were other factors at play, the 5 cent decline between Thursday and Friday coincided with the outbreak of hostilities between Russia and Georgia. This will not have helped the single currency, given the proximity of the EU to both countries. This probably accelerated the flow of safe haven funds into the dollar.

So where now for EUR/USD? The pair is very much oversold but in an illiquid market situation, anything could happen in the short run. There is no known support for the euro right down to about 1.4620 and given the whiplash fashion in which the market has moved of late, it is not beyond the bounds of possibility that we could see the pair slide to that level before we enter a genuine period of consolidation. Two releases this week will have a bearing on short-term direction: Wednesday’s Retail Sales out of the US and Thursday’s GDP data out of the euro area. It is conceivable the GDP data could reveal a horror story for the euro area and if the number is markedly lower than forecast, it could send the euro tumbling. The euro may have a battle to reach 1.50 before then and could find itself being sold off on any rallies towards this key mark, ahead of the US Retail Sales figures. However, given the brutality of the move to the downside, a sizeable correction upwards cannot be ruled out, especially if the euro can earn some momentum and if it pushes above 1.50 and holds there. It is a dangerous market to trade given the pair has not settled into a new trading range and the fact liquidity levels appear to be running so low.

Sterling has had an absolute nightmare against the dollar over the past 10 days, losing an average of almost a cent a day. All technical supports to the downside have given way and cable is now trading at a 2-year low. There is no arguing the current dollar rally is overdone, yet when one looks at the economic fundamentals out of the UK, it does not inspire sterling buying, even at bargain basement prices. A visit to 1.85 is now on the cards, possibly by the end of September, although this may come after a corrective retracement to at least 1.93. Even a 0.6% jump in the annual inflation rate to 4.4% in July was not enough to engineer a sterling rally. Indeed the pair sold off after the release of this data on Tuesday, which tells us in the current uncertain economic climate the market is currently more interested in currencies that are backed by growth stimulating policies like the dollar than in currencies with restrictive monetary policies like the euro and the pound. The woeful economic data out of the UK over the past few months has finally caught up with the pound and the UK currency is now vulnerable to being targeted by speculators that may see it as a soft target. I would like to see some period of consolidation before re-entering the market on sterling, but those who retain shorts on cable should move stops down to around the 1.9350 price level, which is just above the 2008 high which gave way last Friday. A corrective rally is overdue and it is dangerous to sell at current prices below 1.90, unless employing stops close to 1.9150.

The yen has more than held its own since losing the Y110 handle to the dollar late last week. While the dollar has gone on to trounce the other majors on Friday and Monday, it has hit a wall against the Japanese currency, failing to break above Y110.40. The yen is befitting from a wind-down in carry trades triggered by the decline in commodity prices, which is helping it retain its strength across the board. The shift to monetary policy easing by some Central Banks is narrowing the rate differential outlook on many of the yen crosses, which is lessening the appeal of carry trades. However, Japanese domestic economic data has been poor of late and Qtr 2 GDP released later tonight should tell us the Japanese economy contracted in the last quarter and signal it might be in technical recession right now. The yen will not be damaged to any great extent unless the data is so bad that it initiates an argument for a Bank of Japan rate cut, which seems unlikely given rates in Japan are already a lowly 0.5%. The medium term to longer term value trade on the yen crosses is still with EUR/JPY which remains close to historic highs. The pair should be sold down on any advances to the 168 / 169 price region and given the softness shown lately by the euro there is the prospect of a retreat in EUR/JPY to at least 160 before the end of the September.

The loonie is now trading at levels against the greenback last seen this time last year, around the 1.07 price handle. Last Friday’s employment report which revealed the commodity-rich Canadian economy shed over 50K jobs in July was an eye opener and suggests the economy is struggling even more than originally thought. The decline in commodity prices has hurt and given the bullish tone of USD/CAD, there is every prospect of the pair reaching 1.10 in the near-term (next month), with the possibility of a return to 1.15 by year end, if commodity prices continue to fall. I said last week that the loonie did have scope to appreciate against the euro to 1.60. Well, it has gone to as low as 1.5870 today and there is room for a return to 1.56 over the next week as greater confidence in the US economy could help the loonie appreciate against the major European currencies, as well as against the yen.

Bob B - Aug 12