Tuesday, August 26, 2008

Bob's Currency Focus

The key question we would all like an answer to now is has the dollar rally gone too far? From 1.6035 in the middle of July to below 1.46 before the end of August is as aggressive a move as they come, but it has happened during a period when liquidity is markedly low and currency moves tend to become exaggerated. We must look for the change in interest rate differentials over this time period to determine whether or not the dollar’s rally is justified in the wider scheme of events. There is no doubting weaker euro zone data has had futures markets reassessing rate expectations for the euro area and the yield on the March forward contract has fallen to 4.11% today, from 4.61% on July 21, thus a narrowing of 0.5% in the rate differential. The yield on US treasuries has hardly moved over the past month, so therefore we can say since the euro hit its peak, rate expectations between the dollar and the euro have narrowed by 0.5%. Since the ECB started its current monetary tightening cycle way back in Dec 2005, a 1% shift in rate differentials between the US dollar and the euro has translated into an approximate 8% movement in the exchange rate. Therefore the 0.5% shift seen over the past 6 weeks should translate into roughly a 4% gain for the dollar. A 4% gain would mean EUR/USD should now be trading at around 1.5395 and not 1.4595. That suggests the current rally may be overdone by as much as 8 cents. Of course rate differentials are likely to narrow further in favour of the dollar through to the end of the year, when falling commodity costs should give the ECB greater wriggle room to consider cutting interest rates, while any pickup in economic activity in the US will bring closer the day when the Fed will be in a position to increases US rates. For now though, the market seems to have lost the run of itself and it is sheer momentum rather than economic fundamentals that is driving EUR/USD lower. It is therefore dangerous to sell the euro at the current price and while most traders would prefer to follow the trend down, one is best advised to only sell down at an attractive price (closer to 1.50), which is not currently on offer. We could witness a very sharp correction higher in the euro next week, when liquidity returns to normal after the August holiday period comes to an end. Today’s Ifo business survey for August shows sentiment amongst German business executives fell much more than expected, hitting new record lows and pointing a probable recession in the euro area’s largest economy. I previously remarked that the ECB’s rate hike in July could prove to have been a fatal error of judgement and all of the economic data we have seen since holds up that argument. Jean Claude Trichet and his colleagues have not been in touch with reality and their failure to accept the basic economic principle that slowing economic growth will always temper inflation reveals a level of naivety that is worrying. Having been largely responsible for guiding the euro’s meteoric rise over the past 2 years, the ECB may now be looking for ways of trying to cushion its fall.

15 cents this month is what the dollar has gained against the pound. Gains of this magnitude in such a narrow time span are unprecedented and it must added, they are also generally unsustainable. The big problem with cable at the moment is trying to pick a bottom. It had looked last week that 1.85 might prove to be a point from which the pound would rebound, but earlier this morning the pair went as low as 1.8329 and we cannot be confident of having yet hit a bottom. A serious lack of liquidity this month has cost the pound dearly as negative sentiment against the UK currency has encouraged traders to use the rather thin trading conditions to send the currency tumbling. Cable certainly offers value to buyers at current prices, but the problem is that volatile trading could see the market move significantly lower without warning and leave positions exposed. Next week, when market liquidity will improve, we could see a greater volume of value trades come into the market and lead to a corrective bounce in the pound, possibly a sharp bounce. There is no data of any real not this week, with the exception of Nationwide house prices on Thursday, which will show a further retreat in UK house prices. With UK consumer price inflation running at 4.4%, the Bank of England, which meets next week, is not in a position to ease UK interest rates for now, thus cable’s collapse to 1.83 looks to be way overdone. A safer trade involving the pound would be to sell EUR/GBP, because with so much bad news already priced into sterling and the euro economy slowing at an equally fast pace, there is scope for a substantial pullback in EUR/GBP over the coming months.

While the dollar has steamrolled over every other major currency this month, it is only marginally higher against the yen. We have seen a major unwind in carry trades in recent weeks and this together with a rise in risk aversion on equity markets has broadly protected the Japanese currency. The euro has fallen back to the Y160 price mark and we could potentially see this pair fall to 1.45 by year end, particularly if European equity bourses remain subdued. As long as the dollar remains in vogue against other currencies, the yen will struggle to make gains against the US currency and if economic data out of the US gains more positive momentum, USD/JPY will become one of the long plays for the rest of this year, with the potential for a push towards at least 1.15 before the year end. There is the danger of a reversal in US dollar support over the next 2 weeks when liquidity levels rise and in this environment the yen could also find itself on the back foot, particularly against the euro, pound and Swiss franc, given the extent of the currency’s gains in August. Economic data out of Japan will continue to play a minor role and yen traders instead need to focus on the performance of global equity markets as well as following US economic data over the coming weeks.

The loonie has proven itself to be remarkably resilient over the past week, gaining broadly across the board against every single major currency and significantly so against the euro, pound and Australian dollar. The rollercoaster ride of commodities in the past week has failed to puncture support in the loonie, which seems to have gained a new lease of life, possibly owing to a growing appetite for North American currencies, thanks to the revival in the US dollar. Canadian economic data has printed mostly in line with expectations over the past week but the all important litmus test comes later this week, when Quarter 2 GDP is published. Following a contraction in quarter one we should see a marginal gain in growth in quarter 2 as exports grew thanks to a dramatic increase in commodity prices. If we get another contraction, Canada will officially be in a technical recession and this will hurt the loonie very badly, particularly if commodity prices continue to tumble this week. The loonie may come under pressure against the greenback and USD/CAD offers good value on any dips back towards 104.30. The key support on the downside for the greenback is 103.70 and as long as this holds the pair will remain in an uptrend. For those going long, a stop should be placed below this price level. Against the other majors, the loonie could continue to make inroads on the euro, although any break below 1.52 might be unrealistic ahead of a euro correction higher.

Bob B - Aug 26