Bob's Currency Focus

Is it the end of the world as we know it?

The Fed’s bailout of insurance giant AIG is the latest spectacular episode in what has been one of the most frightening weeks in the history of global financial markets. On Monday Lehman Brothers became the largest (by a street) bankruptcy failure in the history of Corporate America. Also on Monday, Merrill Lynch, Lehman’s closest cousin on Wall Street, was taken over by Bank of America in a rushed deal, executed just before markets opened on Monday, when Merrill was certain to be the next guillotine victim of those shorting financial stocks. Today, we learn that Lloyds TSB and HBOS (the UK’s largest mortgage lender) are on the verge of a merger, forced upon HBOS, as their share price has plummeted so much in recent days that their market capitalisation value has plunged to farcical levels. And today the Russian stock market had to be closed after its index fell 17.5% in an hour. This follows a similar closure on Tuesday, after the index lost 20%. These are scary times and the impact is resonated across currency markets as well as equity markets, with the risk aversion Japanese yen slaying all before it. It is not a market for rational trading based upon the latest economic indicator releases and technical analysis charts, but rather it is a market to best avoid, unless the trader has massive risk tolerance levels. The volatility is resulting in huge swings across most major currencies and in particular any currency pair involving the US dollar, or the Japanese yen. Logic is out the window and wide shifts in sentiment towards what is happening in wider financial markets is forcing currencies in one direction or another. A look at the latest Commitment of Traders Report essentially shows a mediocre volume of open currency trading positions against the norm, which tells us 1) liquidity levels remain dangerously low and 2) currency movements are not being influenced to any great degree by speculative currency trading, but by the repatriation of funds across exchange rate borders, primarily to Japan and the US, resulting in the yen and the dollar appreciating significantly against the other majors. The yen has now appreciated to 2-year highs against the euro and the Aussie dollar and to multi-year highs against the high-yielding pound and Kiwi dollars. The carry trade has essentially been completely liquidated in the past 2 weeks although extreme negative market sentiment could see the yen gain further, particularly against the euro.

The current market is too risky and volatile and short stops are not working. Traders are best advised to avoid the dollar and yen and to stay away from the market until it settles, or else stick to pairs like EUR/GBP, AUD/NZD and EUR/CHF. Those stuck in open positions may need to sit them out or if brave enough, to enter the market at current range extremes, and collapse the two positions at the halfway point.

Bob B

Bob's Currency Focus

EUR/USD
The dollar’s relentless rally continues unabated, sending the euro to a 2008 low on Thursday of 1.4327. This happened after the ECB’s ‘no bias’ monetary policy statement when the Governing Council voted to hold rates steady. The market did go after the euro after that event believing the ECB will be forced to cut rates sooner rather than later but the dollar gained ground against all currencies, excluding the yen, after the IS reported that the US Services Sector expanded in August, with the business PMI coming in at 50.6, moderately above the 49.0 expected. Global stocks have tanked today, but the dollar continues to benefit from an inflow of safe haven flows and today it registered its highest exchange rate of the year against many currencies. The dollar and the yen seem to be the only game in town right now with investors reluctant to load bets on European or commodity currencies. Friday will offer another litmus test for the US economy when the nonfarm payrolls report is released. The omens don’t look good however, after Thursday’s initial jobless claims numbers came in at the worst level in 5 years, while both the ISM services and manufacturing reports record contractions in employment during August. It may well be a case of damage limitation and if the figure is something better than -50,000, then the dollar should not be penalised. The euro is oversold, but with support at 1.4365 taken out on Thursday, there seems little to stop the pair quickly descending to test the 1.40 level. Momentum could take the dollar there over the next week. Caution is needed however as the dollar has now registered a 10% gain against the euro in little more than 6 weeks, while the chance of a US interest rate hike seems more distant now than it did back in July. This dollar rally is not supported by any major shift in the rate outlook, which would tend to suggest it is unjustified and over-extended. Another point worth noting is that the positive economic data seen recently out of the US is nearly exclusively down to a sizeable upturn in exports, but in the past month alone the dollar has wiped out all of its losses for the year and subsequently its competitive advantage in the export market. Be warned! This dollar run is not sustainable, even if the greenback continues to make gains in the short run.

GBP/USD
The nightmare continues for sterling and at one stage today the pound was down 23 cents on the price it was trading at on August 1st. The sell-off is extreme and it is not just a dollar phenomenon because sterling is also trading at a record low against the euro and a multi-year low against the yen. The Bank of England reneged on its duty today by pressing the mute button after they voted to keep interest rates unchanged. It beggars belief that the MPC did not see fit to offer some sort of statement to address the turbulence that has been unleashed in UK financial markets at a time when the Chancellor of the Exchequer states the economy is in the worst economic downturn for 60 years. We will have to wait 2 weeks to get an insight into the MPC’s thinking but given the Bank of England’s lack of foresight and indifference to the sort of creative monetary policy adopted by the Fed, much of the blame for sterling’s sudden collapse can be laid squarely at the door of the MPC. Sterling has had only one meaningful upside day since August 1st last and a depreciation of this magnitude is almost unprecedented, for the currency of a major developing economy. The technical indicators are nearly off the chart, so extreme is the sell off in the pound. One bright spark came today when the pound did at least manage to push the euro back to the 81 pence handle, but that is scant consolation for pound supporters that see GBP/USD record new lows on an almost daily basis. Cable has to rise above 1.80 before it is safe to buy. Another weak close today could se it hit 1.75 before the next shot at a recovery.

Bob B - Sep 4

Bob's Currency Focus

EUR/USD
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.

GBP/USD
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.

JPY
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.

CAD
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