Oil crisis and forex market

Oil prices have hit $143 a barrel and there appears to be little let-up as traders push the energy commodity to record highs, almost on a daily basis. At the same time the US dollar is hovering near record lows against a line of major currencies with markets continuously seeking to send the US currency lower. Commodity traders jump on any reason, no matter how minute, to send crude prices higher. The subsequent rise in oil prices is then taken as a vote of no confidence in the dollar and the greenback duly obliges, going lower in value. This would not be so bad were the related moves in some way proportionate, but the reality is that since last summer every 1% fall in the US dollar index has corresponded to a massively disproportionate 10% rise in the price of crude. Of course there are other factors driving crude prices, but it is no coincidence that oil prices began scaling the current spike around the same time the US Federal Reserve embarked upon an aggressive rate cutting campaign, a policy move that caused the US dollar to nosedive. Oil prices have reached such an alarming level that they are now having a damaging effect on global stock markets (inflated energy costs are eating into disposable income and drying up consumption demand for other products and services). US and European bourses are today officially in bear markets (the major indices having lost 20% from the peaks achieved within the past 9 months). As investors scramble for returns outside of equities, we are seeing some major fundamental disconnects in currency markets, something which has been amplified in recent weeks.

What are these disconnects?

1) A rise in risk aversion no longer translates into liquidation of carry trades. If one glances at the major carry pairs – EUR/JPY, AUD/JPY and NZD/JPY, one will notice that even in a situation where equity markets have plummeted over the past month, these carry pairs have in fact gone higher. The reason for this is twofold: a) while stocks have retreated, commodity prices have gone up and commodity currencies like the Aussie and Kiwi dollars have been well bid and b) Volatility levels as measured by the VIX indicator have remained low, even while stocks were selling off at a record pace in June. This is encouraging risk takers to keep selling the yen against higher yielding currencies.

2) Weak economic data is not weakening a currency in the current market. A case in point here is sterling, which has appreciated against every other major currency over the past 2 weeks, despite some dire economic releases from the UK which point to an ailing economy on the brink of recession. The euro has also been appreciating against a backdrop of softening economic data. Why? The Central Banks in the euro area and the UK have highlighted that they are more concerned about rising inflation trends than slowing growth conditions. The ECB is expected to raise interest rates this week at a time when the euro zone economy is slowing rather sharply, while the Bank of England has hinted the next move by the MPC is more likely to be a rate hike rather than a rate cut (markets had been expecting further cuts given the economic downturn). For the immediate term investors are more interested in higher yield, not growth prospects, and the comfort of higher interest rates is attracting their money. This of course is having a damaging effect on the dollar, with the Fed less concerned about rising inflation than the ECB and Bank of England, even though headline inflation is running higher in the US than in the euro area or in the UK.

This disconnect of course cannot last. Eventually markets will reach breaking point, which will happen when there is clear evidence of demand destruction for crude oil, or when spiralling energy inflation sparks some form of direct market intervention, or when the Fed is forced to hike US interest rates before they would like to do so. It may be premature to start expecting conciliatory tones from an ultra-hawkish ECB.

This disconnect situation does throw up some interesting medium term value trades in currency markets. The one that currently jumps out is GBP/USD, which is on offer to sell today just below the 2.00 mark. The UK economic situation is fast developing into a crisis and it is difficult to see how sterling can hold its elevated market position, regardless of what reality disconnect appears to be gripping the Bank of England. The euro also looks to have been on an extended honeymoon, although the ECB still holds considerable street cred with traders and Trichet & Co. cannot be dismissed as lightly as a Bank of England which is less than consistent in its policy approach.

Ted B - Jul 1

Bob's Currency Focus

EUR/USD
Eurozone inflation has surprised on the upside, with the flash estimate for June coming in at an annualised 4.0% rate, against 3.7% in May and a forecast 3.9%. Whatever doubts may have existed about the ECB’s intentions this week have all but vanished and the Governing Council seems certain to raise rates to 4.25% when they meet on Thursday next. Opposition to the move has been mooted and the question now is not a case of whether the ECB will raise rates this week, but rather a case of whether this week’s rise will be the start in a new series of rate rises. The ECB has backed itself into a corner and markets have priced in a further rate hike by September with some analysts now expecting up to 3 rate hikes by the end of the year. Normally this would be very bullish for the currency and indeed the run-up in the euro over the past few weeks has paid testament to this. However we are now looking at a situation where the ECB will be raising interest rates at a time when there is zero or negative growth in the euro zone. An increase in interest rates will serve to expedite the economic slowdown and could potentially derail the euro later in the year. In the short-run this prospect is unlikely to deter traders, whom will want to challenge the 1.6016 high this week. The dollar is being driven by commodity prices, which in turn are influenced by the EUR/USD exchange rate, so with yield differentials set to widen, the immediate outlook for the dollar is not bright. There are a few caveats though, most notably the PMIs out of the euro area on Tuesday and Thursday Vs the US data counterparts. Also, we are dangerously close to further vocal market intervention, as spiralling oil costs sends global stocks plunging and further pits the US economy into recession. Monday sees the end of quarter 2 and some profit-taking is likely to stall the euro’s advance today, but it will continue to be bought on dips in the run-up to Thursday’s ECB. Friday’s US non-farm payroll is unlikely to play a major role in influencing currencies this week, even if we do witness some short-term volatility, because US Fed policy looks set to remain on hold for the foreseeable future. Key resistance on the upside is at 1.5840 and if that gives way, it will leave the way open for euro bulls to push to the illustrious 1.60 price mark. EUR/USD is trading at an uncomfortably high level around 1.58, yet the current risks look to be to the upside and the wise option may be to avoid the pair altogether until after the ECB on Thursday.

GBP/USD
UK mortgage approvals and mortgage lending figures fell to record lows in May, while consumer confidence has sunk to a 16 year low in June against a backdrop of falling house prices and runaway energy costs. Normally such damning data would be sufficient to send sterling packing for a couple of cents against the dollar and over half a penny against the euro, but sterling has found some back teeth in the past week and the UK currency is virtually unchanged on Monday, holding onto the significant gains it made last week against the greenback. There are a few possible reasons for this new-found resilience, one being that we are at the end of the second quarter and profit-taking has led to a liquidation of a large volume of sterling shorts, thus propelling sterling artificially higher. If this is the real reason, then expect sterling to decline, possibly sharply, from Tuesday, as we enter quarter 3. Another plausible reason is the resurgent appetite for high yielding currencies as investors are hedging against a climate of rising inflation and retreating equity values. Sterling is competing again on yield grounds as markets have written off any prospect of rate cuts from the Bank of England this year. The medium to longer term outlook for sterling remains grim however because larger funds are unlikely to want to channel long play funds into a currency where the economy is pretty much tanking. If the CIPS manufacturing and services indices, due out on Tuesday and Thursday, report a contraction in the respective sectors for June, expect sterling’s recent revival to hit a wall. We need to see cable fall below 1.98 to sell the pair again, because while price remains above this support level, bias remains to the upside. The euro could take a run at 80 pence this week against the UK currency, given an expected widening in the rate differentials. Short sterling positions on EUR/GBP could begin to stack up again from Tuesday.

USD/JPY
The yen has been dragged and pulled across the currency markets Monday, first pushing the dollar below Y105 during the morning, only to see the dollar rebound to over Y106 in the afternoon. The euro too has recovered from a low of Y166.08 in the morning to retake the Y167 price handle. Risk aversion, prominent during the Asian session, has given way to complacency as short-term players look for yield and are snapping up USD/JPY and EUR/JPY on dips. Tonight sees the release of the Bank of Japan’s quarterly Tankan Survey, one of the few indicators out of Japan that can really influence the currency market. Thanks to a Reuters slip last Friday, when the news agency inadvertently and prematurely broadcast the quarterly Tankan report results, the market already knows the survey reveals increasing pessimism about the economy and it will help cement the view that the Bank of Japan will not be in a position to start raising interest rates any time soon. The yen is not going to be able to undertake any sustained rally unless we witness a structural breakdown in EUR/JPY. That seems unlikely in the coming days with the rate differential set to widen in favour of the euro on Thursday, so the value trade remains being long on USD/JPY, particularly on dips towards Y105. There is a chance that risk aversion levels could rocket during the week, if the ECB rate announcement has an impact of destabilising the dollar and sending oil prices soaring to even higher record levels.

USD/CAD
The loonie has had a bad day at the office Monday even though GDP was reported to have risen by 0.4% in April, following a contraction over the previous 3 months. The greenback has benefited from profit-taking at the end of the quarter which has seen commodity currencies pare some of the recent gains, and this has hurt the loonie. But it is difficult to see the USD/CAD moving outside of the recent 0.9920 to 103.20 price range anytime soon and the greenback will come under selling pressure on any gains beyond 102.50. In fact Tuesday could witness a sharp reversal in the pair’s direction, if Monday’s greenback rally is nothing more than a profit-taking exercise, which seems likely. Traders should use the opportunity to exit previously stranded USD/CAD longs, rather than use it as an invitation to start going long on the US dollar. Tuesday is a holiday in Canada and this week sees a very light calendar with Friday’s IVEY PMI the only other release of note. Oil prices will continue to be an important influencing factor for the loonie and expect USD/CAD to trade between 1.0050 and 1.0250, with the risk of a breakout to the downside, if the ECB this week helps oil prices to surge. The euro offers no value against the loonie at present values (>1.60), but it is best to wait until after Thursday, before making a decision to enter the market on this trade.

Bob B - Jun 30

Bob's Currency Focus

EUR/USD
Negative sentiment against the dollar hit fever pitch again over the past few days as the Fed’s rather indifferent approach to rising inflation in their monetary policy deliberations this week led futures markets to pare back expectations for future interest rate rises in the US. The dollar has got it in the neck and oil has risen to a fresh lifetime high, close to $142 a barrel. Bernanke’s credibility has been seriously undermined by recent events with the Fed Chairman seen as talking tough but lacking the conviction to follow through on his words. US stock markets are plunging in recent weeks, primarily thanks to the rash policy decisions taken by the Fed over the course of the past 9 months. If the Fed hadn’t handed the ammunition to commodity traders to more than double the price of oil over the 9 month period of its aggressive rate easing cycle, the US industrial averages might not now be facing their worst monthly performance since the age of the Great Depression. While the Fed may be dithering on inflation, the ECB’s bold determination to signal an imminent rate hike a few weeks back, could come back to haunt the Governing Council. Since that statement from ECB President, Jean Claude Trichet, euro zone economic data has pointed to a marked slowdown, with both the manufacturing and services sectors falling into contraction in June and with consumer and business confidence plummeting across the entire euro area. Add to this the fact euro equity bourses have nosedived, a euro which is rising on ECB rate expectations rather than growth fundamentals and all in all you have a situation where one would believe it is the least opportune time for Mr Trichet to announce a rate hike. However, the ECB is likely to be true to its word and we should expect euro zone interest rates to rise 0.25% to 4.25% next Thursday.

The euro is close to the recent resistance line of 1.5840 and barring some sudden reversal, this should come under threat, possibly by as early as Monday. There are some data risks for the euro next week, but on Monday, we have the CPI flash estimate, which is likely to come in at or above June’s record 3.7% rate. If it does, it will more or less seal a rate hike from the ECB next Thursday. If we see further deterioration in the manufacturing PMI (Tuesday) and Services PMI (Thursday), both of which contracted in June according to the preliminary readings, it will put added pressure on the ECB to soften its approach on Thursday. This ECB is particularly hawkish though and it is difficult to see them swaying too much from their recent tough stance, given repeated references by members of the committee to the fact the ECB’s sole mandate is to stem inflation, not to stimulate growth, as is the dual mandate of the Fed and the Bank of England. Traders need to be on the lookout for comments on currencies next week, because of the dollar’s fragile market status and runaway oil prices. Central Bank intervention is most unlikely while the Fed and the ECB are adopting opposing strategies in their respective battles with rising inflation and declining growth. The euro will be vulnerable to a sell-off on EUR/JPY if risk aversion levels remain elevated, while a ‘done and dusted’ policy statement from the ECB would also undermine the single currency, given the extent of gains achieved on the back of a very tough ECB stance. It is dangerous to buy the euro on levels close to 1.58, given all the risks, even if there is a chance of a short-term rally higher. Weak economic data out of the euro zone, some of it very significant, has failed to hold the euro back over the past 10 days, but eventually it will come home to roost, particularly if followed by further soft data next week.

GBP/USD
Sterling has got a timely boost over the past week, just at time when it was being written off. The pound has benefited from a broader collapse of the dollar this week, as well as uncertainty about the euro economy, which has helped fuel a flow of funds into the UK currency. While GDP for quarter 1 was revised down to 0.3% from 0.4%, the current account deficit narrowed sharply during the same period, surprising analysts. The principal reason for sterling’s recovery however has been the Bank of England’s shift in emphasis from growth to inflation, which has markets anticipating the next move by the MPC may be to hike rates. This has helped to attract a new wave of investors that are seeking higher yields, with the 5%-earning pound a favourite once again, if just for the short-term. Ongoing stresses in the housing sector and concerns over activity in the manufacturing and services sectors is likely to prevent frantic buying, although cable now has every chance of hitting the 2 dollar line, ahead of the big-hitting economic releases from Tuesday of next week. It is almost certain UK interest rates will be held at 5% when the MPC delivers its latest policy announcement on Thursday, and the pound’s immediate fate will depend on the fate of the dollar and what the ECB does next week. As long as cable remains above 1.98, an upside bias remains, for now, but that could revert very quickly and cable could find itself back in the middle of the recent trading range (1.94 – 1.98) before the Bank of England even delivers its statement next week.

USD/JPY
The yen broke down several price barriers over the past 24 hours as the Japanese currency has been a principal benefactor of the sudden rise in risk aversion and the market attack on the US dollar. The USD/JPY pair has fallen as low as 106.10, down from the 108.20 it was trading at early Thursday. With the Dow plunging 3% on Thursday evening and oil rocketing to record prices, traders are beginning to offload short yen positions. If the unease continues, the yen could gain appreciably, given the exaggerated price levels which still exist on the EUR/JPY and AUD/JPY carry pairs. News out overnight reveals inflation rose the highest in 10 years in May and while an annualised rate of 1.5% is unlikely to frighten too many traders, it does leave options open for the bank of Japan, if the Bank wished to hike interest rates later in the year. Trading on the yen will continue to be volatile and any sign of a return to stability in stock markets will see the yen quickly fall out of favour. It is dangerous to sell down EUR/JPY ahead of the ECB meeting next Thursday, while there may be some value in buying USD/JPY on dips, when US stocks show evidence of a recovery. The wise move may be to wait until the current downside probe has run its course, however long that might take.

USD/CAD
The loonie has hit fresh highs against the dollar on Friday, taking advantage of a weak dollar and spiralling out of control oil prices. All of the commodity currencies have performed remarkably well, despite the rise in risk aversion over the past few days, but there is an ever-growing opinion that the oil price spike is primarily a bubble and were it to prick at any time, the loonie would have most to lose of all the major commodity currencies. We could see the Canadian currency try to take out the parity line later today, especially as the USD/CAD pair has looked decidedly bearish over the past 2 weeks. Oil prices will continue to form an important support for the loonie, even in the wake of soft economic data. A break through parity could see the pair fall to take on support at 0.9970, where a further break could trigger a sharp retreat to 0.9920. The dollar needs to reclaim the 1.01 line quickly and push the pair past Thursday’s high of 1.0140, if it is to regain any sort of upside momentum.

Bob B - Jun 27