QE speculation leads to broad-based USD weakness
The markets have been fixated on the potential of further Fed easing measures in the form of a second round of asset purchases or ‘QE2’. This past week gave a lot of clues into the Fed’s thinking with the release of the September 21 FOMC meeting minutes and Fed Chairman Ben Bernanke’s speech at Friday’s Boston Fed conference. The meeting minutes showed that ‘many’ on FOMC noted too-slow growth and too-low inflation as arguments in favour of additional asset purchases. Only ‘some’ members said that the economic benefits of purchases may be small. The key point that the market focused on here was that FOMC members said accommodation may be ‘appropriate before long’. Bernanke, in a speech on Friday took an accommodative stance and highlighted too-low inflation as a case for further action.
Investors have priced in a significant amount of QE as economic data has deteriorated and Fed officials have stepped up the rhetoric. The fact is that the weakness we have seen in the USD in the past several weeks has been due to mostly to speculation; the Fed has not acted yet. While most traders are expecting another round of QE, the extent of asset purchases is unknown. As such there is risk that the markets have been too aggressive in pricing in ‘QE2’ and may be disappointed if the Fed does not deliver what the market is expecting. On the other hand, there is the possibility that market participants may not have priced in enough (though the former is the more likely scenario). Uncertainty will remain until the Fed announces their decision.
Asian central bank action also added fuel to USD weakness with the unexpected decision by Monetary Authority of Signapore to widen the band in which its dollar trades to allow for faster currency appreciation. This increased speculation that other Asian central banks may follow and added to the decline in USD. Major technical levels were reached this past week on a softer USD. Swissy (USD/CHF) reached new record lows near 0.9460/70, gold (XAU/USD) climbed to record highs near 1387, the Loonie (USD/CAD) and the Aussie (AUD/USD) both reached parity as commodities gained and the dollar tumbled. Short term Treasury yields also reached record levels with 2-yr yields falling as low as near 33 bps. USD/JPY which is highly correlated with the Treasury yields fell to 15-year lows dipping below 81.00 to around 80.90.
The UK’s deficit plan under the microscope
It’s the UK’s turn to take centre stage next week. The minutes of the Bank of England Monetary Policy meeting will be released on Wednesday at 0930BST, on the same day as the government announces the detail of its spending cuts (due at 1230BST) to reign in the UK’s unwieldy budget deficit, which currently stands at 11.5% of GDP.
The market has been waiting for the coalition government’s Comprehensive Spending Review (CSR) since the emergency budget back in June when Chancellor George Osborne announced GBP 80bn of cuts between 2010/11 and 2014/15, the equivalent of 6% of GDP over 5 years. Since then, we know what departments will be spared the axe: the National Health Service and overseas aid. Leaked reports also suggest that cuts of up to 25% across the other departments will be implemented, which may precipitate the culling of 500K public sector jobs.
Investors seem to have given the UK the benefit of the doubt, and it has avoided a Greek/Irish style assault on its bond market. UK 10-year Gilt yields have been steadily falling since April. Sterling has fared less well, on a trade weighted basis it has fallen more than 4% since August. However, considering the size of the UK’s fiscal adjustment in the coming years this doesn’t seem too harsh and GBP/USD has actually appreciated 9% since September.
Wednesday’s report will give the market the detail it’s been waiting for since June. Although the market will be looking for a firm commitment that the UK will reduce its debt overhang, this needs to be balanced against the effect of harsh austerity cuts on consumer confidence. The facts about the scale of the fiscal retrenchment, combined with a VAT hike planned for 1 January, may cause consumer confidence to plummet, acting as a serious drag on growth. Therefore, the CSR may prove to be a double-edged sword for UK assets.
We believe that investors will use sterling as a way to express their faith, or lack thereof, in the outlook for the UK economy, rather than the FTSE 100. This is because the FTSE is heavily weighted toward the mining and financial sectors and has a large number of international companies. Sterling is thus a better proxy for the outlook for UK growth.
What will investors are watching for? If the government cuts the budgets of departments vital to the UK’s long term growth, such as education, science and R&D, this may spook investors. This, in turn, may cause a grind lower in the pound over the long-term. This would likely also boost expectations for further QE from the BOE, boosting Gilts.
MPC minutes crucial for sterling in the short-term
In the short-term, we believe that the MPC minutes from October’s meeting will be the main driver of sterling. Earlier this week, former Deputy Governor Sir John Gieve said that the MPC should raise rates and refrain from further QE. However, it’s the current members that the market will focus on this week. There is a possibility of a three-way split in the committee with Andrew Sentance maintaining his hawkish stance and Adam Posen calling for further QE, which is a rare occurrence for the MPC.
The markets will be looking to see if any of the other members have come off the fence and joined Posen. If this happens, then the market may take this as a sign the BOE will extend QE, which would be negative for sterling. However, we think it is likely that the MPC discussed the persistent stickiness of inflation as a barrier to further monetary stimulus. While we don’t think that any members will have voted for an extension of QE at this meeting, they may well do in the near future. But the absence of a commitment to more QE from the MPC may disappoint the market, putting downward pressure on gilts and boosting sterling in the short-term.
We think the long-term outlook for sterling is weak and view rallies in GBP/USD back to the 1.6100 area as potential short opportunities with the potential to move lower toward the 1.5850 area. A move above 1.6200 would negate this view.
Europe’s peripheral concerns put to bed for now
Rhetoric coming out of Europe continues to verge on the hawkish side. Axel Weber, head of the German Bundesbank, said that the ECB should stop buying the bonds of Europe’s peripheral economies. Indeed, last week the ECB bought just EUR9m of government bonds, which follows large purchases of Irish, Greek and Portuguese government debt in recent weeks. This gave the market some confidence in the peripherals, and spreads between their bonds versus the benchmark German bund yield dropped last week. It‘s hard to say if the markets think these economies are now out of the woods, or if they are cheered by the fact that the ECB is still willing to intervene when necessary.
Greek bond yields have made an impressive recovery, and credit-default swaps haven fallen from 900 bps, to 683 bps, reversing the rise from May to September. This suggests that the market is getting more confident about Greece’s fiscal consolidation plans. Economic data has also started to improve. Industrial production in August rose by 5.6%, suggesting that the economic contraction in Q3 will not be as bad as Q2, when the economy shrank by a larger than forecast 1.8%.
BoC likely to hold steady on rates, growth concerns
The BoC interest rate announcement is scheduled to be released on Tuesday October 19 at 0900EDT and economists expect the rate to remain steady at 1.00%. We think it is important to note that the BoC has already raised rates 75 bps this year from their extremely accommodative “crisis” lows of 0.25%. This policy tightening diverges from the Feds (where QE2 speculation abounds) and has seen the Canadian dollar strengthen – it reached parity this past week – due to the widening interest rate differentials between the two countries. In the short term, the stronger Loonie should keep a lid on Canada’s export growth with the Unites States.
The next day, on Wednesday October 20 at 1030EDT, the BoC quarterly Monetary Policy Report (MPR) will be released and is followed by Governor Mark Carney’s press conference at 1115EDT. The bank revised their 2010 growth outlook lower from 3.5% in April to 3.2% QoQ in their last report in July. Unfortunately, the most recent GDP data (July MoM) declined for the first time since August 2009, by -0.1%. This suggests the October MPC report will also have to downgrade their 2010 end of year figures, as well as the 2011 estimates. In July the Bank expected their economy to return to full capacity by the end of 2011 – This figure will now likely be pushed back to the beginning of 2012. Meanwhile, the underlying dynamics of inflation should remain relatively subdued for the foreseeable future, and re-affirms our view that a wait-and-see approach is best for the BoC at this juncture.
Key data and events to watch next week
U.S. data kicks off on Monday with August Net Long-term TIC Flows, September Industrial Production, September Capacity Utilization, and the October NAHB Housing Market Index. Wednesday follows with September Housing Starts, September Building Permits, and October ABC Consumer Confidence. Thursday sees MBA Mortgage Applications and the Fed’s Beige Book. Thursday wraps up with weekly Jobless Claims, September Leading Indicators, and the October Philly Fed Index. In terms of economic events, the Fed’s Lockhart will be speaking on the economy in Georgia on Monday. Thursday will see Bullard holding a press briefing on monetary policy and Hoenig speaking in Albuquerque on the U.S. economic outlook.
The Euro zone calendar begins with the Euro-area finance ministers meeting on Euro reforms beginning Monday. Tuesday begins a moderately light data slate with August Current Account, August Construction Output, and the October ZEW Survey of Economic Sentiment. Thursday closes out with October Composite, Manufacturing, and Services PMI alongside October Euro-zone Consumer Confidence. German data begins with the October ZEW Survey of Economic Sentiment and Current Situation on Tuesday. Wednesday sees September Producer Prices and is followed up with October Manufacturing and Services PMI on Thursday. The German Finance Ministry will also be publishing the September Monthly Report on Thursday. Friday ends the data session with October IFO Business Climate, Current Assessment , and Expectations.
U.K. economic data begins Sunday with October Rightmove House Prices and continues on Tuesday with October CBI Business Optimism. Tuesday also sees BOE Governor Mervyn King delivering a speech in Dudley, England. Wednesday follows with the release of the Bank of England Minutes and the much anticipated Spending Review. Thursday wraps up the data slate with September Major Banks Mortgage Approvals and September Retail Sales.
The calendar in Japans starts off with August Tertiary Industry Index on Sunday and September Nationwide Department Sales on Monday. Wednesday sees August Coincident Index and September Convenience Store Sales followed by the August All Industry Activity Index on Thursday. Friday ends the data session with September Supermarket Sales.
Canada’s calendar begins with August International Securities Transactions on Monday. The Bank of Canada Rate Decision is scheduled for Tuesday followed by the BOC Monetary Policy Report on Wednesday. Wednesday also sees August Wholesale Sales followed by September Leading Indicators on Thursday. Friday wraps up with September CPI, September Bank of Canada Core CPI, and August Retail Sales.
Australia’s data slate begins with September New Motor Vehicle Sales on Sunday and the Reserve Bank’s Board October Minutes on Monday. Tuesday sees August Westpac Leading Index and October DEWR Skilled Vacancies. Thursday closes out with Q3 Import and Export Price Indices. New Zealand’s calendar begins with September Performance Services Index and Q3 Consumer Prices on Sunday. Wednesday closes out with September Credit Card Spending and the October ANZ Consumer Confidence Index.
All China data is scheduled for release on Wednesday which sees Q3 Real GDP, September Producer Price Index, September Purchasing Power Index, September Retail Sales, September Industrial Production, and September Fixed Assets Investment Urban Cumulative. Also be on the lookout for the G-20 Ministerial meeting on October 21-23 in Kyungju, Korea.
Strategy
Buying EUR/JPY on pullbacks
A developing trend of easier monetary policy across a consortium of central banks sent equities screaming higher Tuesday. The BoJ was the first to act as it took part in another round of QE with the announcement of an asset purchase plan of about $60bn in conjunction with the unexpected decision to drop its interest rate to virtually zero. Markets also seem to be pricing in Fed QE2 as a certainty rather than a possibility evidenced by the drudging the greenback has taken recently. It seems now that a concerted effort from various central banks towards easier monetary policy has now become a reality. One major central bank that hasn’t hinted at additional easing has been the ECB which is a partial factor in the steep ascent of the single currency. The parabolic move higher in EURUSD seems a bit overdone and significant resistance lurks directly above current levels (50% retracement for the descent from the July 2008 all time highs into 1.3955/60). However, the current trend of euro strength is unmistakable and we would like to exploit any euro pullbacks, specifically against the yen as global liquidity measures may see yen crosses rally on a re-emergence of risk appetite.
EUR/JPY is approaching significant technical supply into 116.25, trendline resistance from the 170.00 record highs. Additionally, hourly charts evidence potential exhaustion as the pair nears channel tops around 116.00. However, we believe that any possible reversal may provide an opportunity to buy dips for a continuation of the recent uptrend. There are a couple factors contributing to the longer term bullish bias. Firstly, EUR/JPY continues to remain in a rising channel which is additionally supported by the 200-hr SMA. Until both the channel support and moving average are breached, the uptrend remains intact. Also, the bullish price/Macd divergence suggests the 119.25 61/8% retracement for the 4/5 to 9/20 decline is in view. The strategy will look to buy half a position of EUR/JPY on a pullback into 114.50 channel support and the remaining on further weakness into 113.25 for an average rate of 113.87. The stop loss will be below the June to July 2010 horizontal pivot around 112.60, for a total risk of about 125 pips. The take profit objective is for 50% at long term trendline resistance into 116.00 and the remaining half into the 119.25 key 0.618 fibo level. We would bring our stops to break even on a move above 116.00.
Support
• 114.50 Rising channel support, short term pivot
• 114.00 Daily Tenkan line, Hourly Rising Channel Support, 200-hr SMA
• 113.25 June – July 2010 Horizontal pivot resistance turned support
Resistance
• 116.25 Trendline Resistance from 2008 170.00 highs
• 117.95 200-day SMA
• 119.25 61.8% retracement (4/5 – 9/20 decline)
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