USD steadies, but EUR remains firm
The US dollar spent a second week consolidating after the recent sell-off and there are some indications the recent dollar downtrend may be coming to a close. USD weakness has been driven by market expectations of a second round of Fed asset purchases (QE2), which has also seen US Treasury yields pushed down. Markets look to have priced in QE2 of around $1.0-1.5 trillion, which is increasingly looking extreme in light of recent Fed officials' comments. Rather than a 'shock and awe' approach (announcing $1 trillion+ of asset purchases over a defined period), the Fed now seems more inclined to take an incremental approach, possibly opting for an open-ended buying program on the order of $100 bio per month. If the Fed does take this route, it suggests potentially significant re-pricing of market expectations is needed and this could be the catalyst for a USD rebound. Indeed, 10 year US Treasury yields have already bottomed and are finishing out the week nearly 25 bps above recent lows.
We'll likely need to have the Nov. 3 FOMC decision in hand before the dollar can see more than the current modest consolidation/correction, and until then we still see risk of another new low for the buck. In EUR/USD the 1.4050/1.4100 zone is the trigger to a renewed push higher targeting the 1.4350/4400 area initially. Next week sees month-end, and USD selling is likely to be evident given gains in US stock markets. On the upside for the USD, we would note the sharp sell-off in gold and the turns higher in the USD against GBP and CHF, our preferred leading indicators of overall USD direction. We also see a potential head and shoulders top forming in EUR/USD and we think a drop below the 1.3650/3700 area could see a more substantial USD rebound.
USD weakness has been mirrored by EUR strength, and while the buck recovered somewhat against other currencies, the EUR pushed on to new highs against most other major currencies. As the ECB continues its march to withdraw extraordinary measures, German government bond yields have continued to push higher and are now at highs last seen back in April (when EUR/USD was also around 1.37-40). We have no indications yet of a peak in German rates and widening interest rate spreads suggest markets are pricing in an early 2011 ECB rate hike. These rate moves suggest the EUR will remain strong in the weeks ahead, but we will be watching closely for a turn lower in German bund yields. Our longer-term view remains that the Eurozone will slow markedly in the months ahead, likely forestalling any ECB tightening and sending rates lower again.
G20 Meetings this Weekend
The G20 meetings in Seoul this weekend is an opportunity for major and emerging economies alike to voice their opinions and concerns regarding the global economy. Over the past few months, investors in search of a higher yield often found emerging markets as their choice; which created a huge flow of money out of the U.S. Dollar and into the emerging currencies. This broad weakness in the dollar, as well as the topic of further Quantitative Easing (QE2), has spurred many of these governments to try to halt their currency’s appreciation through a variety of means: direct intervention, higher taxes on foreign investment, capital controls and talks of protectionism. These measures have created ample tension between global leaders of late, which makes these meetings in Korea of even greater importance.
It is difficult to fathom a significant policy agreement coming from the G20 this weekend, especially when one considers that Brazil – one of the countries creating the most controversy of late – will not have anyone in attendance this weekend. However, we anticipate ministers will look to center their talk around topics like “competitive devaluation”, “excessive market volatility” and “disorderly movements in exchange rates”, which is just more of the same rhetoric we continue to hear week in and week out. Ultimately this will likely be a non-event, but should something unanticipated materialize, it has real potential to shake up the FX market next week.
Is Germany a headache waiting to happen for the ECB?
Another day, another economic indicator highlighting the strength of Germany’s recovery. On Friday it was the IFO survey, which measures business confidence in 7,000 firms in the manufacturing, construction and retail sectors that exceeded analyst expectations. The headline index rose to highs last seen in 2007, prior to the recession. What was more encouraging was the sub-component of the index that measures future expectations for business activity; this was significantly higher than September’s reading. There are also signs that Germany’s recovery is becoming more broad-based and less reliant on exports. The PMI services sector survey reversed recent losses in October, which suggests that domestic consumption may pick up. Retail sales have been lagging in the German economic recovery, but a pick-up in service sector sentiment may be reflected in stronger data as we near the end of the year.
Germany’s strong bounce back from the recession highlights the two-speed recovery in the Eurozone. The German economy expanded by a 2.2 per cent quarterly rate in the second quarter of this year, equivalent to a 4.1 per cent annual rate. This compares with Ireland and Greece, whose economies actually contracted in the second quarter. Germany is growing like an emerging market, while peripheral economies with huge debt burdens will be under pressure for many quarters to come.
This is generating a headache for the European Central Bank. If a currency union should only be as strong as its weakest member then rates should be in deeply negative territory and monetary stimulus should be extended to boost the flagging peripheral economies. But that risks stoking inflationary pressure in Germany, which, along with strong growth, also has a tight labour market fuelled by the unemployment rate, which has fallen to its lowest level for more than 20 years.
The euro has shrugged off recent problems in the periphery, such as Ireland’s debt crisis in September, and instead has been riding on the coat tails of rising German bond yields. But the market may not be taking account of headwinds for the German economy next year. The German government is embarking on a fiscal austerity plan of its own to try and reduce its large government debt burden, which stands at 73.4 per cent of GDP. Spending and public sector jobs are expected to be cut, which could de-rail a recovery in domestic demand. Thus, the ECB may need to keep monetary policy looser than German bond yields suggest, to try and prop up the Eurozone’s largest economy as austerity measures start to bite. So although the ECB remains committed to returning monetary conditions back to normal and avoiding further policy stimulus, depending on how well all of the Eurozone economies perform next year, it may be the latecomer to the quantitative easing party.
The market shifts its focus to more QE in the UK
Chancellor George Osborne may have claimed that Britain took a step back from the brink during his Spending Review on Wednesday, but the markets seem to think the UK has taken a step towards more quantitative easing. As the market digests GBP80bn of spending cuts, 500,000 public sector job losses, a 3- way split on the monetary policy committee and anaemic growth in the money supply, 2-yr Gilt yields have tumbled. The market is increasingly expecting the Bank of England to embark on a second round of quantitative easing as early as their next meeting on 4 November.
This has weighed on the pound, which dropped by nearly 2 per cent on a trade-weighted basis over the week. A weekly close below 1.5750 is a bearish signal for GBP/USD, but perhaps only in the short-term. There are signs that the market may be getting ahead of itself. It’s worth looking at the minutes from the MPC’s October meeting, released on Wednesday, that noted: “The analysis and projections prepared for the November Inflation Report would give the Committee an opportunity to re-evaluate more thoroughly the outlook for activity, the margin of spare capacity and inflation in light of all the news.” This suggests that the MPC may want to see the Inflation Report prior to making any decisions on more QE.
Since the Report is not released until 10 November - after the MPC meeting - there is a chance the market could be disappointed if the Committee decides to hold fire on 4 Nov and not make any policy changes until its meeting on 9 December.
Of course, if they already think that economic conditions are weak enough for more stimulus then why would they wait, but we think that sterling could be choppy as we lead up to the first week of November. In the very short-term we think the GBP/USD is at risk of a reversal, especially if we see a weekly close below 1.5750, which is a bearish divergence signal. Key levels of support lie at 1.5450 – 100-hr simple moving average (SMA), and then 1.5330/40, the 200-day SMA. If GBP/USD does not hold at these levels then we could see it fall back to 1.50. Sterling may also be the main loser as long as last week’s dollar strength remains and investors reduce their short greenback positions as we get closer to the 2/3 November FOMC meeting.
Key data and events to watch next week
The US economic calendar kicks off on Monday with the September Chicago Fed National Activity Index, existing home sales and the October Dallas Fed Manufacturing Activity Index. Fed Chairman Ben Bernanke and Fed Members William Dudley, James Bullard, and Thomas Hoenig are due to speak on Monday also. Tuesday sees the S&P/Case Shiller Home Price index for August, October Conference Board Consumer Confidence and Richmond Fed Manufacturing Index. The Fed’s Dudley is set to speak on Tuesday and Wednesday. Durable goods orders and new home sales for September are also due out on Wednesday followed by Thursday’s weekly jobless claims. Friday wraps the week up with 3Q advance GDP and the Personal Employment Cost Index as well as the Chicago PMI and University of Michigan Confidence survey results.
The Euro zone starts the week off with EZ industrial new orders for August on Monday. Tuesday’s data includes the German GfK Consumer Confidence Survey for November, German September import prices, as well as French October consumer confidence. Due out on Wednesday is France’s September consumer confidence, Germany’s October CPI figures, and a speech from ECB member Carlos Costa. Thursday sees French September producer prices, German unemployment data for October, and Euro zone October confidence indicators. Friday rounds the week out with the EZ CPI estimate for October.
The UK economic data begins with Monday’s BBA Loans for House Purchase in September, the Asset Purchase Facility Quarterly Report for Q3 and speeches by the BOE’s Paul Tucker and Governor Mervyn King. Tuesday includes the release of 3Q advance GDP, August Index of Services, and a speech by the BOE’s Adam Posen while Thursday sees October Nationwide House Prices and GfK Consumer Confidence Survey results. The data comes to a close on Friday with September mortgage approvals, net consumer credit and net lending secured on dwellings.
Japan’s calendar kicks off with September merchandise trade balance figures on Monday. On deck for Wednesday is October Small Business Confidence and set for release on Thursday is September retail trade data and the Bank of Japan target rate. Friday finishes the week with September jobless data, Tokyo and National CPI, September housing starts, and September preliminary industrial production.
In Canada, the week begins on Wednesday with the August Teranet/National Bank HPI and finishes on Friday with August GDP, September industrial product price index and raw materials price index.
The calendar down under starts on Monday with Australia’s 3Q PPI and a speech by RBA Governor Glenn Stevens. Set for release on Tuesday is 3Q NAB Business Confidence and Wednesday includes Australia 3Q CPI data and New Zealand’s NBNZ Activity Outlook and Business Confidence for October. The RBNZ will announce its official cash rate on Thursday and Australia will see the August Conference Board Leading Index. Friday rounds the week with NZ building permits and trade balance data for September as well as Australia’s September HIA new home sales and private sector credit.
Be on the lookout for important China data as well. Sometime between Monday and Friday will see the release of September Leading Index and set for release on Friday is the MNI Business Conditions Survey.
Strategy of the week
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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