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US Dollar Weakness Nearing Extreme Levels
06/01/2009 10:58 am EST
The US dollar consolidated for much of this past week, only to relapse into fresh weakness on the last trading day of the week/month. Healthy demand at US Treasury debt auctions and affirmations of US credit ratings by two rating agencies failed to stem the exodus from the USD, as fears that US deficits will inevitably lead to a weaker USD continue to dominate investor sentiment. The weakness in the USD has evolved into a full-blown downtrend, with commodity prices rallying sharply and gold prices finally surmounting the sticky 965/967 level. A vicious cycle of dollar weakness/commodity strength will eventually short-circuit itself, as higher commodity prices would undermine consumer spending and derail economic recovery, but not before potentially running further. While we continue to view the medium-term (multi-month) outlook for a sharp rebound in economic activity (see below) as highly premature, the investor stampede to own risk appears similarly highly resilient. Even the looming bankruptcy of the largest US automaker has left recovery sentiment apparently unfazed, but probably only because it has been expected for months now.
One important element of the flight from the USD has been a synchronous exit out of longer-dated US Treasury securities. While we see no technical indications of an imminent rebound in the USD, the rally and subsequent collapse in ten-year Treasury yields this week suggest that the heaviest selling there may be done, potentially providing the USD with some support. We would note that US deficit funding fears seem overblown in the wake of this past week's $101 billion 3/5/7-year debt issuance, with foreign participation remaining healthy, but showing a preference for shorter maturities. Looking ahead, it seems unlikely that there will be a single catalyst that turns sentiment more bearish. More likely, a slow trickle of more negative economic data in coming weeks may provide investors with reasons to rethink current optimism. In this vein, the US experienced several negative data surprises this past week (Chicago PMI, mortgage delinquencies, and weak housing data), but this only served to highlight the weak US outlook and exacerbate USD weakness. We will be closely monitoring employment data in particular this week, with increases in euro zone unemployment rates potentially highlighting the risks ahead for the continent. As well, we are mindful of the upcoming G8 summit in Italy on June 12 and 13, and the potential for USD weakness to be cited as a concern. In the last two weeks, we have heard Japanese, EU, and Canadian officials voice concern over the rapid appreciation of their currencies, suggesting a consensus against further USD weakness may be building. US Treasury Secretary Geithner's trip to China may also see some important statements on the USD (see below).
In terms of price levels, EUR/USD broke above a bull flag consolidation pattern with the move up over 1.3960/70 on Friday, potentially targeting additional gains to the 1.4500/30 area. We think the immediate upside remains in play while that break level is sustained. However, the 1.4150/4250 area sees some significant resistance from multiple Fibonacci retracement levels, and the top of the weekly Ichimoku cloud is at 1.4184. USD/JPY seems content to trade broadly between 94/98. In GBP/USD, the 1.5750/5800 area looks to be key support for the overall move higher, while upside targets are now toward the 1.6600/6750 area. AUD/USD still has potential higher while holding above 0.7800/30 and gains look set to target the 0.8350/8400 area. JPY crosses seem likely to remain well supported until there is a more significant setback for stock markets. We are watching the 875/930 levels in the S&P 500 as likely breakout points. Gold looks on track to retest the mythical $1000 level for a third time, but the 965/967 level needs to hold as support or it's a false break higher. In general, we will be alert for any sudden reversal of this past Friday's moves as it would suggest the key breaks were false and more heavily driven by month-end trading conditions.
Mr. Geithner Goes to Beijing
US Treasury Secretary Geithner will meet with top Chinese officials on June 1 and 2 in his first trip to China since taking over the US Treasury. His ostensible purpose is to thank China for doing its share to support the global economy with a sizable fiscal stimulus package and to urge them to move away from an export-driven economy and toward greater domestic consumption. Chinese officials, on the other hand, are more likely to express concern over the value of the USD and to seek assurances that US deficit spending will eventually be reduced. In term of official comments, we would think that Chinese officials are most likely to express confidence in the US administration's efforts to rejuvenate the US economy, which may be interpreted as a commitment to continue buying US debt and support the USD. For the Chinese to signal anything less would be taken as an extremely negative sign for Treasuries and the USD, of which they are massive holders and presumably do not wish to devalue unnecessarily. For his part, Mr. Geithner is likely to repeat the strong USD mantra on more than one occasion. Positive soundings from China could be a significant catalyst to stabilize the greenback and possibly trigger a rebound.
NEXT: Why Data Suggest Recession Still Far from Over |pagebreak|
The US economic data this week left some doubt in the notion that the recession is quickly coming to an end in the months ahead. Reports in the consumer, housing, and business space were lackluster at best and some even showed renewed weakness. Here we offer a brief review.
The most upbeat reports came on the consumer confidence front. The Conference Board index pushed higher in May as the expectations component jumped to 72.3 from 51.0 the prior month. The present situation read increased modestly to 28.9 from 25.5, so it is clear that hope continues to drive confidence. The employment differential (which measures jobs hard to get minus jobs plentiful) improved to -39.0, but remained below the -34.0 January read. This coupled with the new record high in continuing claims, which are quickly approaching the seven million mark, suggests another bleak employment report is in the offing on June 5. Should employment losses continue at current levels for the foreseeable future, we would expect confidence to retrace. The jump in oil prices last week (on another huge decline in inventories) to above $66 per barrel will not bode well for expectations once this trickles through to higher prices at the gas pump. Comparisons between the tech and oil bubbles suggest that $50-70 per barrel could be the new norm for some time.
Housing remained on shaky ground and the forward-looking statistics do not suggest a turnaround anytime soon. The April existing home sales report showed a worsening in the inventory overhang to 10.2 months worth of supply, up from 9.6 the month prior. Prices collapsed to a -15.4% annual rate (worst since January) as nearly half of the sales came from the distressed properties space. Speaking of homeowners in duress, we also got the 1Q mortgage delinquency data and it flashed a spike in the default rate to a new record 9.1% from 7.9% the prior quarter. Subprime mortgages saw the delinquency rate jump to a staggering 25.0% from 21.9% to boot. The rub here is that these numbers occurred during a period when many US banks engaged in a foreclosure moratorium at the behest of the US government. This means that the 2Q numbers are only likely to get worse. And it also looks like mortgage rates are about to go higher. The recent backup in Treasury yields has seen the 30-year Treasury to 30-year mortgage spread narrow to just 45 basis points, the lowest since early 2005. We find it hard to believe that banks will continue to provide such cheap lending rates should government yields continue their upward trajectory (isn't that what got us into the subprime mess to begin with?). Bank rates react with a bit of lag, but the recent narrowing in this spread suggests 30-year mortgage rates are on their way back up towards a 6% handle.
On the business side, things are looking anything but up. While the "stellar" April durable goods report (up 1.9% on the headline vs. expected 0.5%) had many jumping for joy and once again calling the end of the US recession, the details suggested the exact opposite. The core number, which excludes the notoriously volatile defense and aircraft components, actually fell -1.5% on the month to match the cycle low, annual run rate of -24%. The Chicago PMI report also disappointed in a major way. The headline collapsed to 34.9 in May from 40.1 but that wasn't the worst of it. The details of the report were downright ugly. The standouts were employment, which sank to a new cycle low 25.0 from 31.8, and new orders, which relapsed to 37.3 from 42.1 the prior month. If past is prescient, we could be setting up for a dismal ISM report on June 1. Both durables and Chicago PMI provide an ominous sign for 2Q capital expenditures, as the hand-off will be similar to what we saw in 1Q. The lack of business investment will continue to put pressure on jobs and this in turn will hurt retail activity in the months ahead. Bottom line, we are far from out of the woods in this economic downturn.
A Busy Week for Central Banks; ECB May Steal the Limelight
The week ahead brings policy meetings from the ECB, BOE, the RBA, and the BoC. The market is not expecting any of these central banks to change policy, though the rhetoric will be closely examined for any signs of cautious optimism. In May, both the BoE and the ECB were more dovish than the market had expected. Not only did the BoE surprise the market by extending the amount of its quantitative easing by GBP 50 billon to GBP125 billion, but this was followed a week later by the inflation report, which introduced the risk that UK growth this year could contract by as much as 6% y/y during the first part of this year. Despite the dovish tone of the BoE, it is likely to take a couple more months before it has bought its present quota of bonds, suggesting scope for policy surprises from the BoE this week is limited. Sterling may trade cautiously ahead of the policy meeting, but it is probable that consumer confidence and PMI data will garner a bigger market reaction. The ECB may therefore be the more interesting policy meeting.
In the press conference that followed May's ECB meeting, President Trichet was keen to make the point that 1% was not necessarily the floor for interest rates. While the May rate cut had been anticipated, the announcement that the ECB would buy covered bonds had not been. As yet, the EUR has not suffered from the ECB's plan to use unconventional policy since the small amount outlined by the ECB last month (EUR60 billion) is no match floor the quantitative easing policies adopted by both the Fed and the BOE. On June 4, the ECB should put some flesh on the bones of its bond-buying plan. The market should also pay close attention to any comments regarding the outlook for inflation. Following the May policy meeting, Trichet commented that inflation will turn negative mid-year. The impact from lower energy prices (which helped drive euro zone CPI to flat y/y in May) should be temporary, and therefore, this does not contribute to fears of deflation. However, there is talk that the weakness of the real economy in the euro zone may be translating into more sustained downward pressure on inflation. If the ECB agrees with this outlook, the chances of further rate cuts in the months ahead will rise and this will weigh on the EUR.
MORE: Key Data and Events to Watch This Week |pagebreak|
The US data calendar has some top-tier events lined up. The action kicks off today (Monday) with personal income/spending, ISM manufacturing, and construction spending. Tuesday brings pending home sales and motor vehicle sales, while Wednesday has ADP employment, ISM services, and factory orders on deck. We'll see the usual weekly jobless claims on Thursday along with nonfarm productivity. Friday rounds out the week with the all-important employment report and consumer credit. Look for comments from Treasury Secretary Geithner as well, who will be holding talks with officials in China early in the week (could be important for the US dollar). Fed Chairman Bernanke will also testify before the House budget committee on Wednesday.
It is a top-tier week in the euro zone as well. PMI manufacturing is up on Monday, while Tuesday has euro zone unemployment and French producer prices on tap. Wednesday brings the PMI composite measure (manufacturing and services), euro zone GDP, and euro zone producer prices. Thursday is the big day with the ECB rate decision and press conference, and also euro zone retail sales and French unemployment due out.
The UK also has some important data on tap. PMI manufacturing starts things off on Monday, and this will be followed by consumer credit and consumer confidence on Tuesday. PMI services is up on Wednesday. The highlight of the week is Thursday with the BOE rate meeting and Friday ends it with the producer prices report.
It is extremely light in Japan. Vehicle sales are lined up for Monday, while capital expenditures close out the week for data on Wednesday.
The agenda in Canada is characteristically light, but important nonetheless. Industrial product prices and monthly GDP are up on Monday. Thursday sees building permits, the Ivey purchasing managers index, and the Bank of Canada rate decision. The employment report highlights the week on Friday.
It is an important week down under, but all of the noteworthy action is in Australia. Retails sales kick off the week on Monday. The current account and RBA rate meeting are scheduled for Tuesday, while GDP is up on Wednesday. Thursday ends it with the trade balance.
By Brian Dolan, chief currency strategist, FOREX.com
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