The Fed’s future path still seems more bullish than the European Central Bank. If so, the yiel...
Consolidation May Give Way to USD Rebound
06/22/2009 10:45 am EST
Major financial markets spent another week knocking around in seemingly impenetrable ranges, and FX was no exception. EUR/USD opened the week by testing the pivotal 1.3750 level, only to spend the rest of the week recovering higher, but importantly failed to sustain a break of 1.4000 on several occasions. Cable was wickedly choppy, bouncing between roughly 1.6200 and 1.6500 on multiple round trips before closing the week mostly unchanged. USD/JPY showed a bit more direction, but stayed within ranges that have held for the month to date. For the week, the USD index, a gauge of the USD against six other major currencies, looks set to finish out nearly unchanged. Have the summer doldrums arrived early? Possibly, but we think the current phase of consolidation more likely represents a potentially important medium-term (multi-week) turning point in the global risk rally that has developed since mid-March. As an indication of risk appetites in FX, we would note that the JPY crosses have sustained potentially significant weekly losses, having peaked two weeks ago, in a sign that risk aversion is creeping back in.
The driving theme during the risk rally has been a perceived stabilization in the synchronized global economic downturn. That encouraged risk capital to go back to work, generating an exodus from safe havens (selling US Treasuries and the USD), and a move into riskier assets (stocks, commodities and higher yielding currencies, including the infamous carry trade (long JPY crosses)). Along the way, the USD came under additional pressure over concerns about US deficits stoking inflation, the status of the USD as the global reserve currency, and worries over the US losing its vaunted AAA debt rating, to name just a few. While we don't dispute that the rate of deterioration in economic data has slowed, we don't see much evidence of growth ahead and still think a genuine recovery is many, many months away. In this sense, we think markets have gotten ahead of the curve for any recovery and are due for a relapse as expectations are revised lower.
On the USD itself, the many concerns voiced recently appear to be dissipating, albeit slowly. The major actors questioning the dollar's reserve status have grudgingly acknowledged that there is no alternative to the greenback in the foreseeable future, and investor demand for US debt remains resilient even in the face of record issuance. Credit rating agencies over the last few weeks have also downplayed the prospects of any change to the US credit rating in the immediate future. Next week's Treasury debt auctions may be a final hurdle in the USD's road to recovery (see below), meaning that if they go well, the USD may see a more sustained rebound. In the bigger picture, though, we will acknowledge that the sheer size of US borrowing requirements this year will likely remain a headwind for the USD. We also consider the fears of inflation materializing any time soon to be overblown due to minimal growth expectations and would note that market-based inflation gauges (five-year TIPS/Treasury spreads=1.55%) remain well below normal levels (2.5-3.0%) and may have seen a near-term peak. In short, we think markets are in the process of reversing course, and that risk aversion is likely to increase in the weeks ahead as growth prospects are re-evaluated. In this environment, we would look for the USD to recover further ground and for the JPY crosses to slide lower still.
On the technical front, trend indicators suggest the recent USD downtrend is over, as ADX readings have clearly topped out and even dropped back below 25 in some USD pairs, EUR/USD most notably. We are watching a potential ascending triangle pattern in the USD index, where the expected upside breakout (above 81.45/55) should occur next week if the pattern is valid. The equivalent breakdown level in EUR/USD, where a potential head and shoulders topping pattern is evident, would be on a drop through 1.3720/50. We look to use remaining USD weakness to buy on dips and to sell JPY crosses on significant rebounds.
SNB Stays the Course on CHF Intervention, for Now
Actions speak louder than words. If SNB rhetoric last week failed to make clear its policy on the CHF, apparent intervention to weaken the CHF versus the EUR was loud and clear.
The confusion this past week started after the SNB's Jordan commented that markets should not become used to a certain level of intervention and that the purchases of foreign currency have fulfilled their purpose. The market interpreted these remarks as signaling that the SNB may now have less interest in staving off CHF strength and that the EUR/CHF level of 1.5000 may no longer be the appropriate pivot for the franc. It now seems that the context of these remarks was purely to explain how intervention as a policy measure has been successful to date in halting CHF appreciation. Jordan did go on to warn that further intervention would be used, if necessary. In this episode, it appears that the SNB tolerance of CHF versus the EUR lasted only five hours or so. The message from that is that offsetting CHF strength is still an important part of SNB policy.
The fact that rates remain very close to zero is a key reason why intervention is being used as an alternative policy tool. Demand for CHF as a safe haven is another factor explaining why the SNB resorted to this policy in March of this year. Safe-haven demand for the CHF is widely considered to have played a large part in the prolonged period of slow growth suffered by Switzerland in the 1990's. However, safe-haven demand in general has eased since March, and this is noticeable in the softer USD and higher bond yields since then. It follows that as the global recovery establishes itself, demand for the CHF should fall. This implies that the SNB should be able to ease back its intervention policy in the coming months. However, domestic economic conditions remain weak. GDP fell by 3.2% on an annualized basis in Q1 and the SNB president last week stated that this poor figure obscures an even sharper fall in final demand. The SNB forecasts growth will fall by 2.5%-3% this year, but sees downside risks to these projections. The Swiss government sees only a gradual return to modest growth in early 2010. Given economic weakness, the SNB is unlikely to be able to normalize interest rates for some time and is likely to retain its watch on the value of the EUR/CHF. That said, Jordan's comment that markets should not become accustomed to intervention at a particular level, previously 1.5000 to most market minds, suggest the SNB's trigger point may move a touch lower. As a consequence, dips in EUR/CHF towards the 1.4900/1.5050 area should be considered EUR buying opportunities, with the 1.5150/1.5250 area likely to contain most price action near-term.
MORE: This Week's Fed Meeting in Focus |pagebreak|
Record US Note Issuance and Fed Meeting in Focus
The US Treasury will auction a record $104 billion in notes next week and the results will be closely followed by markets. Should the auctions continue to show robust demand for US paper, we would look for the dollar to remain better supported overall as US funding worries dissipate further. The auctions include $40 billion in two-year notes on Tuesday, $37 billion in five-year notes on Wednesday, and $27 billion in seven-year securities on Thursday. Traders should closely monitor both the bid-to-cover ratios of these auctions and what percentage of the offering goes to indirect bidders, which is used as a proxy for foreign official demand. The three-auction average bid/cover ratios are 2.79 for the two-year, 2.19 for the five-year and 2.35 for the seven-year. Meanwhile the three-auction average indirect take is 45% for the two-year, 35% for the five-year and 31% for the seven-year. These numbers will be our benchmark when gauging whether the auctions were a success or not. Results below these trends would suggest waning demand for US government assets and would undoubtedly see the US dollar come under renewed pressure.
The Fed is scheduled to meet on Wednesday and release its press statement at 215pm ET. That rates will remain unchanged at the 0.00% to 0.25% range is baked in the cake and thus all of the attention will once again be on the press statement. The economic outlook is likely to remain gloomy, but the Fed will probably reiterate that "The pace of contraction appears to be somewhat slower." Much has been made as to whether the Fed will announce how long they expect to leave rates on hold, much like the Bank of Canada announced that they are not moving until 2Q 2010 at the earliest. We think the likelihood of this is slim. There would be little upside to this sort of move and if anything, it would create credibility issues if the Fed were forced to move before their stated deadline. It is more likely that they will adopt a message similar to the prior statement when the group said that they expect "exceptionally low levels of the federal funds rate for an extended period." They are also unlikely to expand the $300 billion program to buy Treasuries. This is because the Fed's effort thus far has been futile. Indeed, since the purchases started, interest rates have actually moved higher. In sum, barring any major surprise (which we do not anticipate will happen), the meeting and accompanying communique will probably elicit little in the way of price action.
Key Data and Events to Watch This Week
The US calendar gives us plenty of top-tier data to chew on in the week ahead. Tuesday kicks it off with existing home sales, and Wednesday is busy with durable goods, new home sales, weekly crude oil inventories, and the Fed meeting (analysis above). Thursday sees the final cut of 1Q GDP and weekly initial jobless claims. Friday rounds out the week with personal income/spending, core PCE prices, and the University of Michigan consumer sentiment index.
It is similarly busy in the euro zone. Monday starts things off with the German IFO business sentiment indicators. Tuesday follows with euro zone PMIs, French consumer spending, French business confidence, and German consumer confidence. Wednesday brings euro zone current account, while Thursday sees euro zone new industrial orders. Friday closes it out with French consumer confidence and German consumer prices.
Japan has a lighter agenda and it begins with the tertiary industry index on Sunday. Tuesday has the leading index and all-important trade balance on deck. Thursday sees consumer prices and the all industry activity index.
The UK sees an even less eventful schedule. Home prices are due on Sunday, home loan data is up on Tuesday, and the CBI distributive trades report ends the week on Wednesday.
In Canada, the only noteworthy data point is international capital flows on Monday.
The action down under is skewed toward New Zealand. Credit card spending is up on Monday, while consumer confidence and the current account are on tap Wednesday. The highlight is on Thursday with the 1Q GDP report due. Australia's only notable report is leading indicators on Thursday.
By Brian Dolan, chief currency strategist, FOREX.com
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