The Fed’s future path still seems more bullish than the European Central Bank. If so, the yiel...
The Never-Ending USD Consolidation Is About to End
06/29/2009 10:38 am EST
The month of June has been characterized by a seemingly endless consolidation in both USD currency pairs and in many cross-currency pairs as well, not to mention stocks and other major asset markets. Looking back, it's perhaps easiest to view the consolidation in terms of investor risk appetites and the stabilization in the global downturn. Since March, generally less-worse data has seen risk appetites improve, leading to substantial gains in risky assets like stocks, commodities, and, in FX, higher JPY crosses and a weaker USD. In June, the optimism over the near-term outlook gave way to the realism that major economies were simply stabilizing at extremely low levels and that any recovery or outright growth was months away and likely to be anemic at best. And it was that tug-of-war between optimists and realists that played out in the form of the choppy, consolidating price action we have experienced.
Over the course of the past month, we have been of the view that the realists would eventually win out and that risk aversion would return more forcefully, leading to a stronger USD, weaker stocks and commodities, and lower JPY crosses. Along the way, numerous red herrings were thrown on the trail, most of a USD-negative nature (e.g. end of the USD as the global reserve currency; US deficits; loss of US AAA credit rating), which distracted us from the ongoing sentiment-driven environment. Returning to that focus, investor sentiment is the key to anticipating the next directional move in FX, we think. In light of the relatively minor pullback seen in risky assets overall, and with incoming data continuing to suggest stabilization over relapse, we think the optimists are more likely to win the tug-of-war with the realists. As such, we are now more biased toward another surge in risk appetites, leading to a renewed slide in the USD and a further advance in the JPY crosses and gold. While we stick to the views that fears over a USD implosion are without basis (see below), and that the US economy will fare better than other major economies (the euro zone in particular), we have to reckon that those themes will come into play only later this year. In the near-term, then, we prefer to sell the USD on strength while the current consolidation persists and buy JPY crosses on weakness within recent ranges.
From a technical view, we are increasingly convinced that the current consolidation represents a messy fourth wave in a five-wave decline in the USD, with the last wave down yet to come. Should the fifth wave materialize, we don't expect it to be especially substantial or long-lasting, which comports to our longer-term view that USD strength will return later this year. Additionally, several key risk markets—gold and the S&P 500 in particular—survived tests of their Ichimoku clouds, which are now key support levels. In concrete terms, EUR/USD could see gains into the 1.47/48 area on strength over 1.4250/4300; GBP/USD could see 1.74/75 on strength over 1.6600; USD/CAD could see a return to the 1.05/1.08area; and USD/CHF could see back to 1.05/1.06, SNB intervention notwithstanding. USD/JPY is likely to see less overall weakness if we are correct, and may only slip back to 92/93. In this environment, it seems easier to know when you're wrong than when you're right, so we will be closely watching the following daily close (5 pm NY) levels as a signal to abandon the view in favor of risk appetites: S&P 500 close below 880/890; EUR/USD below 1.3750; GBP/USD below 1.6150; USD/CAD above 1.1700; USD/CHF above 1.1200; gold below 925/930.
As with all good consolidations, this one too shall eventually end. This week stands out as an appealing window of opportunity. In addition to being month/quarter/half-year-end, where fresh portfolio adjustments may trigger a break, Friday, July 3 is likely to be an exceptionally thin holiday market ahead of the US Fourth of July holiday. FX markets have a nasty habit of breaking out around US holidays, when only the US is celebrating (e.g. 4th of July or Thanksgiving). A potential catalyst may be the June NFP report on Thursday, and if the NFP change shows further improvement as expected, and possibly coupled with initial claims dropping below 600K, could embolden risk appetites and see the risk rally re-ignite. Other standout potential catalysts are the Japanese Tankan survey and the Chinese manufacturing PMI, both on Wednesday morning in Asia. As always, with range consolidations, we are wary that the first side to break is frequently the wrong side, typically followed by a quick reversal and break of the other side of the range, which is why we concentrate on daily closing levels. Month/quarter end flows are likely to keep the price action choppy and seemingly inexplicable, but ultimately reward patience with opportunity.
NEXT: Are Concerns About the US Dollar Overblown? |pagebreak|
If past is prescient, a US credit downgrade would do little to the perceived riskiness of US government assets. Among the top ten economies in terms of nominal GDP, Japan, Italy, and Spain have all fallen from the coveted AAA perch (according to Standard and Poor's ratings) in recent years, and this has had little impact on the relative rate at which they were able to float government paper. Usually when the perceived risk of an asset rises, investors will demand a higher rate of return in order to compensate for that risk. The facts on the ground suggest the impact from moving down a notch in the ratings environment is negligible. Italy and Spain lost their AAA status back in May 1998, and the spread between their ten-year government debt yield relative to that of the US (the de facto risk-free asset) actually narrowed by 50 basis points within the following 12 months. Japan was knocked down from AAA in February 2001, and six months later, its spread to US ten-year paper was only about ten basis points higher. It was back to pre-credit downgrade levels within 12 months. More recently, Spain lost its AAA rating in January 2009, and its ten-year yield differential to the US has narrowed a massive 90 basis points—so much for greater perceived riskiness! If this is any indication of what the market reaction will be in US yields from a rating downgrade, it seems we are making a big fuss about nothing.
When it comes to the issue of foreign reserves, much has been made about the US dollar potentially losing its premier status in this space. While we believe this will be a long and drawn out process of diversifying away from the US dollar, we also find it interesting to see what the implications would be. The best example we have of this in recent memory is the Japan experience. The yen's share of global reserves has been on a secular decline, and has dropped steadily from around 7% of total global allocated reserves in 1995 to near 3% in 2008. One would think, given the reaction in the USD every time its reserve status is questioned, that this diversification away from yen would have proved detrimental to the currency. The reality is actually much different. During that same 1995-2008 period, the value of the trade-weighted yen (a weighted basket of currencies of Japan's main trading partners) rose a massive 25%! So when it comes to the US dollar, the impact from a lower global allocation is likely a touch exaggerated, to say the least. While knee-jerk reactions will undoubtedly continue to play out in the short term (witness the dollar weakness on China's latest call for a super sovereign currency), the medium-term implications for the buck from more diversification in global reserves is likely to prove less than significant.
Last but not least, we would be remiss not to mention the unfounded concerns with regards to US funding needs. While budget deficits and government spending look to remain at astronomical levels, confidence in the ability of the US to pay its debts remains unshaken. The fact that the US economy is one of the most productive, enjoys unparalleled political stability, and accounts for a massive 25% of global growth is not lost on the investor community. The proof was in the pudding this past week when despite a record $104 billion in Treasury note issuance, demand looked to be near all-time highs. What was even more reassuring is that the longer-dated of the three securities on offer actually garnered the most appetite. The seven-year note auction was well oversubscribed with the total number of bids outpacing the amount on offer by 2.82 times. This was the best bid/cover in the security's short history and well above the average 2.35 seen over the last three offerings. What was more impressive is that indirect bidders took 67% of the amount rewarded. Indirect bidders are a proxy for central bank demand and this suggests that all of the talk about foreign governments diversifying away from US assets has yet to be substantiated. We wonder aloud why foreign officials continue to talk down US assets in public even as they buy them hand-over-fist behind the scenes.
ECB Rate Decision Outlook
The next ECB policy meeting is scheduled for this Thursday, July 2. The ECB is expected to maintain its current degree of enhanced credit support, but no change in policy is likely either in rates or in unconventional policy measures.
The enormous size of the ECB's first ever one-year loan auction on June 24 has reduced the potential for any shocks from upcoming ECB meetings. The ECB first announced that it would extend the term of funding to 12 month on May 7, but the size of last week's auction was a surprise. Demand was underpinned by a revival in speculation that the ECB is unlikely to push the refinancing rate below its current 1%. This was partly the result of comments from the ECB's Weber earlier in the week that the ECB has used its room to cut interest rates. In total, the ECB last week lent EUR442 billion in its one-year tender. It seems inevitable that the sheer size of the liquidity injection should help keep short-term rates low and enhance credit availability within the broader economy, but the ECB's reaction to the auction will be closely examined in next week's post policy meeting press conference.
The ECB also announced in May that it plans to buy EUR60 billion in covered bonds (due to commence in July). This is more similar to the quantitative easing adopted by central banks such as the Fed and the BoE. However, the size of the plan is small. Clearly, the ECB intends to continue concentrating its effort to restore liquidity in the money market. Insofar as growth is not expected to reappear in the euro zone until 2010, there is little danger of the ECB withdrawing its six or 12-month tender in the immediate future, though, in tune with the ECB's anti-inflation credentials, following the 12-month action last week, the ECB's Stark stated that the measures adopted will be unwound swiftly and the liquidity absorbed when macroeconomic conditions improve.
The EUR has not shown clear signs of being depressed by the ECB's huge injection of liquidity. However, it seems that the ECB is intent on keeping short-term rates low, a view which is supported by the lack of inflation in the region (German June CPI flat y/y). On balance, therefore, ECB policy is consistent with the view that the EUR will struggle to make headway against other currencies in the weeks ahead.
MORE: Key Data and Events to Watch This Week |pagebreak|
The data calendar in the US is packed despite a holiday-shortened week for equity and bond marts. Tuesday kicks it off with the Case-Shiller home price index, Chicago PMI, and consumer confidence. On Wednesday, we get the ADP employment report, ISM manufacturing, construction spending, pending home sales, weekly crude oil inventories, and auto sales. Thursday is the highlight with non-farm payrolls, initial jobless claims, and factory orders all on deck.
The euro zone is a touch less busy. Monday starts off the week with euro zone consumer confidence. French producer prices and German employment are due Tuesday, while German retail sales are on deck Wednesday. The highlight of the week comes Thursday with the ECB rate decision (analysis above), while Friday rounds out the week with euro zone PMI composite and retail sales.
Japan is on the lighter side. Industrial production is out on Sunday along with retail trade. Monday has the employment report, while Tuesday sees small business confidence and the highlight of the week, the Tankan industry surveys.
The UK has some top-tier numbers lined up. The Hometrack housing survey starts things off on Sunday. Monday has net consumer credit and consumer confidence due up. Home prices and GDP are scheduled for Tuesday, while Wednesday sees PMI manufacturing. Friday ends the week with the PMI services report.
Canada is super light and the only noteworthy events are industrial product prices and GDP, both on Tuesday.
The action down under is pretty average. New Zealand trade balance and building permits are first up on Sunday. Tuesday is busy with New Zealand business confidence, Australian new home sales, Australian private sector credit, and Australian performance of manufacturing index. Wednesday has Australian retail sales on tap, and the Australian trade balance closes out the week on Thursday.
Also worth mentioning are important events in Switzerland and China. SNB governing board member Thomas Jordan is due to hold a speech on Thursday, and given the recent interventions by the SNB in the FX market, this could prove market moving indeed. China sees PMI manufacturing on Tuesday and a better-than-anticipated number could give risk assets a shot in the arm.
By Brian Dolan, chief currency strategist, FOREX.com
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