The Currency Week Ahead: The Reflation Trade Is Under Pressure

07/13/2009 10:43 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

Risk aversion reappeared with a vengeance this past week, in a follow-on move after the weaker-than-expected US June NFP report undermined prospects for an imminent economic recovery. Rather than a series of weaker data reports as the catalyst, it appears to be more a case of a growing shift in sentiment aggravated by crowded long risk positioning. To be sure, there were some data disappointments (UK May industrial production fell; lower trade levels reported by China and US; softer US and euro zone sentiment gauges, to name a few), but the timing of the moves suggested technicals and positioning as the primary catalysts. The resulting market moves showed all the hallmarks of risk aversion: Government bonds higher, carry trades (JPY crosses) lower, and stocks and commodities lower. The USD was largely unchanged on the week in US dollar Index terms, but the buck generally showed strength against all but the JPY (see below). Importantly, we also note that the commodity currencies (AUD, NZD, and CAD) generally outpaced other key currencies in weakening against the USD, which we view as a leading indicator of a trend shift.

Regular readers of this weekly article will know that we have been expecting a relapse in risk sentiment, though it all but exhausted our patience after June's incessant consolidation. We predicted that strategic view on the historically extreme global downturn and on expectations that economic recovery will be weaker and take longer than investors have become accustomed to in recent recessions. While we expect further unwinding of risk positions in the weeks ahead, which may become more extreme depending on how corporate earnings come in (see below), we also stay with the primary strategic view that a genuine risk recovery will take root later this year. The timing is uncertain, but we would not expect a case for a resumption in growth to become apparent until late 3Q/early 4Q. However, we are not alone in that expectation, which suggests important tactical considerations to bear in mind. Chief among these is that declines in risky assets will frequently be met with latent buying interest from medium and longer-term investors anticipating the eventual return to growth. For example, this past Wednesday saw AUD/JPY collapse from 74 to 71 in a few hours, only to recover to 73.50 within 24 hours. With that in mind, we would look to cover short-risk trades (e.g. carry trades like short EUR/USD or short AUD/JPY) after volatile declines, with a view to re-selling on rebounds. Another tactical consideration to bear in mind is that summertime markets are notoriously volatile and unpredictable. In this regard, we will widen out our expectations of price moves in general and anticipate more frequent spike reversals (i.e. a sharp rebound after a sharp decline, or vice versa after a move higher, usually within a few hours), as well as parabolic (i.e. accelerating) short-term price moves.

Looking ahead this week, we would first note that Wednesday's sharp decline in risky assets was followed by two days of consolidation, generally speaking. The market indecision suggested by that consolidation that Monday may see a volatile resolution, and we would expect this to cause further declines in risk assets (e.g. stocks, commodities, JPY crosses/gains in the USD excluding USD/JPY and bonds). In terms of individual markets, we would note that the S&P 500 is potentially seeing a head and shoulders (H&S) topping pattern playing out, with a break below 870 likely to be a break of the neckline, targeting weakness to the 810/815 level. It has also dropped into its Ichimoku cloud, with a daily close below the cloud base at 865 suggesting greater weakness ahead, as well. In gold, price has dropped below the cloud, with the bottom of the cloud at 927.49 now offering important resistance, while weakness below 904/900 suggests fresh losses ahead. In currencies, many of the JPY crosses are testing below the cloud base, with EUR/JPY (130.80), AUD/JPY (72.25) and CAD/JPY (82.88) having posted daily closes below. NZD/JPY may make a close below its cloud base (58.12) any day. In the USD pairs, we are in many cases still within the recent ranges and we will be alert for a break lower in EUR/USD if below 1.3750, GBP/USD if below 1.6050/70, AUD/USD if below 0.7700, if more pronounced USD demand surfaces. The USD index tested the bottom of its cloud at 80.65/70 and we will be watching for a daily close above to confirm the potential for additional gains.

JPY Strength Raises Intervention Risk

The JPY emerged as the strongest currency of the past week, but the sharp and sudden decline of USD/JPY has rankled the Japanese Ministry of Finance (MOF). Just as the Japanese economic decline shows signs of stabilizing, the last thing the MOF needs is runaway JPY strength. MOF verbal intervention immediately followed Wednesday's collapse below 94.00 and the market has been rife with talk of semi-official buying interest below 92.00 since then. We think the threat of intervention is very real, but that the MOF will initially jawbone and use proxies to support USD/JPY. In that sense, USD/JPY can test lower, but we prefer to buy on dips while the 90.00 level holds. At the moment, a potential short-term double bottom is in place at 91.75/80, but the pair will likely remain heavy while below 94.00/50. Should risk aversion increase materially, we think heightened USD demand could help support USD/JPY while leading to breakdowns in EUR/USD, AUD/USD, and other non-JPY pairs.

NEXT: Bank Earnings and Implications for the US Dollar |pagebreak|

Earnings announcements kicked off this past week, but the real action begins in earnest with bank earnings in the week ahead. There are a total of 35 companies slated to report, and 11 of these are in the financials space. These include heavyweights Goldman Sachs (Tuesday), JP Morgan Chase (Thursday), Citigroup, Bank of America and Morgan Stanley (all on Friday). All but one of these companies is expected to report a net profit for the second quarter, but the important thing to gauge will be whether the actual numbers come in better or worse than expectations. With banks at the epicenter of the financial crisis, a return to profitability in this space will be needed before the "all clear" can be declared. Better-than-anticipated earnings should see equity marts come off their recent lows and break decidedly higher. Thin markets on the back of relatively lower volume around the summer could make for some interesting moves indeed.

In a scenario of better bank earnings and commensurately better bid risk assets, the US dollar would likely once again become the proverbial whipping boy. The currency vehicle of choice in the punishment process will likely be EUR/USD. Looking at the month of July thus far, the pair has been correlated nearly 90% with the move in US stocks. In other words, EUR/USD has moved in tandem with shares nine out of ten times this month. We anticipate that the relationship will hold near term as European banking concerns remain mostly on the back burner. While the S&P 500 remains depressed while below the 900 mark, an earnest break above that level could elicit some buying interest in size. Should bank earnings blow away expectations to the upside, we would not be surprised to see the index recover all the way back towards the 930/950 zone last seen in mid-June. Using the 2009 relationship as a guide, this would point to a EUR/USD closer to the 1.43/1.44 area, or the early-June highs.

Should things not turn out so well on the earnings front, however, risk trades and EUR/USD specifically could be in for a rough time. The aforementioned S&P 500 remains on a knife's edge just above what has become important support near the 870 level, as current economic data blur the outlook. The first pit stop on a break through there would be the 100-day moving average, which lurks at 852, and then the 830/800 level would be up for grabs through there. That first level would point to a EUR/USD trading closer to the 1.33/1.34 area, while the more bearish and less likely scenario puts it closer to the 1.29/1.30 zone. With EUR/USD seemingly coiling up in a daily sideways triangle consolidation, the likelihood of a major break in the near future looks extremely likely. The direction of the break remains unclear for now, but we expect bank earnings this week will at least help chart the course.

UK CPI Outlook Could Determine Course of Quantitative Easing

The Bank of England's decision on July 9 to keep interest rates unchanged was overshadowed by its announcement not to alter its existing commitment with respect to quantitative easing. Yields on the ten-year gilt pushed up sharply, and cable was squeezed higher on the news. The Bank had made it clear in June that it would take until August before its program of assets purchases totaling GBP 125 billion would be complete. Rather than make an announcement on July 9 as to whether or not it would extend the plan, the BoE stated that "The committee will review the scale of the program again at its August meeting, alongside its latest inflation projections."

This statement has heightened the importance of the August 6 MPC meeting for the gilts and sterling markets. There are several things that the Bank of England will be able to do next month. It could signal an end to quantitative easing. It could announce that it will complete the amount that the government has authorized, which would mean an additional GBP 25 billion in asset purchases. It could decide to delay further a decision on asset purchasing dependent on economic data. Alternatively, it could ask the government to extend the plan further.

The absence of a commitment to an extension of the plan in July increases the chances that the BoE will not extend the plan any further. One contributing factor could be the failure of CPI to move below the BoE's 2.0% inflation target. May CPI stands at 2.2% y/y, and June inflation data are due on July 14, with the market expecting a fall to 1.8% y/y. This release, combined with the Bank's new inflation forecasts (due to be presented in the Inflation Report on August 14), could be crucial in the Bank's decision. Therefore, very weak June CPI could have a significantly negative effect on the pound and gilt yields. Also important to the BoE's decision will be economic data, which generally remain soft, and BoE lending data. To date, official lending data continue to show weakness in lending to businesses, in mortgage lending, and in consumer credit net flows. This highlights the risk that QE may yet be extended.

The underlying tone in sterling in the week ahead will be subject to the whims of risk appetite. However, given its implications for QE, soft UK CPI data would increase the risk that cable will eventually break lower below 1.600.

Key Data and Events to Watch This Week

The US calendar sees a plethora of economic events in the upcoming week. Today starts the action with the monthly budget statement. Tuesday is a touch busier with producer prices, retail sales, and business inventories on deck. Wednesday brings consumer prices, the NY Empire manufacturing report, industrial production, crude oil inventories, and the minutes of the FOMC's June 24 meeting. Thursday has the usual weekly jobless claims data, international capital flows, the Philly Fed manufacturing index, and the NAHB homebuilder sentiment index. Friday rounds out the week with housing starts and building permits. In a word, busy!

The euro zone is a touch lighter. ECB president Trichet gets the ball rolling today with a speech at the IFO seminar. Tuesday has the euro zone ZEW economic sentiment index, German ZEW and euro zone industrial production. Wednesday sees euro zone consumer prices, while Thursday has French consumer prices on deck. The euro zone trade balance and euro zone construction output will close things out on Friday.

It is a pretty light week in the UK. The BRC retail sales monitor leads the way today along with RICS home prices. DCLG home prices and consumer prices are due on Tuesday, while Wednesday sees jobless claims and the unemployment rate.

Japan also sees a rather typical week. Today has industrial production and consumer confidence. The Bank of Japan rate decision is expected on Wednesday, and, if past is prescient, will be a non-event. That day also has machine tool orders and the tertiary industry index on tap. The leading index rounds out the week on Friday.

Canada is characteristically light. The Bank of Canada's senior loan officer survey will provide a pulse on the credit markets on Monday. Motor vehicle sales are due Tuesday, while Wednesday has manufacturing shipments lined up. Friday is the busiest day with consumer prices and the leading economic index.

It is also a pretty standard week down under. New Zealand retail sales kicked it off yesterday, while Australian business conditions are up on Tuesday. New Zealand business PMI, New Zealand consumer prices, and the Australian leading index are all up on Wednesday. Friday has Australian import and export prices.

China is once again on the radar and has a ton of data due to be released on Wednesday with GDP, producer prices, consumer prices, retail sales, and industrial production all scheduled. The markets have been paying close attention to Chinese data in an effort to gauge the outlook for global growth, and as such, these releases could prove quite market moving.

By Brian Dolan, chief currency strategist,

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