The Fed’s future path still seems more bullish than the European Central Bank. If so, the yiel...
Risk Rally Stalls for the Moment
10/26/2009 10:10 am EST
Despite the crescendo of USD negativity this past week (e.g. CNBC devoted a full day's worth of programming to the weak dollar theme), the greenback actually held up pretty well while the JPY struggled further as the biggest loser. On the week, the USD is better against the JPY, GBP, and CAD, and slightly weaker against AUD, EUR, NZD, CHF, gold, and silver. Perhaps interestingly, EUR/USD broke above the psychological resistance level of 1.5000, made little progress and looks set to close just below it for the week. Euro zone finance ministers and ECB president Trichet did their best to talk down EUR/USD, but the market paid little attention. Cable experienced a massive rejection from a break above its Ichimoku cloud on strength early this past week and looks quite vulnerable (see below). CAD went on a roller coaster ride, but ultimately fell against the buck on more strident warnings from the Bank of Canada against further strength. BOC governor Carney used the "I" word (intervention) and traders reacted for the time being with further short covering in USD/CAD. We are cautious that markets will continue to heed the BOC threat, but excessive USD short positioning there may see further gains toward the 1.09-1.10 area, where we would reconsider selling USD/CAD. The 21-day SMA at 1.0550 may be the trigger higher, and a daily close above would be bullish, in our view.
It's too soon to say the risk rally is reversing, but it certainly feels as if investor euphoria has run its course. Stocks (S&P 500) lost ground on the week despite some better 3Q earnings (see below) and Treasury yields finished out the week at their highest levels since the end of summer. Still, we have no firm technical clues of a broader reversal and instead must reckon with further consolidative price action in the week ahead. However, due to extreme positioning (short USD, record long gold) a reversal could get messy in short order, so we will be on high alert for signs of a larger reversal. In addition to the weak USD and risk on/off themes, it looks like a case of increasing differentiation between economies based on the fundamental outlook. We expect the differentiation theme to continue even if a USD-positive correction should occur. In order of appeal, we would use pullbacks as multi-week buying opportunities in AUD, NZD, and CAD, as mentioned above. In order of aversion, we would look to continue to sell JPY and GBP on remaining strength.
Sterling Set to Remain on the Defensive vs. EUR in Approach to November MPC
The plunge in the value of the pound following the release of shockingly poor UK Q3 GDP data (-0.4% m/m) begs the question of whether sterling can stage a turnaround in the coming sessions. Against the EUR, the outlook for the pound has been worsened by the perception that the euro zone recovery remains on track. Friday's releases of the German October IFO survey and the euro zone October PMI both showed further improvement. Both Germany and France returned to growth in Q2 2009, and these numbers, combined with a worse-than-expected contraction in the UK economy during Q2, played a significant part in depressing the value of the pound versus the EUR through the summer. Looking ahead, the prospects for UK Q4 GDP will be supported by the VAT hike on January 1, 2010, which is likely to lead to some front loading of expenditure. That said, UK economic potential will be dampened for some time by rising unemployment, higher savings rates, and the reining in of fiscal stimulus. With the gap between the recovery in the euro zone appearing to accelerate away from that in the UK, and given the ongoing concerns about the UK's appalling fiscal position, the value of GBP versus the EUR is likely to remain severely weakened for some time. Forthcoming UK house price data is likely to show further stability, while lending data are also expected to confirm that conditions are less bad. The CBI distributive trades data may also show signs of an improvement in the high street activity. However, in the wake of the horrible Q3 GDP release, none of these data releases are likely to be strong enough to push the risk of further QE from the BoE off the table. In the approach of the November 5 MPC meeting, sterling is likely to trade on the defensive. A break above the EUR/GBP 0.9200 level could lead to a jump higher to the 0.9310 area.
We remain cautious with regards to the potential of such a pickup given the dreadful state of the consumer balance sheet and the awful employment landscape. Given that, by our calculations, the consumer still needs to unwind roughly $500 billion in non-real estate credit to get back to sustainable debt/income levels and unemployment will continue to rise in the first half of 2010 right through 10%, making this sort of organic growth questionable to say the least. This is the main premise behind our view that the current rally in equities is well overdone and a sharp short-term correction is looming.
The next two weeks will paint a better picture of the current earnings landscape as we have 290 companies slated to report. As such, the price action in all markets will be beholden to the outcomes in this space. Given very strong intermarket correlations, with commodities, stocks, and yields all moving opposite to the US dollar, we could be setting up for a significant reversal in the recent trends. In other words, should earnings disappoint on the top line, we would expect the US dollar to find a solid short-term base and see a significant pickup in buying interest. Those likely to suffer the most on earnings disappointments are AUD and CAD, as much of the near-term strength here (economic fundamental improvement notwithstanding) can be directly attributed to the euphoria in the commodities space. The gold bulls will also undoubtedly head for the exit.
MORE: Earnings, Treasury Auction, Data and Events This Week|pagebreak|
Earnings Still Show Little Organic Growth
With about a third of S&P 500 companies having reported 3Q earnings, the picture remains eerily similar to the 2Q results. The bottom line results (EPS) are coming in 16% above expectations, while the top-line sales figures have registered marginally below conservative forecasts at -0.1%. This suggests businesses continued to drive the bottom line via cost cutting, mainly on the employment front. We didn't get that net -768,000 job loss in the quarter by accident. With the consumer seemingly in deleveraging mode (as per recent trends in consumer credit data) and the unemployment rate likely to be sticky above 10% well into 2010, driving organic earnings growth will be extremely difficult still. If nothing else, these rather lackluster earnings reports suggest a potential short-term top in the equity space as the price action looks to have overshot reality. Indeed, the US market is now trading at a 20.5 price-to-earnings ratio, about 17% above the long-term average valuation. Long-term fundamental difficulties notwithstanding, the USD could be poised to carve out a short-term bottom over the next week or so if this pattern on the earnings front continues to play out. The buck has seen a -95% correlation with equities thus far this year, so any reversal in risky assets should elicit a nice pop in the US dollar.
Treasury Auctions Again in Focus
The US Treasury is scheduled to offer a record $123 billion in notes next week and the outcome of these auctions could have serious implications for the US dollar. Among these are two-year ($44b), five-year ($41b) and seven-year ($31b) offerings. The key metrics in terms of gauging the health of the auctions will be the bid/cover ratio, the indirect take, and the market tail. The bid/cover ratio measures the amount of interest in the auction relative to the amount being offered. Thus a bid/cover of 2.7 or greater for the two-year, 2.3 or more for the five-year, and 2.5 or above for the seven-year would be considered healthy participation. The indirect take is used as a proxy for foreign central banks, so a higher percentage suggests more foreign interest for US paper. An indirect take above 50% would be a good sign that foreigners are not shunning USD-denominated debt. Lastly, the market tail measures what yield the auction participants bid at (in other words, what return they deem as compensation for their risk) relative to where the market is trading. Should the tail come in above four basis points (0.04%) or so, this would suggest investors are demanding more return for holding US paper than what the current market is offering. This means holding US paper is deemed more risky at the margin. So a positive tail above that 4bp threshold would be a USD negative as yields would likely spike. A large positive tail coupled with a weak bid/cover and thin indirect take would be decidedly US dollar negative. For now, however, the demand for US paper remains robust and has shown little signs of waning.
Key Data and Events to Watch This Week
The US data week begins with the little-advertised Chicago Fed National Activity Index on Monday. Case-Shiller home prices and consumer confidence are up on Tuesday, while Wednesday sees durable goods, new home sales, and the usual weekly oil inventory report. The highlight of the week comes Thursday with 3Q advance GDP along with the typical jobless claims data. Personal income/spending, Chicago PMI, and the University of Michigan consumer sentiment index round out the week on Friday.
The euro zone kicks off with German consumer confidence on Monday. French consumer confidence follows on Tuesday, while German CPI is up on Wednesday. The euro zone business climate indicator, euro zone consumer confidence, and German employment are on tap Thursday. Euro zone CPI and German retail sales close things out on Friday.
The UK has a light week on deck and starts with the CBI distributive trades report on Tuesday. Consumer credit and mortgage approvals are up on Thursday, while consumer confidence is due Friday. The Bank of England will also release a report on the asset purchase facility on Monday, and this could be market moving as well.
Japan is on the busier side for a change. Retail trade kicks off the action on Tuesday. Small business confidence, PMI manufacturing, and industrial production are due Wednesday, while Thursday has employment, household spending, and consumer prices. Housing starts and the Bank of Japan rate meeting are up Friday.
Canada also has an important week ahead. Data is on the light side with industrial product prices on Thursday and monthly GDP on Friday. However, we also have Bank of Canada governor Carney speaking on Monday and finance minister Flaherty on Tuesday. Given the recent musings with regards to concern about the Canadian dollar strength, these speeches could offer up some market-moving tidbits.
The calendar down under is more lively than usual. In Australia, we have PPI on Monday, CPI on Wednesday, leading indicators, and new home sales on Thursday. New Zealand starts with consumer confidence on Tuesday. Business confidence, trade, and the RBNZ rate decision are all due Wednesday, while building permits round out the week Thursday.
By Brian Dolan, chief currency strategist, FOREX.com
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