When Is a Good Time to Buy the Euro?

02/03/2010 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

The euro finally snapped a four-day losing streak thanks to an improvement in risk appetite and upward revisions to euro zone economic data. Manufacturing activity across the region was slightly stronger than originally reported, and we believe that the recent slide in the euro will lend even greater support to the economy. The reason why we have not heard a peep from European policy makers about the rapid decline in the euro is because having a weak currency has more advantages than disadvantages in this current market environment.

So When Is a Good Time to Buy the Euro?

Since the beginning of December, the euro has fallen over 7%, or more than 1,000 pips, against the US dollar. Such a sharp decline in the currency will certainly attract bargain hunters. However, in the forex market, trends can last far longer than most of us can anticipate. Forex trading is an expectations game, and until traders or investors expect things to change, they probably won’t.

In order to figure out when is a good time to buy the euro, we have to understand what made it the worst performing G10 currency in the first place. As much as the larger members of the European Monetary Union are trying to ignore the problems in Greece, hoping that they will magically resolve themselves, until Greece gets bailed out, the path of least resistance for the EUR/USD is down and not up. The fiscal problems plaguing Greece and the other PIIGS (Portugal, Italy, Ireland, Greece, and Spain) are fundamental issues that need to be addressed before investors large and small are willing to put their money back into euro. According to a report from Bloomberg, investors are pulling cash out of Europe at a record pace as central banks slow their own purchases.

Part of this decline in demand is undoubtedly tied to the risk of investing in the region. The cost of protecting against a default in the euro zone for five years, which is measured through credit default swaps, hit a record high last week. So a good time to buy the euro is when members of the European Union finally step up to bail out Greece. At the same time, a Greek bailout would not be needed to turn the euro around if the weak currency starts to stimulate the region’s economy, triggering a wave of positive economic reports.

Another reason why traders have turned aggressively bearish on euro over the past few weeks is because of their belief that in the coming months, euro zone growth will lag behind that in the US. If the reverse happens because the strength of the US dollar curbs demand for US exports and the weakness of the euro boosts demand for European exports, the expectations would have to be reset once again in favor of the euro. Finally, on a shorter-term basis, 1.4050 is the level to watch in the EUR/USD. If the currency pair manages to rise above that level, we could see a stronger rally towards 1.43, but even a move up to that level would not break the downtrend in the EUR/USD. German retail sales are due for release, and the recent improvement in the labor market suggests that consumer spending may have recovered.

US Dollar: A Dash of Optimism

The rally in US equities and the rise in bond yields confirm that today’s dollar’s strength reflects an improvement in risk appetite. Stronger US economic data and healthy manufacturing PMI reports from other parts of the world added a dash of optimism to the financial markets. The central bank rate decisions and employment reports that are scheduled for this week can either be a vote of confidence for the global recovery, or trigger additional concern among already-weary investors.

We think that it will probably be the former since the improvement in manufacturing PMI suggests that service activity may have accelerated as well. This is non-farm payrolls week, and based upon the decline in jobless claims, there is a good chance that NFPs may print positive once again, which would add further fuel to the rally in the dollar. The only question is what the dollar will trade on this week—risk appetite or relative growth. The dollar’s performance against the yen has and will continue to trade on US fundamentals. Until the sovereign risk issues for the euro zone and the UK subside, we expect currencies to trade primarily on relative growth.

NEXT: Impact of New US Economic Reports; Obama Budget


Manufacturing Activity Hits Five-Year High

This morning's US economic reports have been mixed with manufacturing ISM rising from 55.9 to 58.4, the highest level in more than five years, and construction activity, personal income, and personal spending all falling short of expectations. January was a good month for the manufacturing sector with activity accelerating in the US, UK, euro zone, and Australia. In the US, a pickup in export orders, employment, supplier deliveries, production, and prices contributed to faster manufacturing activity.

Yet most impressive was that the sector is continuing to expand despite the appreciation of the US dollar in December. The global pickup in manufacturing activity is largely tied to the expansion of manufacturing demand in China in the second half of 2009. However, signs of a slowdown in the Asian giant have begun to emerge, and combined with dollar strength in January, it will be interesting to see if the global improvement in manufacturing can be sustained. Personal income growth slowed to 0.4% in December, while personal spending slowed to 0.2%. Incomes grew by a faster pace than expected, but the upward revision to the November data put income growth lower than in the previous month.

Given the sharp decline in retail sales in December, the slowdown in spending was not particularly surprising. According to the PCE deflator, inflationary pressures are also up modestly. The positive economic report was enough to turn traders optimistic, but not enough to trigger a full-fledged reversal in the greenback. Only something like non-farm payrolls could alter the trend in the forex market. Although this week is non-farm payrolls week, we will have to wait until Wednesday for the market to turn its focus to NFPs because pending home sales is the only piece of US economic data due for release on Tuesday.

Obama’s Budget

Meanwhile, the dollar also benefited from the Obama administration's upward revision of GDP. The White House now expects the US economy to grow by 2.7% in 2010, up from their prior forecast of 2%. However, despite the improvement in growth, the jobless rate is expected to average 10% this year. In President Barack Obama’s new $3.8 trillion 2011 budget, the focus is jobs. In fact, a total of $100 billion will be set aside for a type of jobs stimulus plan, of which Obama has dubbed an “urgent priority.” Most of the new plan comprises a $61 billion expansion to a worker taxpayer credit, called “Making Work Pay.”

Under this program, which affected 110 million households last year, $400 will be provided to individuals and $800 to couples until 2011. The rest of the jobs creation process consists mostly of promises to continue infrastructure spending and subsidies, which indirectly, will secure more jobs. So the big question for both sides of the aisle is how the Obama administration can afford these new proposals. The answer lies in spending cuts and tax hikes.

The president’s current plan calls for a discretionary spending freeze, which currently represents 17% of federal spending. However, defense, education, and research and development would not see any cuts in funding. The next stage in his plan is to allow the Bush tax cuts to expire, essentially bringing in $1 trillion in new tax revenue. If all goes as planned, Obama expects the deficit to shrink to $727 billion in the next three years.

GBP/USD: A Manufacturing-Led Recovery

Although the British pound ended the day virtually unchanged, a quick look at the charts will indicate that the currency pair has staged a dramatic comeback, having traded as low as 1.5850 on an intraday basis. We received yet another piece of evidence today that suggests the BoE will leave their quantitative easing program unchanged later this week. The manufacturing sector purchasing managers index surged to a 15-year high at 56.7, which is a strong vote of confidence for the UK economy. The surge definitely bodes well for growth, even after last week’s GDP suggested a sluggish recovery. The new orders component, often a leading indicator for economic activity, rose at the strongest rate in about six years and was driven mainly by export demand. It seems that the stagnating pound has finally offered some assistance in the export department. At this point, it is really starting to look like manufacturing is the main driving force behind the UK’s recovery.

Monthly house prices, as tracked by Hometrack, advanced for the sixth straight month, by 0.1%. However, it was cautioned that it was probably more of a shortage of supply than a pickup in demand that caused the rise. Housing seems even less secure when considering that annualized house prices slid and mortgage approvals declined for the first time in about a year. Other economic data showed that the BoE’s index of M4 money supply came out in line with previous estimates of -1.1%. Construction sector PMI is due for release tomorrow.

NEXT: Latest on Aussie Dollar and Japanese Yen


AUD/USD: RBA Expected to Raise Rates to 4%

The improvement in risk appetite has driven the Australian, New Zealand, and Canadian dollars higher. Positive economic data from Australia, including a rise in manufacturing sector PMI and house prices, has set the tone ahead of this evening’s monetary policy announcement from the RBA. Over the past few weeks, the Australian dollar has fallen victim to the same pressures as the other high-yielding currencies. Risk aversion along with demand for US dollars has pushed the AUD/USD below 90 cents. However, on the eve of the Reserve Bank of Australia’s monetary policy decision, currency traders are buying the aussie on the hope that the RBA will increase interest rates once again.

A rate hike is pretty much a done deal, and if the RBA fails to deliver, they stand the risk of triggering a very sharp selloff in the Australian dollar. Although this would be welcomed by the central bank, recent economic data including yesterday’s manufacturing PMI numbers suggest that the Australian economy does not need more stimulus. In fact, growth is so robust that the RBA has been on a rampage to clamp down on asset bubbles. Yet after four consecutive interest rate hikes, it may be time for the RBA to slow things down. After raising rates in December, central bank deputy governor Ric Battelino said that the “neutral” rate is no longer 5%, and we estimate that it is probably closer to 4.5%. Australian interest rates are currently at 3.75%.

If the RBA raises rates by 25bp, it would leave only 50bp of additional tightening before they get to 4.5%. This is only the first monetary policy meeting of the year, and the Chinese government’s active efforts to slow their economy could encourage the central bank to spread out their remaining rate hikes. Therefore, we believe that the RBA will raise interest rates by 25bp to 4%, but set the market up for a possible pause in March. Based upon the latest inflationary numbers, the RBA has the flexibility to slow things down. Up until now, the central bank has said they will “lessen gradually the degree of monetary stimulus.” Any hint of hesitation to raise rates the following month will temper the reaction in the aussie, which suggests that another rate hike may not be enough to turn the AUD/USD around. In order for the aussie to rise back above 90 cents, not only would the RBA need to raise interest rates, but they would also need to leave the door wide open for another rate hike in March.

USD/JPY: Worries Escalate Over Japan

Japanese yen crosses have strengthened across the board as the yen falls in lock step with the decline in volatility. The Bank of Japan’s top economist had some less-than-optimistic comments about the Japanese economy. Momma worries that even despite a continued recovery in the global economy, the spread of the rebound in capital spending and the labor market will probably be limited. On the topic of deflation, he confirms that there is no “magic” bullet in fighting off price pressures, but assures that the situation is the BoJ’s top priority. Momma says that if such solution existed, they would have already taken the necessary steps. From Momma’s comments, the BoJ seems a little helpless in their fight and suggests that new programs may be on the way. Economic data showed that vehicle sales rose to 36.8% from 36.5%. However, it will probably not be until next month when we see the potential impacts of lost sales that Toyota’s recalls have caused. Economic data for tomorrow is limited to the monetary base and labor cash earnings.

AUD/USD: Currency in Play for Next 24 Hours

AUD/USD will be the currency pair in play. In Australia, we are expecting the highly anticipated RBA rate decision at 10:30 pm ET, or 3:30 GMT. We will also have the NAB business conditions and confidence at 7:30 pm ET, or 00:30 GMT. In the US, pending home sales were scheduled for 10:00 am ET Tuesday, or 15:00 GMT.

Click to Enlarge

AUD/USD is still within the Bollinger band sell zone, but today’s rallies build evidence behind a new swing in momentum. To the upside, resistance should be steady at the psychological 0.9000 figure, which happens to be close to where the ten-day moving average and lower one-standard deviation Bollinger band are lying. To the downside, support stands at the December 23 low of 0.8733. In any event, today’s change in pace could be the start of a new direction in the aussie.

By Kathy Lien of GFTForex.com

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