The Fed’s future path still seems more bullish than the European Central Bank. If so, the yiel...
The Forex Trading Week Ahead
11/29/2010 11:26 am EST
North Korea is firing artillery shells at South Korea; the Irish banking system is on the verge of collapse, with fears of broader contagion steadily increasing; China is pursuing additional credit restraint; and the Fed is undertaking QE2 in last-ditch effort to salvage the US recovery. If ever there were a time to hit the panic button, now would seem to be it. While we certainly think the environment is ripe for a major risk selloff (USD, CHF, JPY, gold higher/EUR, GBP, AUD, stocks, and commodities lower), we think it's going to be more of a slow-motion train wreck rather than a sudden bus plunge.
The risk to this view is that we do have a more sudden risk relapse, and we would note in particular the time of year (end-of-year profit taking/positioning reduction around the corner) and the US Thanksgiving holiday week (where lower liquidity can trigger exaggerated movements) as increasing that potential. But our primary scenario is a gradual decline in the beginning, likely followed by an accelerating cascade of risk selling over the next few weeks and months. From a strategic point, this suggests looking for opportunities to get short of risk. From a tactical point, it suggests there still is time—and likely multiple opportunities—to get short risk in the weeks ahead.
In broad brushstrokes, our thinking on the crisis topics above, which we look at in greater detail below, is as follows. The North Korean provocation should be a flash in the pan, as neither side wants to risk a full-out military conflict. We expect China to work behind the scenes to rein in its psychopathic ward and that crisis tensions should fade relatively quickly as in past.
The euro zone debt crisis is far more troubling and there's clearly a growing sense of inevitability of sovereign defaults in the euro zone, though it's likely to drag out over years. In the shorter term, a two-tiered European debt market is in the process of becoming entrenched, and we think there is more potential of the core being dragged down with the peripherals when investors suffer the expected crisis of confidence in the EUR and euro zone debt as a whole. We would note a chart of periphery—German bond spreads shows an ascending triangle, suggesting that yield spreads may blow out sharply within the next couple of months. EUR/USD has also closed (slightly) below the 1.3374 bottom of its daily Ichimoku cloud.
China's efforts to rein in inflation may temporarily upset the growth/commodity demand apple cart in the short run, but Chinese demand is a fierce beast and should prevent a sudden collapse in commodity prices or commodity currencies. A greater euro zone financial crisis is also a risk for a sudden collapse in commodities, but our preferred view is that ongoing US weakness and weakening European demand will gradually impact China's growth, and that's what will send commodities lower. On the charts, we would note what looks to be a head-and-shoulders topping formation on the CRB, AUD/USD, gold, and WTI crude oil. At the minimum, the symmetry among these suggests a continued correlation-based approach to FX and commodities. At the extreme, if the right shoulder equals the left shoulder in duration, a break lower could occur within the next one to three weeks.
For the Fed's QE2, the flood of dollars that many feared is instead staying on banks' balance sheets. At the same time, US data have shown some encouraging signs, suggesting the Fed may not need to do the full QE2. We think there is still a more significant round of USD short covering to come as worst-case fears of QE2 are priced back out. For the USD index, we would note the Fibonacci significance of the 80.00/80.10 level, with a break above that level suggesting a higher USD ahead. The 1.3330/1.3340 level is the equivalent support in EUR/USD.
NEXT: Is Euro Zone Crisis Only Just Beginning?|pagebreak|
Euro Zone Crisis Is Only Just Beginning
Those who thought a bailout of Ireland by the EU and the International Monetary Fund (IMF) would calm the markets and ease pressure on Portugal and Spain were sorely disappointed. Irish bond yields have risen more than 80 basis points since the start of this week. Spain is arguably the bigger problem for the euro zone, and its ten-year bond yield is now nearly double that of Germany’s at more than 5%, pushing the Spanish/German bond spread to record highs.
Spain’s precarious financial position is extremely worrying for the markets. It is the fourth largest economic force in the euro zone and has a one-trillion-EUR economy. Spain’s budget deficit is projected to be 9.5% of GDP for this year, and like Ireland, it has a weak banking sector, hobbled by the bursting of a giant real estate bubble that caused the unemployment rate to surge to more than 20%. Ireland’s bailout will amount to 85 billion EUR, Dublin announced this week, which is small change compared to Spain, where estimates for the cost of financing a Spanish bailout top 450 billion EUR. Investors are now concerned that the EU/IMF stabilization fund, which totals 440 billion EUR, would be inadequate, and Spain may be too big to bail out.
Right now, the small risk that Spain may need a bailout is the biggest threat to the euro zone project. Without a permanent mechanism to deal with the troubled economies, it appears that the markets will continue to target Europe’s weakest economies.
European authorities need to address both sovereign and banking sector issues. Germany is leading these preliminary discussions, and it wants all bonds issued by the euro zone nations to include standardized “collective action” clauses, which would be the first step to private investors sharing the burden in case of a default. Germany wants this clause to be included from next year, two years before the automatic default mechanism will be implemented. The European Central Bank (ECB) also wants the troubled financial sectors of Europe’s periphery to be fully recapitalized. Irish banks alone have sucked in more than EUR 130 billion of special ECB loans. If they can be recapitalized and weaned off ECB funds, then the central bank can concentrate on its aim to normalize monetary conditions by removing these special liquidity facilities.
Euro zone officials need to agree on these measures and implement them quickly and efficiently to bring some certainty to the markets and help ease pressure on the peripheral economies. Right now, there is a cacophony of voices talking at odds to each other. To settle the markets, euro zone officials need to stand firm and start singing from the same hymn sheet.
Fears of China Tightening Have Become a Reality
Fears of further monetary tightening out of China have become a reality, undermining global equity and commodity prices. The People’s Bank of China (PBOC) has taken a myriad of measures in the past months to rein in lending and curb growth and inflation. Last Friday’s announcement of an additional 50-basis-point hike to the reserve requirement ratio (RRR) was the fifth increase this year and brings up the average RRR across Chinese banks to 17.5%. In monetary terms, the hike is equivalent to the removal of approximately 350 billion yuan in banks’ lending capacity, and is in direct response to elevated loan levels despite past attempts to depress lending (latest net yuan loans release was 588 billion yuan vs. expected 450 billion). Furthermore, on October 19, the PBOC raised the benchmark interest rate by 25 basis points to 5.56, the first hike since 2007. Despite the historic hike, the higher-than-expected October CPI release (4.4% vs. expectations of 4.0% year over year) reflects continued upside pressures on inflation and suggests further tightening measures may be necessary. We believe the PBOC will continue its gradual tightening cycle and expect another hike to the benchmark interest rate by early- to mid-December.
NEXT: The Impact of China's Tightening Measures|pagebreak|
The impact of Chinese tightening measures on commodities has been loud and clear. Gold prices have declined about 7% from recent highs to lows, oil prices have seen a greater-than-9% move, and silver has witnessed a 14% high-to-low range. Declining commodity demand as a direct result of China’s policy direction has translated into the currency markets, with commodity currencies (AUD, NZD, CAD) seeing significant declines of late. AUD/USD tested highs around 1.0180 in early November, but fell precipitously to test the key 55-day SMA (support on recent uptrend) around 0.9750. The kiwi traded close to the 0.8000 level against the dollar, but stalled just ahead of it and saw a subsequent three-big-figure decline to current levels around 0.7630. The loonie was not spared in the China-induced commodity currency selloff. USD/CAD traded under parity in early November, but has since seen a test just short of the 1.0300 level. Wednesday’s Thanksgiving eve risk rally has seen commodity currencies recover some of their recent losses, but we believe further strength may be used as an opportunity to sell at more attractive price points. The impending reality of a hike to China’s benchmark interest rate in December, along with persistent euro zone periphery woes, will likely cap commodity and commodity currency upside in the weeks ahead.
Post QE2, Has the Fed Got It All Wrong?
Last week, the Fed released the minutes of the November FOMC policy meeting. Traders wanted to see if the decision to provide another $600 billion in additional asset purchases was as contentious in the Fed as it was in Congress and the media. As it turns out, “nearly all members” backed QE2, however, they differed over the costs and benefits associated with the program. Overall, “most” participants judged that additional quantitative easing would put “downward pressure on longer-term interest rates and boost asset prices.” Meanwhile, “some” noted concerns that the expansion of the Fed’s balance sheet may lead to a “reduction in value” of the US dollar and “several” suggested it may cause an “undesirably large increase in inflation.”
In the early aftermath, it appears the Fed may have gotten it wrong in their assessment of the effects of additional QE. Treasury yields have risen (especially in the long end of the curve), asset prices have fallen, the USD has rallied, and today’s October PCE—one of the Fed’s primary tools to measure inflation—came in line with consensus expectations. Additionally, the newly elected House members are keen to keep the seemingly ever-rising costs of government at bay. Taken together, this suggests mounting inflationary fears are largely unfounded at the moment. In fairness, a majority of the USD strength can be attributed to European peripheral sovereign debt concerns, as well as the unwinding of extreme short positioning in the dollar. However, the back up in ten-year Treasury yields may continue to unpin the USD in the weeks to come. From a technical perspective, ten-year yields look to have stabilized between 2.72% and 2.96%. Should a breakout occur, we believe it will be rebuffed on either side, as there is strong resistance from 3.06%-3.13%—a series of horizontal pivots and the 200-day SMA—and support around 2.60%, followed by 2.45%. USD/JPY will likely see a similar pattern, as it has traded between 82.80 and 83.90 of late, with further support seen into 81.50/82.00 and resistance near 84.50/85.00.
NEXT: Key Data and Events to Watch This Week|pagebreak|
Key Data and Events to Watch This Week
By Eric Viloria, CMT, senior currency strategist, FOREX.com
Monday: November Dallas Fed manufacturing activity
Tuesday: September and 3Q S&P/Case-Shiller Home Price Index, November Chicago PMI, November Conference Board Consumer Confidence, November NAPM-Milwaukee, Fed Chairman Ben Bernanke speaks in Ohio
Wednesday: November ADP employment change, 3Q final non-farm productivity, 3Q unit labor costs, November ISM manufacturing and prices paid, October construction spending, Fed’s Beige Book, speeches by the Fed Vice Chairman Janet Yellen and Dallas Fed President Richard Fisher
Thursday: Weekly jobless claims, October pending home sales, speeches by Philadelphia Fed President Charles Plosser and St. Louis Fed President James Bullard
Friday: November employment report, November ISM non-manufacturing index, October factory orders
Monday: Euro zone (EZ) consumer, economic, industrial, and services confidence indicators for November
Tuesday: German November unemployment data, French October producer prices, EZ CPI estimate for November, EU’s Olli Rehn will speak on securing financial stability
Wednesday: November final German, French, and EZ manufacturing PMI
Thursday: French 3Q employment data, 3Q preliminary EZ GDP figures, October EZ PPI, ECB interest rate announcement
Friday: November final German, French, and EZ services PMI, October EZ retail sales
Monday: November Hometrack Housing survey, October net consumer credit and net lending secured on dwellings, October mortgage approvals
Tuesday: November GfK consumer confidence survey
Wednesday: November Nationwide House prices, November manufacturing PMI
Thursday: November construction PMI
Friday: November services PMI
Monday: October retail trade, November small business confidence, Bank of Japan (BOJ) Governor Masaaki Shirakawa and Deputy Governor Nishimura are set to speak
Tuesday: October household spending, October employment data, October preliminary industrial production, October housing starts and construction orders
Thursday: 3Q capital spending, BOJ Deputy Governor Nishimura speaks
Monday: 3Q current account, October industrial product price and raw materials price index
Tuesday: September and 3Q GDP numbers
Friday: November employment report
Australia and New Zealand
Monday: Australia October HIA new home sales, Australia 3Q company operating profit and inventories, New Zealand October trade balance data, November NBNZ activity outlook and Business Confidence, speech by Reserve Bank of Australia (RBA) Governor Glenn Stevens
Tuesday: Australia October building approvals, 3Q current account balance, October private sector credit, NZ October building permits
Wednesday: Australia November AiG Performance of Manufacturing index, Australia 3Q GDP figures, November RBA commodity price index, New Zealand November ANZ commodity price
Thursday: Australia October trade balance, October retail sales
Friday: Australia November AiG Performance of Service index
Wednesday: November China manufacturing PMI and HSBC manufacturing PMI
Friday: November China non-manufacturing PMI and HSBC services PMI
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