The Fed’s future path still seems more bullish than the European Central Bank. If so, the yiel...
Tax Cut Deal Will Continue to Buoy the Buck
12/13/2010 11:31 am EST
The greenback has bounced back after the announcement of a compromise on extending the Bush tax cuts was reached between the White House and congressional Republicans. First off, we would note that this is not yet a “done deal” and Democratic opposition could still sink the plan. In the end, though, we think they'll hold their noses and adopt the plan, as the alternative—tax rates rising to start the year—is nearly unthinkable.
The tax compromise has benefitted the USD in two important ways, which hold the keys to the USD outlook ahead. The first is that the tax cuts amount to another dose of fiscal stimulus, which just a week ago seemed an impossibility, and improves the near-term growth outlook for the US economy. Economists are raising 2011 GDP estimates by 0.5-1.0%, looking for somewhere between 3.0-4.0% GDP for the full year. Better growth prospects, in turn, reduce the likelihood that the Fed may need to do the full amount of QE2, and reduces the potential for QE3, removing major dollar negatives for the time being. The second effect was for US yields to rally sharply, providing interest rate support for the USD, again on the back of better prospects for growth and the need for higher rates sooner. We think a fair amount of the backup in US rates is due to year-end positioning reductions, and we would note that many of the best-performing asset classes (e.g. metals and commodities) saw similar setbacks in the past week. (On that note, thinner year-end liquidity conditions are becoming more apparent across all markets.)
We also remain cautious on the prospects for growth to materialize quickly in a way that meaningfully improves the jobs outlook, which is the key to US rates eventually moving higher. As such, we think US rates will eventually begin to drift lower and may have already peaked below key 3.35/3.40% resistance in the ten-year yield. If so, the upside for the USD might be limited in the near term, especially in USD/JPY, where key 84.50/85.00 resistance remains intact. If the US tax cut plan is eventually adopted, we would reckon with a final knee-jerk rally in the USD as political uncertainty is resolved, but after that we would anticipate some give back. If the plan is scuttled by politics, the USD is expected to suffer greatly. We would also note the near complete absence, so far at least, of USD-negative impact from the higher US deficits the tax cuts entail. But we think such concerns will also likely restrain USD strength in the near term.
While the Fed is likely pleased that additional fiscal stimulus may be forthcoming, they are no doubt unhappy with higher US rates, which is at complete odds to its asset purchase program. At this week's Fed meeting on Tuesday, we expect the Fed to be at great pains to talk down US rates, and we think they'll firmly commit to buying however much is needed to keep rates low. Fed assurances that rates will remain low for an extended period should also work against further moves higher in US yields, likely limiting the dollar's upside. The biggest risks to an extended USD rally mostly come from external developments, namely the European debt crisis and excessive Chinese tightening discussed below.
Europe’s Leaders Shimmy Up to a “Fiscal Harmony”
It’s been another interesting week for the euro zone. While pressure has eased a little on the troubled peripheral nations such as Portugal and Spain, a permanent solution to Europe’s debt crisis still remains a long way off. One idea that has divided Europe is the issuance of common euro-area bonds. This would tie the borrowing costs of the stronger core nations with the weaker peripheral nations and spread credit risk between all members.
While this would no doubt be beneficial to the weaker economies of Ireland, Greece, Portugal, and Spain, who would be able to borrow money at cheaper rates, the upside is more limited for the core economies, especially Germany, who would see its borrowing costs rise.
This idea, although touted by Jean-Claude Juncker, President of the EU, was effectively ruled out on Friday when Germany’s Angela Merkel and French President Nicolas Sarkozy rejected the idea during a joint press conference, saying that it would make governments less fiscally responsible. Instead they called on individual nations to get their fiscal houses in order and restore economic competitiveness. They also said there was no need to top up the European Financial Stability Fund (EFSF), which currently stands at EUR440 billion. This stands at odds with the European Central Bank, who has called for leaders to increase the size of the bailout fund as a way to wean weaker European banks off the Central Bank’s cheap financing.
NEXT: Euro Zone Problems Are Far from Resolved|pagebreak|
However, it was reported on Friday that Ireland’s financial sector is still addicted to ECB funding. Irish lenders received EUR136 billion in loans from the ECB and the Irish Central Bank up to November 26—just after it applied for the emergency funds. Until the bailout loan is actually in the bag (currently Irish lawmakers are still voting on the 2011 budget, which needs to get passed before the funds will be released) and there is more clarity on the banking sector’s restructuring plans, then Irish lenders are likely to have to continue to resort to the ECB in order to meet their financing needs.
One interesting development from Friday’s Franco-German summit was the commitment from Merkel and Sarkozy to converge their tax policies to the peripheral nations to help them become more competitive. They also said that next year they would present structural proposals to bring greater economic coordination to the euro area. Although far from fiscal union, it is a stab at fiscal harmony, which many believe is necessary to ensure the survival of the euro-area project.
The details of greater economic coordination were not elaborated upon, and we don’t expect to hear anything too interesting at next week’s EU Summit December 16-17. However, Europe’s authorities are making slow but sure progress toward understanding that the market won’t accept a piecemeal approach to this sovereign debt crisis, and instead a comprehensive solution needs to be found.
Europe’s problems are far from resolved, and we don’t expect there to be any great breakthrough at next week’s summit. EUR/USD could dip to 1.3105 before it finds support at its 200-day simple moving average. However, any positive signals from the summit that Europe’s leaders are willing to do what it takes to resolve this crisis and get the euro zone on a more sustainable footing could provide a temporary boost to sentiment. But EUR/USD is unlikely to rise above 1.3420, the recent high, and in our view, the grind lower in EUR/USD is set to continue.
Further Tightening out of China
China represents a sizable portion of the global growth outlook. Chinese trade data came in stronger than expected (exports rose 34.9% YoY vs. 22.9% in October and imports gained 37.7% YoY vs. 25.3%) and further underpins the global economic recovery. However, China now faces a more pressing issue with the task of controlling inflation and an overheated real estate market. In response, the People’s Bank of China raised their reserve requirement ratio (RRR) by 50 basis points in efforts to further address these issues. Nevertheless, without firmer measures to try to cool growth such as meaningful interest rate hikes and more flexibility to allow the yuan to appreciate, then markets are unlikely to conclude that China’s growth will slow anytime soon. This weekend, the November CPI (a measurement of inflation) was expected to rise to 4.7% from 4.4% in October and economists are anxiously awaiting news on a possible interest rate hike in response. In this instance, we think there would be little harm in raising interest rates from their current low levels as it would be consistent with the PBoC’s desire to “normalize” policy.
As China tightens to manage liquidity and control inflation, we may see periodic setbacks in risk sentiment as well as dips in commodity prices and the prices of commodity-linked currencies (gold, silver, AUD, CAD, and equities). Any such pullbacks are likely to be short lived, and in our opinion, should be viewed as potential buying opportunities.
Dovish Outlook to Weigh on the Kiwi
We expect the kiwi (NZD) to underperform after a dovish shift in the Reserve Bank of New Zealand’s (RBNZ) monetary policy stance. The Monetary Policy Statement (MPS) issued by the RBNZ was downbeat and noted that the near-term outlook for GDP has softened. This was highlighted by below-average investment, weak household spending, and a slowing housing market. The MPS went on to state that “interest rates are likely to increase modestly over the next two years, for now it seems prudent to keep the OCR low until the recovery becomes more robust and underlying inflationary pressures show more obvious signs of increasing." Additionally, the bank stated its concern that a strong New Zealand dollar is negatively impacting exports.
The RBNZ also urged the government to eliminate the fiscal deficit to ease current pressures on interest rates and the New Zealand dollar. This is likely in response to the recent move by S&P to revise its outlook on New Zealand from stable to negative as the country has become increasingly reliant on foreign debt. The RBNZ revised down its forecast for the 90-day bank bill rate to provide further evidence of maintaining steady rates. We believe that this, along with the downbeat economic outlook and widening fiscal imbalances, is likely to weigh on the New Zealand dollar. As such, we would view NZD strength as sell opportunities with a bias lower. In NZD/USD, the daily Tenkan line is currently around 0.7535/40 to provide immediate resistance. A move above the convergence of the 21- and 55-day simple moving averages, which is around 0.7590-0.7600, may see to the daily Ichimoku cloud top and prior highs around 0.7675. Key levels to the downside include the 100-day simple moving average (SMA) which is currently around 0.7400/10, the 0.7350 pivot, and 200-day SMA currently around 0.7220.
By Brian Dolan, chief currency strategist, FOREX.com
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