Forex Traders Still Troubled by News Abroad

01/13/2011 1:04 am EST

Focus: FOREX

Kathy Lien

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

China is starting to weigh on the minds of currency traders. The latest Chinese economic report doesn’t make the outlook in Asia any brighter. China has been the engine of growth for many countries around the world at a time when the US economy was floundering. If the Chinese economy starts to slow and the US economy does not pick up the slack, 2011 could be another tough year. Last night, China reported a much-smaller-than-anticipated trade surplus. Economists predicted a surplus of $21.7 billion, which was slightly less than the $22.9-billion surplus reported in November. Unfortunately, last month China’s trade surplus was only $13.08 billion, the smallest in eight months. Exports rose a mere 17.9%, down from 34.9% in November, while imports increased by only 25.6%, down from 37.7% the previous month. Whether the timing of the trade surprise was intentional or not, President Hu will be arriving in Washington on January 19 for his official state visit.

There is usually no mystery to these significant data surprises. President Hu’s visit is a big deal because it is his first “state visit” since 2006, even though the two leaders have met a number of times in the past. It should be no surprise that President Obama will be pressing China to revalue its currency, but these carefully negotiated summits are more about expanding cooperation and promoting partnership. President Hu will also be able to point to the latest trade numbers and say that his hands are tied because of slower export demand. In all likelihood, the trade surplus will increase just like it did between April and June of last year. A week before President Obama was set to meet with Hu Jintao, China reported its first monthly trade deficit since 2004. Coincidence or not, we leave that to you, but from an economic perspective, the latest trade report has raised concerns about Chinese growth and its implications on the rest of the world.

Euro Zone: Watch Out for Portugal

After falling every single trading day last week, today’s rally in the euro was a welcomed relief. The rebound in the currency is extremely impressive considering that Portugal was the biggest story in the market today. According to a poll conducted by Reuters, 85% of dealers expect Portugal to be the next domino to fall. Portuguese credit default swap (CDS) spreads have increased to a record high of 548 basis points (bps), which is the same level to which Irish CDS spreads widened before the government was forced to initiate bailout negotiations. Over the weekend, Die Spiegel, a leading German newspaper, reported that Germany and France were pressing Portugal to accept a rescue package.

The Portuguese government denied a need for a bailout as recently as Sunday, but having gone through this twice in the past 12 months, we know that denials by the government are the first step before acceptance. Both Greece and Ireland vehemently denied the need for a bailout before they were eventually forced into accepting theirs. Portugal's ten-year bond yield surged above 7%, which means that the borrowing cost is still sustainable, but barely so. Some investors expected Portugal to ask for a bailout as early as Wednesday, when they had a bond auction scheduled, but the greater likelihood is that they will wait until after the auction is held. Their next T-bill redemption is scheduled for Jan. 21, two days after the Eurogroup/Ecofin finance minister meeting, which is the perfect venue to discuss Portugal's situation. Although Portugal only represents a small percentage of total euro zone GDP, its problems have sparked concerns about the creditworthiness of Spain, a country that accounts for more than 10% of the euro area's GDP. The market could cope with a bailout of Portugal, but not a bailout of Spain.

With no end in sight to the European sovereign debt troubles, things will certainly worsen before they improve. Spain also has a bond auction on Thursday. We don't expect demand at the two auctions to be exceptionally weak, but that will not stop investors from turning on Portugal. Economic data from the euro zone was actually better than expected. Manufacturing activity in France accelerated, with industrial production rising 2.3% in November. The Swiss franc traded lower against the euro despite stronger-than-expected retail sales. On a seasonally adjusted basis, retail sales rose 2.5% year-over-year, more than double market expectations. Shortly after the US market open, the Swiss franc sold off aggressively against the euro, sparking concerns about Swiss National Bank (SNB) intervention. There is no question that the SNB is worried about the strength of its currency, but we are suspicious of this rumor, as SNB intervention typically causes a much stronger and faster reaction in the currency than the one seen today.

NEXT: New Developments for GBP, CAD, and JPY

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GBP Lifted by Deals with China

The British pound has also strengthened against the euro recently, but for completely different reasons. Economic data was weak, with UK mortgage lender Halifax reporting a larger-than-expected decline in house prices. The housing market has been the Achilles heel of the UK economy, and last month, house prices fell 1.3%. According to their in-house economist, no major improvement is expected because “Low interest rates will continue to enhance affordability for those entering the market while limiting pressure on existing homeowners to sell, but economic uncertainty, weak earnings growth, and higher taxes could put downward pressure on demand.”

Nonetheless, the pound performed extremely well thanks to significant deals between China and the UK. The British government announced that UK and Chinese companies have signed GBP2.6 billion ($4 billion) worth of deals in the energy and automotive sectors. The deals are freshly minted and were announced after the bilateral meeting between Chinese vice premier Li and British deputy prime minister Clegg. Li, who is widely expected to succeed premier Wen Jiabao next year, also said it is “Entirely possible” to double the value of the trade activity between the two countries by 2015. China is still a relatively small trade partner for the UK, but that could change in the coming years, and if it does, it could be a big boom for the UK economy. Many economists have raised their interest rate forecast for the UK, and the latest deal will only solidify their belief that the central bank could tighten as early as August. 

CAD: Higher Oil Prices Offset by Weaker Data

Against the greenback, the New Zealand dollar was the day’s best-performing currency. A smaller- than-expected trade deficit led by gains in exports helped to lift the currency. Chinese demand for dairy and lumber boosted the prices of some of New Zealand’s most important exports. New Zealand has been slow to recover, but the rise in commodity prices have helped to accelerate that process. The Canadian and Australian dollars, on the other hand, ended the day unchanged against the greenback. Retail sales in Australia rose 0.3% in the month of November, which was right in line with expectations. Construction sector activity contracted at a slightly slower pace, which is encouraging, but not by enough to lift the currency.

The Australian trade balance is due for release this evening, and given the strength of the aussie towards the end of the year and the weakness of manufacturing activity, the trade surplus should decline. Meanwhile, there is a lot of focus on oil after BP shut down the Tran-Alaska pipeline after a leak this weekend. The pipeline transports oil from Prudhoe Bay field, America's largest oil reserve. This field produces approximately 630,000 barrels of oil each day, which is the equivalent of 40% of the UK's daily consumption. As a result, oil prices have jumped, leading many experts to believe that Americans will soon be paying $4 a gallon for gasoline. According to a member of Kuwait's highest oil policy body, OPEC members "Are unlikely to meet before their scheduled meeting in June if prices reach $100 a barrel." This official believes that OPEC production will not be increased until oil crosses $110, so no near-term relief is in sight. Interestingly enough, this has lent little support to the Canadian dollar.

This could be due in part to building permits, which fell 11.2% in November, the sharpest decline in more than two years. With the Canadian dollar trading above parity, manufacturing activity stagnating, and housing activity slowing, the Bank of Canada has little reason to alter interest rates despite the improvement in the labor market. For the time being, the downtrend in USD/CAD remains intact with only Canadian housing starts due for release tomorrow.

JPY Hits Four-Month High Against Euro

Despite the lack of fundamental news out of Japan, the yen continues to show resilience against many of the currency majors, hitting a four-month high against the euro and a one-month high against the aussie. Continued sovereign debt woes in Europe and a flood-hit Australian export sector are leading many to pull away from the higher-yielding, risky currencies and flock towards the safety of Japan’s low-yielding yen. This risk-averse sentiment has caused many headaches for Japanese government officials, who must take continually progressive actions to prop up the lagging Japanese economy. In addition to keeping the target rate at “virtually zero” for an extended period of time, the Bank of Japan (BoJ) is also reinforcing its stance on the purchase of risky assets across many classes, including ETFs, REITS, and corporate bonds. “The asset purchase program is also aimed at breaking the vicious circle in capital markets caused by risk aversion,” stated BoJ deputy governor Kiyohiko Nishimura last week. “The purchases are designed to act as a catalyst to induce investment in riskier assets,” which the Bank hopes will spur the economy and help to recover some ground against the deep, deflationary economic environment plaguing Japan.

The latest core CPI data showed prices falling for the 21st straight month in November; the BoJ forecasts prices to continue to plunge into 2012, which could mean more monetary easing to come. However, such actions come at a cost. With a national debt of nearly 200% of its GDP, Japan could face a credit downgrade, according to warnings by ratings agency Moody’s, if it doesn’t take steps to bring its deficit in check. Such warnings have placed officials in a tight position, as the price action of the Japanese yen remains very much out of their control. 

Instead, the yen continues to strengthen amidst a pullback of risk sentiment in the market, which has mainly resulted from mixed US fundamental data and the opaque future of European sovereigns. As the BoJ tries its best “To avoid creating an impression of the monetization of government debt,” according to Nishimura, the Bank must still continue to take such steps out of necessity. While today was another empty day on the economic calendar, things return to normal starting tomorrow with the leading indicators report due for release. Activity is expected to have increased slightly following better-than-expected manufacturing and service sector activity reports.

By Kathy Lien of KathyLien.com

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