The Fed’s future path still seems more bullish than the European Central Bank. If so, the yiel...
Key Currency Themes This Week
03/07/2011 10:28 am EST
Mid-East tensions continue to drive the markets, while traders are also reacting to interest rate news from the ECB and other central banks. Here's what to watch in the week ahead.
By Brian Dolan
The greenback has slumped further as violence in Libya has escalated and fears continue to mount about the unrest spreading to other, more economically significant countries in the Middle East. Despite the largest gain in jobs since census-induced hiring in mid-2010 and other signs of improvement in US labor markets (e.g. further declines in initial claims), the buck limped out at its lowest level for the year according to the USD index. But the USD’s performance was mixed against most currencies besides the EUR, which rallied across the board on ECB rate hike expectations (see below). All in all, it could have been much worse for the USD, and this suggests a safe-haven bid may be returning to the greenback. US stocks declined and Treasury yields fell on safe-haven buying of US Treasuries in spite of the ostensibly upbeat Feb. jobs report.
Precious metals and commodities also continued to gain ground on the Mid-East upheaval. The focus there is firmly on efforts to oust Libyan leader Gaddafi, and we would suggest it is a question of when, not if, he disappears into exile, potentially setting up a rapid reversal in safe-haven assets. In the meantime, civil conflict in Libya is likely to drag on, and the dollar’s descent seems likely to continue, though it will probably be less of a rapid collapse and more of a slow grind.
Over the next several weeks, EU leaders will be meeting to tackle their debt/financial crisis, culminating in the March 25 summit that aims to produce the comprehensive crisis resolution mechanism. The end of this week will see the "European Competitiveness Pact" unveiled, which aims to strengthen economic and fiscal coordination among member states. Indications are that deep divisions remain on many of the key issues, such as establishing concrete debt reduction goals, increasing the size of the bailout fund, and whether to allow it to buy peripheral government debt. The risk to recent EUR gains is that EU leaders fail to produce a credible mechanism and markets conclude sovereign defaults remain a serious threat, which may see the EUR come under pressure despite rate hike expectations. Lastly, we would note the relatively minimal gains in EUR/USD since the relatively surprising ECB announcement (only about 120 pips), which we interpret as a sign that most of the move was already priced in.
We see immediate upside potential for EUR/USD while the 1.3800/13850 area holds. Initial resistance is at 1.4020/1.4050, above which gains to the 1.4180/1.4200 area are expectated. Overall, a Fibonacci wave extension suggests 1.4420/1.4425 as a potential target for the current advance once above 1.4050.
ECB Takes Its Anti-Inflation Medicine
ECB governor Trichet surprised the markets last week with an explicitness he has saved until the last six months of his term in office. He reverted to the verbal code words he used during the Bank’s previous tightening cycle when he said that “strong vigilance” is warranted with a view to continuing upside risks to price stability. In the past, this signaled that a rate hike was imminent. Now the market expects Trichet to announce a rate hike at April’s meeting. But it wasn’t this stock phrase that surprised market watchers; it was Trichet’s candidness.
Although he said the ECB never pre-commits to a rate decision, he added that he expects rates to rise by 25 basis points and that a rate hike next month would not signal the start of a tightening cycle. This was central bank communication at its most clear.
Immediately, investors scrambled to re-adjust interest rates armed with this new information. Three-month euro swap rates surged ten basis points to their highest level in two years, while Euribor—the inter-bank lending rate—also surged on the news. The extra yield boosted EUR/USD, which is now on the brink of 1.4000.
Up until last week, the markets had been expecting the Bank of England to hike first. After the ECB press conference, the yield differential between German and UK yields widened considerably, which boosted EUR/GBP to 0.8600.
So why did the ECB bite the bullet? The most likely reason is that rapidly rising oil prices don’t warrant extraordinarily accommodative interest rates. Indeed, Trichet omitted to mention that the interest rate was appropriate; instead he said the current stance of monetary policy was “very accommodative.”
NEXT: But Will One ECB Rate Hike Be Enough?|pagebreak|
But will one hike be enough? We would say probably not. Inflation in the euro zone is running at a 2.3% annualized rate. Even with a 25-basis-point increase, real interest rates will still be negative, so the ECB isn't going to stamp out inflationary pressure with a small, one-off rate hike. So if the Bank is serious about inflation, a series of hikes seems more likely. The market has rushed to price in a more-than-50% chance that rates will rise to 2% (from the current 1%) in 12-months’ time.
The ECB and the Federal Reserve are now at opposite ends of the policy spectrum, with the Fed seemingly committed to providing the full $600 billion allotment of QE2 to the US economy until June. The diverging paths of the two largest global central banks should benefit EUR/USD. So far, the pair has failed to break above 1.40, but in the coming weeks, based on its yield advantage, we see EUR/USD back at the 1.4250 highs last reached in November 2010.
Commodities Stay Aloft Amid Mid-East Tensions
Last week, crude oil prices rose to fresh 29-month highs ($104.30/$104.35) amid the rapid deterioration of stability in Libya and the threat of it spreading to other Middle East/North African (MENA) nations. The persistent violence has caused supply disruptions in Libya of approximately one million barrels a day, which is over half of the nation's daily output. While news that Saudi Arabia guaranteed to use spare oil capacity if needed temporarily calmed the markets (Saudi Arabia's spare oil capacity is estimated to be five million barrels a day), it’s not an exact match since Arabian oil is much heavier than Libya’s light sweet crude and is thus problematic since it needs additional refining. With the current geopolitical environment riding emotionally high, fundamentals are likely to remain in the rear-view mirror. Furthermore, even prior to the political unrest in the Middle East, we saw signs of demand growth picking up in China and India, and with the US unemployment rate falling to 8.9%, it signals demand in the west may begin to pick up as well. Lastly, market participants are beginning to envision a weaker USD moving forward, based on diverging interest rate expectations between the Fed and the ECB and Bank of England (BOE), which has caused greater demand for commodities and ultimately adds more fuel to the fire.
The flight-to-safety trade has not just been all about oil, but was also present in precious metals. We noted recently that “With tensions in the Middle East unlikely to subside anytime soon, this flight-to-safety trade could be stronger and last longer than the market currently anticipates, subsequently traders are beginning to take action.” Over the past week, gold broke to new nominal all-time highs near $1440/oz and silver just made fresh 30-year highs of $35.35/$35.40 at the time of writing. Going forward, price action should remain volatile, however, pullbacks could be shallower than anticipated as investors who have missed the current move higher in commodities may look to jump on board in the not-too-distant future. A resolution to the Libyan turmoil, on the other hand, could see a more serious setback.
Bank of England Gets Pipped at the Post
After the events in the euro zone, it now seems unlikely that the Bank of England will be the first of the major central banks to hike interest rates. The Bank meets this week to decide on policy, but it is expected to remain on hold. In fact, since the last meeting, the market has slightly reduced its bets that rates will rise in the UK over the next few months as economic data has disappointed, especially Q4 2010 GDP and the PMI services sector survey for last month. Sonia rates (GBP swap rates) have fallen from their peak, and three-month UK Libor (inter-bank lending rates) remains within its near-term range.
This has thwarted the rise in sterling, and for now, the top in GBP/USD is 1.6300.
EUR/GBP looks ripe to outperform in the near term. After 0.8600, the 0.8900 high reached in October comes back on the radar.
Kiwi Under Pressure Ahead of Interest Rate Meeting
On Thursday, March 10, the Reserve Bank of New Zealand (RBNZ) meets to decide on interest rates. The outlook for the island nation has been very bleak after the tragic, 6.3 magnitude earthquake that struck Christchurch on Feb. 22. This was the second major earthquake in just six months, with the previous quake occurring on Sept. 4. Both quakes are estimated to have caused as much as NZ $20 billion in damage and have delivered a blow to growth prospects with the risk of a relapse into recession indicated by Q3 GDP, which contracted by -0.2%.
The 90-day bank bill rate has plummeted from about 3.20% on Feb. 21 to current levels of around 2.86%. Additionally, Prime Minister John Key said he would “welcome” an interest rate cut. He went on to say that “The market has priced in a cut from the Reserve Bank. That would probably be my expectation, that the Reserve Bank would cut, but it’s for them to determine that.” While some market participants are anticipating a rate cut, the distribution of expectations is relatively balanced with about half of analysts forecasting no change in rates. Of those expecting the bank to slash rates, about half are looking for a 50-basis-point cut while the other half is anticipating 25 basis points. With recent weakness in NZD, it appears that a cut may be priced in, which indicates that the risk is to the upside.
Technically, NZD/USD is facing a significant pivot around its 200-day simple moving average (SMA), which currently comes in at about 0.7380, and the Dec. lows around the 0.7345/0.7350 area. The pair is trading below the daily ichimoku cloud, which suggests a downward bias. A daily close below the 200-day SMA and Dec. lows is likely to see further downside. Key levels to the upside include the daily Tenkan line, which is around 0.7480 ahead of the daily cloud base, and the Kijun line, which is around 0.7580/0.7590, just below the 0.7600 area where the 55- and 100-day SMAs converge.
By Brian Dolan, chief currency strategist, FOREX.com
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