May…A Rocky Start for World Currency
05/09/2011 10:42 am EST
A surprise upturn in the US dollar and ongoing pressure in Europe may cause the dollar to strengthen further against the euro and pound, but the commodity currencies still have the strongest outlook.
“Sell in May and go away” has taken on a whole new meaning after the last few days.
Major markets appear to have been uniformly caught excessively long of risk assets (stocks, commodities, and metals) and short USD, which we think was the primary driver of the past week’s declines.
To be sure, there were some setbacks in the fundamental outlook for the global recovery, but nothing of the sort to justify double-digit percentage declines in many markets—except for excessive positioning, which we cautioned about in last week’s update.
For example, many point to the sharp drop in the April US ISM non-manufacturing index, from 57.3 to 52.8, as an ominous sign for the US recovery, and by extension the global rebound. But the ISM services index is a volatile series and prone to overshoots.
Other US data for the week indicated the fragile US recovery is continuing apace, not rip-roaring but also not stalling:
- April ADP +179K private jobs added
- April NFP +244K total jobs added
- April ICSC chain store sales up +8.5% YoY (prior +2.0%), despite higher gasoline prices
In short, we think fears of a significant slowdown in the US recovery are overblown at this point, and that the attendant risks to the global recovery are also exaggerated. Growth and demand in Asia remains quite solid (Although Chinese data next week will be an important barometer on this), and we think the sell-offs in risk assets are primarily for positioning.
However, we would note a subtle shift in momentum between the US on one side and the UK and Europe on the other. The latter are showing signs that recent growth has likely peaked, especially in the UK.
With the view that the global recovery is ongoing, we expect the commodity currencies (AUD, CAD, NZD, and NOK) to remain resilient against the majors (USD, GBP, EUR, and JPY), and for the USD to perform a bit better against the other majors. This view suggests looking for opportunities to sell those majors against the commodity currencies at advantageous levels (e.g. selling EUR/AUD, GBP/CAD, EUR/NOK, etc.).
Greece Debt Crisis Heats Up
As this is being written, news continues to break surrounding an emergency meeting of Eurozone finance officials to discuss some facet of the Greek debt crisis, and the EUR is under pressure across the board.
We doubt reports that Greece will seek to leave the euro, so we are left to contemplate that the meeting is either to consider a request to amend Greek bailout terms or to prepare for a debt restructuring. If it’s to adjust bailout terms, we think the impact on the EUR will be relatively short-lived. If a debt default/restructuring is in the works, we also think the fallout may be more limited than at first glance.
For months now, markets have been pricing in the prospect of a Greek debt restructuring, and with ten-year government bonds trading at around 57 cents on the EUR, a significant haircut is already priced in. What is likely not priced in is the amount of losses core (French and German) European banks would suffer if a restructuring actually materializes.
There are further risks to Eurozone financial stability and the EUR from this, although performance ultimately will depend on the terms of any restructuring or default. Of course, there may be unexpected developments from the emergency meeting, as the subject was not disclosed. Still, we are cautiously optimistic that the EUR has only gotten caught up in the overall risk sell-off, with an additional battering from Friday’s headlines.
The major pillars of recent EUR gains are still in place:
- the ECB is still on track to tighten in July
- the Germans and French will not let the EUR break up
- and the global recovery is still on track
We think EUR/USD back above 1.4450 or 1.45 will signal the worst is past, but that EUR/USD below 1.42 to 1.4250 means greater downside potential.
NEXT: UK Public Spending Cuts Start to Bite|pagebreak|
UK Public Spending Cuts Start to Bite
After the disappointing bounce in UK growth in the first quarter, initial signs suggest that the second quarter may not do much better. PMI data, which measure sentiment and activity in the manufacturing, services, and construction sectors, all came in below expectations for April.
The most worrying sign so far comes from the services sector. Not only does activity in this area contribute the most to GDP (approximately 70%), but also firms in April noted that cuts to public spending caused a decline in business.
This is concerning for two reasons. First, public sector spending is only going to get cut further as the year progresses. Second, government spending rose in the first quarter and provided a boost to GDP. However, this prop to growth is being pulled away as we move into the second quarter, which is likely to dampen the economic recovery as we progress through the middle of the year.
So what does this mean for interest rates—and most importantly, the pound? The answer isn’t clear-cut. Although interest-rate expectations are driving markets, and there is now less than one hike priced into the UK rates curve for the next year, it is relative interest-rate expectations that drive currencies.
The pound is still well supported versus the dollar, as the market seems happy to continue to sell the greenback as long as there is no end in sight to the Federal Reserve’s ultra-low-interest policy. We expect it to continue to trade in a range between 1.60 and 1.67 for the time being.
Against the euro, the pound has been under pressure. But after breaking through tough resistance at 0.90, EUR/GBP sold off after the ECB’s Trichet was less hawkish than expected during his press conference last Thursday. So, although the chance of rate hikes from the Bank of England have diminished markedly in recent weeks, this doesn’t lead directly to a weaker pound—investors are sensitive to what other central banks are also doing.
Looking ahead, the Bank’s Inflation Report is released on Wednesday at 10:30 London time. This will give us updated growth and inflation forecasts. It will be interesting to see how the Bank adjusts its outlook for prices after March’s decline in the headline inflation rate to 4% from 4.4%. Also, watch for any comment from Mervyn King regarding how long he thinks the current weakness in commodity prices may last, and the impact on inflation.
Precious Metals Come Crashing Down
What a difference a week makes! The sharp rise of commodities in April has been swiftly undone in the first week of May.
If you would like to know where commodities are headed, keep your eyes on silver, as it led both moves—higher in April and lower in May. The past week in silver can be summed up in one word: breathtaking, as at one point it was down more than 30%.
So what happened?
In efforts to try to dampen volatility, the Chicago Mercantile Exchange (CME) has been raising margin requirements in silver. Typically over the past six months, the higher margin would lead to a mild correction that presented traders with an opportunity to establish their bullish bias at better levels.
However, this time the CME continued raising margins five times, to the tune of 84%, over a two-week period. On April 25, the initial margin requirement stood at $8,700; effective today, May 9, the CME is set to raise it to $16,000!
This was the most likely catalyst that led to the sell-off in silver, although news that George Soros and Carlos Slim (the richest man in the world) have been selling silver no doubt added to the panic.
It may be prudent to wait for the “falling knife” to stick in the floor, rather than try to catch it. After the strong US employment report, it appears commodities may have done just that, as price action in silver saw an hourly RSI positive divergence into the lows. Additionally, gold bounced off longer-term trend-line support around $1,460 to $1,465, and failed to make a lower low.
However, while commodities appear to have stopped their freefall, it doesn’t mean we are ready to jump back on board just yet. At the end of the day, rather than trying to pick a bottom, we’d prefer to establish a bullish bias only upon a break back above the top of the Ichimoku cloud around $36.55 to $36.65, in search of a move back towards $40 to $42. This way we would be more confident a meaningful bottom has formed.
Conversely, there is an extreme risk of a continuation lower should gold break below the aforementioned trend-line support, which rises to $1,470 on Monday.
Crude Oil’s Descent: Trend Reversal or Correction?
A number of factors may have contributed to Thursday’s precipitous oil decline, which saw crude prices print their second largest USD-denominated loss to date—down $9.44 to $99.80/bbl in WTI, and down $10.39 to $110.90/bbl in Brent.
The US dollar’s resurgence seems to have played a prominent role in oil’s dramatic swing lower as well as the broader commodity sell-off, as Trichet’s exclusion of the term “vigilance” injected doubt into the market in terms of timing the central bank’s next move—EUR/USD plummeted towards the 1.4500 figure, and has dropped even lower since to around 1.4380.
Demand destruction, on the back of higher prices, was also put forward as a reason for the steep drop in crude oil. Higher interest rates, alongside inflationary concerns and its dampening effect on Chinese and Indian oil demand, have been a concern for some time now, and may have added momentum to Thursday’s oil price decay.
Additionally, rumors of potentially higher CFTC margin requirements for crude, similar to those recently implemented in silver, made the rounds, adding fuel to the “crude sell-off” fire. While unsubstantiated at the moment, we would be remiss to completely dismiss the potential for this rumor to eventually become fact.
While all of the above are legitimate explanations for Thursday’s oil descent, we think the extensiveness of the swings suggest exaggerated technical trading as the main driver of price action. Thus, any continued declines in crude may be short lived, as there has been no significant shift in the fundamental oil market structure, and this may provide attractive risk-reward value for longs.
The 100-day SMA in WTI crude oil looks key, as the moving average has provided decent support since the fourth quarter of 2010—WTI only managed to dip below the 100-day SMA (currently around $97/bbl) by approximately $2, before resuming its uptrend.
Accordingly, we think the longer-term crude oil uptrend remains intact, and believe prices will trade within a $95 to $105 and $105 to $115 range for WTI and Brent, respectively, in the weeks ahead.