The Fed’s future path still seems more bullish than the European Central Bank. If so, the yiel...
A New Trend Is Underway in Forex
05/16/2011 11:15 am EST
Important forex themes for the week ahead include new trend reversals, slow growth forecasts for the UK and Asian markets, and a new phase for euro zone debt concerns.
After last week’s rout in risk assets (commodities, stocks, and JPY crosses) and the subsequent rebound in the US dollar, we were largely constructive on the move, viewing it as only a positioning-driven correction within a larger uptrend. Price movements in the past week, however, have now convinced us that a larger trend reversal lower is likely taking place.
While there are plenty of individual stories and themes playing out, we prefer to focus on the strength of the global recovery as the primary driver. And here, we think recent data points to moderating global growth, as Asia shows signs of decelerating (see below) and major developed economies appear set to languish as austerity measures increasingly take hold.
German factory orders and euro zone industrial production both declined month-over-month in March, suggesting that the strong 1Q growth in the euro zone is unlikely to be sustained. Anecdotally, we continue to hear market talk of sizable leveraged names (hedge funds) exiting long risk/growth trades and turning more bearish.
Additionally, a quarterly Bloomberg News survey also revealed a decidedly bearish shift in sentiment among global investors for the months ahead. Lastly, the impending conclusion of the Fed’s QE2 asset purchase program is cited by many as feeding into expectations that US rates may rise and stocks may fall, though we don’t ascribe recent risk asset strength to QE2 at all.
We will continue to look to incoming data for suggestions about the strength of the global recovery and to inform our view of risk sentiment.
We think positioning is still a factor, but recent sharp declines in major currencies and commodities suggest that a potentially significant portion of the excess has been worked off, meaning the pace of declines may moderate in the week ahead.
Still, we don’t think positioning is anywhere near short “risk” assets, so we will look to use rebounds in any consolidation periods as an opportunity to re-sell key commodities and major currencies/buy USD on dips. Please note that this is a reversal of the view we suggested in last week’s update.
Technically, we are getting trend reversal signals in many major markets: The CRB commodity index has dropped below the daily Ichimoku cloud; West Texas Intermediate (WTI) crude oil and silver have both dropped into the cloud but so far are holding above the base (hopefully offering room for a rebound); gold is lagging and holding well above the 1435/1436 cloud top, possibly signaling it will play catch-up (see below); EUR/USD has dropped into the cloud; and the USD index has tested the bottom of the cloud from below.
These developments suggest that there may still be some bounce left in certain commodities and currencies/pullback in USD, but that another week like the last two would trigger unambiguous signals of an even larger reversal lower in risk assets/higher for the USD in the weeks ahead.
NEXT: UK Leads the “Soft Patch” in Global Growth|pagebreak|
UK Leads the “Soft Patch” in Global Growth
Last week’s inflation report delivered what many had expected: A downgrade to the UK’s growth forecast for 2011. The Bank of England’s central projection for growth this year is between 1.8% and 3.5%. This is below the Bank of England’s February forecast of 2%-4%.
Inflation was revised higher, which was also expected, but the Bank surprised the market with its interest rate forecast. Its projections were based on interest rates rising to 1% by the end of the year. This surprised the market since investors had been pricing out the prospect of any rate hikes this year after a spate of weaker data, including first quarter GDP, which was below the growth rate of Greece.
The Bank’s signal last week suggests that rates may be increased as early as August and then again at the end of the year. But with growth essentially flat since the third quarter of 2010 and PMI survey data for April pointing to the slowdown extending into Q2, we think that rates may remain on hold for some time yet.
Interestingly, in the aftermath of the inflation report, short sterling futures, which measure interest rate expectations, have not had a significant move, suggesting that the market is not convinced the Bank will raise rates at all this year.
There are two reasons for this. Firstly, the outlook for growth has deteriorated. Austerity measures have just started to take hold and household incomes are likely to remain constrained for some time yet. That is bad news for the UK economy, as it relies heavily on consumption and services to grow.
Secondly, the fall in commodity prices has the potential to affect UK inflation rates more than in the US because the Bank of England looks at headline inflation, which includes energy and food prices. So if oil prices continue to come off, then we could see CPI rates decline in the coming months. There is a caveat to this: Processed food prices. They have risen strongly in recent weeks and have the potential to keep upward pressure on inflation for some time to come.
Putting that concern to one side, weak growth and the potential that inflation has peaked do not support higher rates. While the UK economy faces strong headwinds in the medium term, if the Bank holds off on raising rates, that may boost growth as we move into 2012. So there is a chance that this “soft patch” is a temporary bump in the UK’s economic profile.
Sterling had a volatile week, falling back from 1.6500—the post-inflation-report high—and closing the week below 1.6200, the lowest level since the start of April. The economic outlook is particularly cloudy, which makes it hard to predict the direction of sterling. We think the risk is for another down move, with 1.6500 the high for now. Below 1.6180—which is the top of the Ichimoku cloud—GBP/USD is no longer in a technical uptrend, and we may see downside to 1.6000.
NEXT: Euro Takes Hit as Soverign Crisis Enters Act Two|pagebreak|
Euro Takes Hit as Sovereign Crisis Enters Act Two
Since last summer, the euro has shrugged off sovereign debt concerns. It brushed off the Irish bailout in November, and within days of the Portuguese bailout, EUR/USD was in touching distance of 1.5000. But since last week, the prospect of a second bailout for Greece and a new phase of the crisis have spooked investors.
It appears that the market is starting to discount sovereign concerns, which makes it unlikely that EUR/USD will move back to the 1.5000 level, in our opinion. EUR/USD closed last week on a weak note, below 1.4190, which is the top of the Ichiomku cloud and the end of the EUR/USD technical uptrend. Below 1.4150, we may see a sharp decline to the 1.3950/1.3960 zone, which is also the bottom of the Ichimoku cloud chart.
The decline in the euro is not only due to sovereign concerns. The single currency is also weakening along with other risky assets and it is moving inversely to the dollar, which has strengthened 4% against its major trading partners since the start of May.
As risk aversion and the dollar rebound grips markets, the euro will remain under pressure. However, we don’t anticipate the single currency to go down in a straight line. The ECB still seems committed to normalizing interest rates at a quicker pace than the Federal Reserve, and strong growth figures for the first quarter of this year have kept interest rate expectations elevated.
Right now, there are another two ECB rate hikes priced in by year end. This seems excessive when the peripheral economies are struggling and Portugal returned to recession in Q1, but unless we see a dramatic slowdown in inflation or overall growth rates, then the ECB may hike rates again in July. If interest rate differentials do start to drive FX markets once more, then the euro is the sure winner.
However, we believe that sovereign concerns may run for some time yet after Germany said it would not agree to extend more aid to Greece until the conclusion of an IMF audit in June on how well Athens is complying with the conditions of the first bailout.
While Germany remains unwilling to pledge extra financial help to Greece, the euro may be on the back foot. After all, this time last year, the euro was in freefall when Germany and other nations failed to agree on the first rescue package.
Asian Growth Outlook Subdued
This week, the People’s Bank of China (PBoC) raised banks’ reserve requirement ratio (RRR) by 50 basis points (bps), effective May 18. This is the fifth time this year the PBoC hiked the RRR, which has reached a record high of 21%.
This comes after an abundance of Chinese economic data was released on Wednesday. The data showed that while inflation ticked down slightly in April to 5.3% year-over-year from the previous 5.4%, it remains at elevated levels, which is likely to be concerning to policymakers.
Additionally, new yuan loans for April rose by much more than anticipated—to 739.6 billion from the prior 679.4 billion—also an alarming indicator. This suggests that the PBoC may continue to tighten to withdraw liquidity and control inflation.
As the world’s second largest economy and major consumer of commodities, expectations of continued tightening by China may keep pressure on risk sentiment as the policy measures are likely to weigh on growth. This can be seen by lower-than-forecast April industrial production of 13.4% year-over-year (consensus forecast 14.6%; prior 14.8%) and an unexpected drop in retail sales to 17.1% year-over-year (consensus 17.6%; prior 17.4%). As noted by PBoC Governor Zhou, “There is no limit to how far the required reserve ratio can be raised.”
On Thursday, Japan will release its first quarter GDP, which is expected to show a contraction of 0.5% quarter-over-quarter from the prior -0.3%. The decline is largely due to the March 11 earthquake, and a second consecutive quarter of negative GDP would confirm a recession.
Recent indicators suggest significant deterioration in the Japanese economy, with the most notable being a sharp drop in March industrial production by -15.3% month-over-month from the prior +1.8%. Weakness is expected to persist for some time, and the expectations are for continued contraction before a recovery materializes.
The Bank of Japan is set to meet this week and is not expected to make any changes at its policy announcement on Friday, though the risk is for board members to support Deputy Governor Nishimura to increase asset purchases. While markets are risk averse, yen crosses are likely to remain under pressure, however, the downside in USD/JPY may be limited as the threat of intervention lingers, suggesting more pronounced weakness may materialize in non-JPY/US dollar pairs.
By Brian Dolan, chief currency strategist, FOREX.com
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