Top stories for currency traders this week include renewed strength in the euro, US dollar weakness, and upcoming monetary policy decisions by the central banks in Australia and New Zealand.
Last week, I suggested to a fellow trader that the strength of the global recovery remained very much in doubt despite the G8’s optimistic pronouncement. I also mentioned that risk assets (stocks and commodities) were set to weaken further, and that this would support the US dollar (USD).
Stocks and many key commodities did decline last week (S&P 500 closed below the daily Ichimoku cloud bottom at 1305/1306, and the CRB commodity index is potentially forming an "abandoned baby top” bearish reversal pattern on daily candles), but the USD lost further ground anyway. USD weakness is clearly attributable to fresh US data disappointments that have rekindled talk of another round of Fed asset purchases (QE3).
We think QE3 is highly unlikely, but that won’t stop markets from speculating on it, which will keep pressure on the USD until we get some fresh indications from the Fed one way or the other (watch for Bernanke speaking on Tuesday).
Also, Congress continues to dither on raising the US debt limit, which led Moody’s to warn of a potential downgrade to US ratings unless progress is made soon, adding further pressure to the greenback. Until a deal is reached, the political stalemate will also weigh on the buck.
USD weakness was not equally distributed, however. In particular, we would note that the buck was barely changed against the commodity currencies (Australian dollar (AUD), Canadian dollar (CAD), and New Zealand dollar (NZD)), suggesting to us that commodity-related markets remain vulnerable.
Indeed, USD weakness is typically associated with risk-asset (stocks and commodities) price gains, and the fact that this did not happen reinforces our view that risk sentiment remains quite vulnerable. In this environment, our preference remains to look for opportunities to get short risk assets on remaining strength, potentially in select JPY crosses.
The star performer of the past week was clearly the euro (EUR), which gained against all major currencies except the South African rand (ZAR). The resolution of the latest chapter in the Greek debt saga has given the EUR a healthy lift, but we will be watching closely to see if the pace of recent gains is sustained, or whether NFP-related excessiveness was too extreme.
The European Central Bank (ECB) is meeting on Thursday and the expectation is that Trichet will signal a July rate hike using the "strong vigilance" code words. The single currency seems most likely to remain supported in the run-up to the ECB meeting (barring any major peripheral turmoil over the weekend—see below), but if Trichet fails to signal a rate hike next month, EUR is likely to beat a hasty retreat, a la the last meeting on May 5.
NEXT: Greece Passes Key Test; EUR/USD Heading Higher
|pagebreak|Greece Passes Debt Test: Is EUR/USD Targeting 1.5000?
After a month-long review, the Greek Finance Ministry said that the European Union (EU)/International Monetary Fund (IMF) and ECB had concluded “positively” on Friday. While there was little detail on what exactly was positive, it effectively means that Greece is likely to receive the next tranche of bailout funds at the end of this month and is also in the running to get a second bailout, rather than return to the capital markets next year.
It is likely that Greece has signed up for even more austerity measures and asset sales to try to bring down its debts organically, instead of having to borrow more money. This makes the public workers strike scheduled for Saturday likely to be the first of many in the coming weeks.
But what is most important to Greece right now is the EU and how supportive it is of Athens. Three dates in June are crucial: On June 20, the Eurozone finance ministers meet, and Greece is likely to be top of the agenda; on the 24, European leaders meet, and they are likely to agree to a second round of financial support for Athens; then on the 29, the IMF should release its next tranche of bailout funds.
It’s a crucial month for Athens, but after Friday's announcement, things have become much easier for the Southern European nation, and its bond yields actually fell at the end of last week. This gave the euro the green light to rise above 1.4500 on Friday versus the greenback. Investors are rushing into the single currency after signs that the US economy is faltering, as well as a cooling in financial pressure in the periphery.
The stage is set for EUR/USD to make another stab towards 1.5000. A weekly close above 1.4500 is extremely constructive for the pair, and we may see 1.4670 first and then the 1.4850 highs from early May.
But there is one large caveat to this. To start with, Portugal holds a snap election on Sunday. Any sign that political turmoil will threaten its deficit reduction-program may weigh on sentiment towards the single currency. Banking sector stress tests are also due for release this month (though there have been reports that the Eurozone bank regulator has requested banks to re-submit fresh data, suggesting a possible delay) and Spain has set a deadline of September for its troubled Caja banks to re-capitalize.
So there are potential obstacles the euro has to climb to remain well supported, but as long as the prospect of QE3 in the US remains on the table, this should favor the euro over the greenback, in our opinion.
Is Bank of England (BOE) Getting More Dovish?
Last week could end up being one of the most pivotal weeks of the year for the Bank of England. Andrew Sentance, who had voted for 12 straight rate increases (and been voted down on each occasion) left the Committee, as his term on the Monetary Policy Committee (MPC) expired.
In a television interview on the day he stepped down, Sentance said the Bank risked its credibility by not raising interest rates and allowing inflation to reach 4.5%. However, just as his words hit the airwaves, there was further evidence that the economy is slowing and weak GDP in the first quarter is seeping into Q2.
Firstly there was the PMI manufacturing survey, which tumbled to its lowest level since September 2009. Additionally, the services sector survey, which represents the lion’s share of the UK economy, fell in May to its lowest level since February. Cracks are starting to emerge in the UK’s growth picture, and this makes a near-term rate hike extremely unlikely.
This was reinforced when one of the more dovish members of the BOE, Paul Fisher, said that he was open to the idea of extending the Bank’s asset-purchase program if the economy was to contract sharply. He also reiterated his stance on rates, saying that it was too early to hike.
Of course, Fisher is only one member of the Committee, but Sentance’s replacement, Ben Broadbent, a former Goldman Sachs economist, seems to have a less-hawkish bias than his predecessor.
Interest rate expectations for the rest of the year have fallen sharply since February and remain back at October 2010 levels, when a rate hike was barely priced in for this year. We think that the outlook is too cloudy to pinpoint exactly when the Bank will normalize interest rates, but it currently looks like it may not be until the first quarter of 2012.
Low rates and weak economic data are weighing on the British pound (GBP). While we think it will eventually grind lower against the dollar, we think it will experience a sharper move against the euro and the Swiss franc (CHF). Although the franc is at record highs versus the pound, we think it may move lower towards 1.3500. We also think that the pound looks more vulnerable than the euro right now, and this supports a move towards 0.9000, the highs last reached at the start of May.
NEXT: Rate Decisions Upcoming for Australia, New Zealand
|pagebreak|Steady Australian Cash Rate…for Now
Australia’s economy contracted -1.2% in the first quarter as the aftermath of Queensland flooding negatively impacted commodity export volumes. The drawdown in GDP alongside disappointing April employment numbers in the midst of a moderating global recovery will likely see the Reserve Bank of Australia (RBA) hold its cash rate steady at 4.75% for the seventh consecutive month on Tuesday.
However, we expect the policy statement to contain hawkish undertones similar to those in the May 3 minutes—"If economic conditions continued to evolve as expected, higher interest rates were likely required at some point if inflation was to remain consistent with the medium-term target"—as Q2 GDP looks set to rebound from firming domestic demand, business investment, and public consumption.
Additionally, a significant factor in Q1’s disappointing GDP print stems from the decline in net exports on the back of the tragic earthquake in Japan (Japan accounts for about 18% of Australian exports). The bulk of such export-related losses are likely to remain confined to Q1, which may see external demand alongside domestic demand provide a substantial boost to second-quarter growth.
Accordingly, we think the RBA may begin tightening policy in July or August, but we maintain a bias for an August hike, as it would allow the RBA to take into consideration Q2 CPI readings.
New Zealand Rates to Stay on Hold for Extended Period
The Reserve Bank of New Zealand (RBNZ) rate decision is set for release on Wednesday, and the official cash rate (OCR) is almost certain to be kept unchanged at 2.5%. Comfortable core inflation levels, downside economic impacts from the earthquakes, lower export volumes, and the elevated NZD are likely to be the determining factors in steady RBNZ monetary policy.
We think the RBNZ may signal higher rates for 2012, but the recent sharp ascent in NZD is likely to force the central bank’s hand to maintain a steady policy stance for the remainder of 2011. Further supporting the case for continued passive RBNZ policy is the elevated domestic currency (NZD/USD printed record highs last week).
Sustained NZD strength at lofty levels would have substantial downside impacts on net exports. This may see the RBNZ attempt to rhetorically weaken the currency, but such attempts may be of limited success considering the broader backdrop of USD weakness.
By Brian Dolan, chief currency strategist, FOREX.com
