The Fed’s future path still seems more bullish than the European Central Bank. If so, the yiel...
What FX Pros Are Watching Now
09/07/2011 7:00 am EST
Eurozone debt and the potential for QE3 in the US remain the critical themes for currency traders, driving up risk and impacting major currencies, commodities, and stocks around the world.
August managed to end on a reasonably hopeful note after the drubbing that started the month, but September has started on a decidedly downbeat note. US and European data continues to point to stalling recoveries and the market debate over whether it’s merely a slowdown or the start of a double dip recession has been reengaged.
While it’s too soon to say which way the outlook may break, both prospects are decidedly negative for risk sentiment. Looking ahead, there seems to be little light at the end of the tunnel, as governments continue to pursue austerity and deficit-reduction measures even in the face of slowing growth.
President Obama is set to deliver a long overdue job-creation plan, but it’s unlikely to result in meaningful stimulus measures given the intractable opposition of House Republicans. While Washington fiddles, risk appetite and financial markets seem likely to see further distress in the weeks ahead.
Risk assets responded in relatively predictable fashion this past week, with stocks and commodities falling from key technical levels, gold soaring, and the Japanese yen (JPY), Swiss franc (CHF), and US dollar (USD) strengthening against other major currencies.
The S&P 500 tested the upper level of a potential bear flag consolidation channel we highlighted two weeks ago at 1230. Price was also rejected from above the daily Kijun line and has since fallen back to test the Tenkan line at 1176—both are signs the downtrend may be resuming. The base of the bear flag is at 1140, below which we would expect declines to accelerate.
The CRB commodity index similarly failed above the 342 daily Ichimoku cloud top and has since dropped back below the cloud, though it held above the 335 Tenkan line on Friday. Gold and silver rallied sharply back near recent highs as Eurozone debt concerns reignited (more below), but we are cautious due to a shift in thinking on additional Fed easing (also more below).
Safe-haven currencies performed well, but they have all run into key price/intervention levels: EUR/CHF tested 1.1000 following Friday’s NFP report; USD/JPY is holding above 76.00/50 as the new Prime Minister/former Financial Minister Noda warns on additional JPY strength; and the US dollar index ran into the bottom of its daily cloud at 74.76.
We’ll be watching all those levels this week, and breaks through them will suggest a more material erosion in risk sentiment. Until then, our preference remains to re-sell risk assets on rebounds.
NEXT: Greece Ignites More Eurozone Concerns|pagebreak|
Greece Ignites More Eurozone Concerns
The euro (EUR) was the biggest loser in the past week against other G-10 currencies, as incoming data pointed to further slowing in the core, and tensions flared again over Greece as the week ended. International Monetary Fund (IMF) and European Union (EU) auditors suspended their examinations of Greek progress on deficit-reduction targets, as it became evident Greece was likely to miss its 7.5% deficit target due to a deeper-than-forecast recession.
But the auditors also pointed to deficiencies in the implementation of austerity measures, and markets quickly grew worried that the next installment of EU/IMF aid to Greece would be withheld. We don’t think that’s plausible, since the result would be a Greek default, which the EU powers-that-be have ruled out.
Should they (Germany) renege on that commitment, it would open the door to speculation of which member would next be thrown overboard. We think Greece will ultimately get the next aid package late in September, but with a serious wet noodle lashing by EU/IMF auditors.
Even though we don’t think Greece will be denied further aid, it doesn’t mean markets won’t continue to question the EUR and push it lower. Indeed, beyond Greece there are multiple reasons to keep selling EUR.
Slowing growth in the core and weak growth on the periphery remain obstacles to further deficit reduction, suggesting broader Eurozone debt concerns should plague the single currency for some time to come. That same erosion in growth is likely to see the European Central Bank (ECB) step back more explicitly from further tightening, and next Thursday’s ECB press conference could see a much-chastened Trichet.
Last, but certainly not least, in a development we have been watching for several weeks now, German yields have plunged, narrowing the spread between US and German two-year yields to levels last seen in January. The spread suggests EUR/USD should be trading around 1.3100/1.3150.
EUR/USD has also dropped back under the cloud (1.4251 cloud bottom/1.4267 cloud top), and the downside should remain in focus while those levels hold. Finally, the Tenkan line (1.4367) looks set to cross down below the Kijun line (1.4302), and with price below the cloud, that would constitute a strong sell signal, possibly making this week a very bad week for EUR.
We will look to use 1.4250/1.4360 as levels to enter short EUR/USD positions, if possible.
NEXT: What (and When) Will the Fed Decide About QE3?|pagebreak|
Shift in Thinking on Additional Fed Easing/QE3
The latest Federal Open Market Committee (FOMC) minutes released earlier this week suggest a greater likelihood of additional easing measures by the Fed. Perhaps significantly, they decided to extend the one-day September 20 meeting to a two-day affair, where two-day meetings have historically tended to result in policy changes.
The minutes indicated that more data would be needed, but incoming data since the last FOMC meeting has all been disappointing, highlighted by the recent zero change in jobs in August. While the Fed could decide it needs more time to evaluate the economic outlook—and certain hawkish members will oppose additional easing—we think the chance of additional Fed easing is increasingly likely later this month.
Among the more likely options the Fed has at their disposal to stimulate the economy is to lengthen the maturities of held Treasury debt in an effort to drive down longer-term interest rates, which would lower consumer borrowing costs on mortgages and other financing rates, potentially spurring consumer activity. (The current average maturity is in the 5-7 year range.)
The Fed could do this by selling shorter-dated debt and buying longer maturities in equal amounts, keeping its balance sheet the same size. Additionally, the impact could be increased if the Fed also shifts its Treasury purchases from maturing MBS/agency debt to longer-maturity Treasuries.
Importantly for the USD, this would not amount to additional quantitative easing, as the Fed is not increasing the amount of money in the system. If they pursue this course, the USD may actually see gains against most other majors, the exception being the JPY, where USD/JPY would stay under pressure as US yields fall further.
Additionally, the absence of increased asset purchases may also prevent another speculative surge in commodity and stock prices, which could simultaneously prevent another surge in inflation and shield the Fed from criticism it’s seeking to support equity markets—both key objectives for the central bank.
Precious metals prices could also react quite negatively, as additional dollars will not be “flooding” markets and inflationary pressures will be restrained, hence our caution on gold ahead of $2000 per ounce.
While we’ll need to see what the FOMC ultimately decides, the important point is that additional easing measures may not necessarily be USD-negative. If they choose to lengthen maturities without increasing the size of the balance sheet, it could turn out to be a USD-positive, as fears of QE3 are priced out.
USD strength, in turn, could also contribute to further weakness in commodities on top of the absence of QE3. If they do pursue additional asset purchases and increase the size of the balance sheet, then the USD picture is worse, but it will depend on the size of QE3.
We’ll be looking closely at the September 7 Beige Book, as well as listening to what Fed Chairman Bernanke has to say at his September 8 speech, his next/last speech before the September 20-21 Fed meeting.
By Brian Dolan, chief currency strategist, FOREX.com
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