The Fed’s future path still seems more bullish than the European Central Bank. If so, the yiel...
The Forex Trading Week Ahead
06/04/2012 10:10 am EST
The outcome of important central bank policy meetings in the Eurozone, the UK, and Australia will be among the primary drivers of world currency markets this week, writes Kathleen Brooks of FOREX.com.
The Eurozone crisis continued to deteriorate last week with fears about the economic effects of the crisis taking center stage. Eurozone unemployment reached 11%, the highest since the euro came into circulation, and the latest manufacturing surveys for March were weak for Europe, China, the UK, and even the US.
The severity with which investors have ditched risky assets and moved into bunds, Treasuries, and gilts suggests that the markets are now pricing in the potential for a global recession. Without official action it’s hard to see how we can break out of this cycle of risk aversion, and this week, there are three pivotal central bank meetings including the Reserve Bank of Australia (RBA), the European Central Bank (ECB), and the Bank of England (BOE).
No Fireworks from the ECB
At the end of last week, rumors that the ECB was buying Spanish sovereign debt helped to boost risk assets. EUR/USD closed the European session just below 1.24 after falling as low as 1.2280 after the non-farm payrolls (NFP) release, and Spanish bond yields closed at 6.53%, 17 basis points lower than the peak they reached earlier in the week. This highlights two important things: 1) the markets are deeply oversold, especially risky FX and European equities; and 2) if there is remedial action by the ECB or other European authorities, then there could a powerful relief rally.
This Wednesday’s ECB meeting will be the most important event in the currency bloc for the coming week, though we don’t think the ECB will be too radical.
ECB head Mario Draghi was speaking last week and reiterated that governments should do more to stem the crisis. He also added that conditions in the markets are not as stressed as they were in November prior to the Bank’s LTRO auctions. This is true to an extent.
While Spain has come under intense pressure along with Italy, the core European nations like France, Netherlands, Belgium, Austria, etc., have not seen their bond yields come under selling pressure from the markets. In fact, the French-German ten-year bond spread has actually been narrowing, suggesting that there is demand for French bonds even after the Socialist victory in the Presidential election.
The ECB is likely to say that it will offer support to Europe’s banks to prevent them from going under, but Draghi and company are likely to stop short of offering a more sustainable solution to this crisis.
Of course, the Bank could also cut interest rates, which currently stand at 1%, a record low for the currency bloc. The manufacturing sector PMI remained in deep contraction territory in May, and the unemployment rate surged to a record high of 11% in April. Added to that, the flash estimate for May CPI fell to 2.4% from 2.6% in April, which could give the ECB more room to cut rates. However, the Bundesbank is still a powerful hawkish element in the central bank, and it is likely to resist such a move until the situation deteriorates even further.
This is bad news for the periphery, which needs lower interest rates. However, the lack of action from the authorities is likely to weigh on the euro, which could benefit their export markets (if they manage to stay in the currency bloc, that is).
There were signs last week that Germany might be willing to adjust fiscal targets after an official in Berlin said that Spain is unlikely to meet next year’s 3% fiscal deficit target. But the radical action that some expect, including Eurobonds or using ESM funds to re-capitalize Spanish banks, don’t appear to have made much traction in Brussels.
If the ECB is fairly muted in its response to the crisis this week, then the baton is passed to the EU leaders when they meet at the end of June for the next EU summit. So, the markets are left waiting for political action, and Europe’s politicians don’t walk to the market’s beat. This combined with the Greek elections on June 17 are likely to keep uncertainty high and leave risk assets vulnerable to more downside.
There is a pre-election poll blackout in Greece from this weekend in the two weeks leading up to the elections, which only adds to the uncertainty and increases the chance of a selloff. Added to that, Spain issues 2014, 2016, and 2022 bonds this week. Any signs of weak demand for its debt could cause a fresh bout of risk aversion.
The euro had a dreadful May versus the dollar, having fallen 6%. It is now looking very oversold from a technical basis. However, the fundamental picture remains bleak, and the euro is still sensitive to headline risk, both positive and negative.
If it can make its way back to 1.2510, then we may see a deeper pullback towards 1.2710. However, below 1.2350 opens the way to retest 1.2290, then 1.2150, and eventually 1.20. Without remedial action from the ECB or EU authorities, it is hard to see how this pair can resist further downward pressure.
BOE: Increased Chances for More QE
The extremely weak PMI data at the end of last week, which showed the manufacturing index plunge to its lowest level for three years along with the escalation of the Eurozone crisis, has increased the chances that the Bank of England will expand its QE program when it meets on Thursday.
We believe that the Bank will do more QE in the coming months, and the sharp deterioration in the manufacturing PMI could be enough to prod the Bank into doing more this week, which is not the market’s central scenario.
The minutes from the May meeting suggested that the decision to remain on hold was finely balanced, and even Adam Posen, who recently moved to the neutral camp after having consistently voted for more stimulus, said that his decision was tough.
The inflation report was also more dovish than some expected, with growth for 2012 revised lower. Although inflation is expected to remain higher than the 2% target this year, the Bank sets policy with a two-year time frame and expects inflation to fall below target in the coming years. Thus, with the much-worse-than-expected PMI number, it could shift some members to take action now to prevent deflation later.
The British pound (GBP) followed the euro lower last week, but managed to stage a recovery on Friday after falling below 1.5300 against the dollar. We believe that a breach of this important support zone would be a very bearish development for this cross, and may open the way to 1.50 and then potentially to the 1.45 lows from 2010. However, this pair is starting to look oversold, so any remedial action from the European authorities to sort out the sovereign debt crisis could boost sterling and negate any of the negative impact from more QE from the BOE.
QE Taking Off in the US?
The third consecutive miss in the payrolls report for May increases the pressure on the Federal Reserve to take some remedial action when it next meets later in June. The US created 69,000 jobs last month, which was much weaker than the market had been expecting. The April figure was also revised lower to 77,000 from 115,000.
This is starting to look like the summer slowdowns we have experienced over the last three years, which have spurred QE and Operation Twist from the Fed. There was very little good news in the report: the underemployment rate rose to 14.8% from 14.5%, weekly wages expanded by a meager 0.1%, the work week fell, and the rise in the unemployment rate erased recent months’ worth of gains.
The gold price surged after the report and had risen $70 by the time London closed. The strength in the yellow metal was viewed as the market pricing in the prospects for more QE, so when the Fed meets in two weeks, will it pull the trigger on more stimulus?
The reason to do more is compelling: the deteriorating economic outlook at home and the escalation in the sovereign debt crisis in Europe. But what could the Fed do that they haven’t tried already?
While the market seems to prefer fresh money being pumped into the economy, the Fed may be less willing to do this, as it could hurt inflation expectations, especially if the European crisis is “solved” in the coming months. Instead, it may decide that the drop to a record low in the 10-year Treasury yield last week has done enough easing for the US economy, so it may start with a more cautious route such as extending Operation Twist.
This would require the Fed maintaining the size of its balance sheet (should be dollar neutral) while buying securities further down the curve to keep rates lower for longer. The market may be more sensitive to outright QE, which could boost risky assets and weaken the dollar. If the Fed chooses to do more Twist, the impact on the market may be fairly muted, as this is the less-aggressive option open to the Fed. However, if the Fed embarked on some targeted action towards the housing market, for example—fresh purchases of mortgage-backed securities—then we could see risk respond well.
This week, Fed chairman Ben Bernanke testifies to the US lawmakers on the economic outlook. This will be watched closely, as he explains to the Congress the decline in the data, especially the deeply disappointing and demoralizing jobs report while politicians are gearing up for election season.
His words will be scrutinized to see if there are any signs of more policy action from the Fed. This could keep the dollar volatile on June 7.
The dollar declined slightly on Friday after reaching fresh two-year highs last week. However, while the Eurozone crisis remains the focus in the short to medium term, we think the dollar could strengthen further, although in the second half of this year, the outlook for the dollar is less clear. A deteriorating economic outlook and a Presidential election is a formula for a weaker dollar in my book. But right now, Spain, Bankia, and a lack of action from European authorities are dominating.
RBA Could Cut Rates Again
The data out of Australia, the UK, and Europe has disappointed to the downside in recent weeks, however, at this stage it looks like the RBA and BOE may be the only central banks to take immediate action. A drop in retail sales in April combined with an 8.7% fall in building approval permits for the same month highlight the deteriorating backdrop for the non-mining sector of the Australian economy.
After the 50-basis-point cut at its April meeting, the risk is that the RBA waits until July to see the impact of the previous cut, but we still think that the RBA could react when it meets on June 5. The market expects a 25-basis-point cut to 3.5%, which would be the lowest level for rates since Q1 2010.
We agree with consensus and believe that the RBA will choose to err on doing too much in case the external environment gets worse. As a commodity producer, Australia is reliant on the external environment, so the weakness in both Chinese and European data may be enough to force the RBA’s hand. However, if it does cut rates, then we think it will signal that it is on pause unless the situation deteriorates further. Overall, though, the Aussie dollar’s and the RBA’s rate trajectory may be determined by the Eurozone crisis and the future of Chinese growth.
If the RBA cuts rates, we could see AUD/USD initially dip to 0.9500. However, the Eurozone crisis is likely to have a larger impact on the Aussie in the medium term. If there is continued stress, we could see it fall back towards 0.9120—the 200-week moving average—while remedial action from the European authorities could see it lead a rally in FX markets.
By Kathleen Brooks of FOREX.com
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