Kathleen Brooks and Eric Viloria of Forex.com outline the important issues for currency traders in the coming week.
At last week’s Jackson Hole symposium, Fed Chairman Ben Bernanke expressed his view that the economic situation remains “far from satisfactory” and specifically that “the rate of improvement in the labor market has been painfully slow.”
Furthermore, minutes from the most recent FOMC meeting indicated that the many members saw additional stimulus would likely be warranted “fairly soon” unless incoming data indicated a sustainable strengthening in the pace of recovery.
The release of the August employment report disappointed, with a decline in job growth to 96,000 from the prior downwardly revised 141,000 (previously 163,000). This underscored the weakness in the recovery, and reinforced views that the Fed will soon act to ease monetary policy.
If the previous number that was thought to be 163,000 was unsatisfactory, then the August readings are clearly unacceptable. The details of the report show an unexpected decline in manufacturing payrolls of -15,000 (consensus +10,000) and private payroll growth of 103,000 (consensus 142,000).
What may look like a bright spot in the report, a drop in the unemployment rate to 8.1% from 8.3%, is actually representative of a decline in the work force. This is due to changing demographics, and more importantly discouraged workers that are simply giving up.
Market action has indicated expectations of more accommodation from the Fed. Treasury yields have fallen, the dollar is significantly weaker, and equity markets remain buoyant in the face of disappointing labor data.
With the strong comments made from Bernanke and many of his colleagues at the Fed, we anticipate easing from the FOMC at next week’s meeting. Just what form of easing remains the key question. Many participants are focusing on another round of asset purchases, or QE3.
At the minimum, we expect the Fed to extend the forward guidance on interest rates into 2015. No action from the FOMC would hurt Bernanke’s credibility in light of his very dovish comments of late. QE3 is questionable, however, as the previous two rounds of quantitative easing have been unable to allow the Fed achieve levels of unemployment consistent with its mandate.
We would expect that QE3 would have to be larger than previous rounds, as asset purchases tend to have a diminishing impact. A new program that is open-ended would allow the Fed to be noncommittal on the size and may impact markets positively. Such an aggressive program could weaken USD significantly as the Fed expands its balance sheet. However, the bank could follow the ECB in sterilizing purchases, which would limit USD downside.
Technically, we see the potential for further USD weakness, as key levels this week have been breached. The dollar index broke below long-term bull channel support and the 200-day simple moving average (SMA), EUR/USD is above long-term bear channel resistance, USD/CAD made new lows for 2012, and USD/JPY remains below its weekly cloud.
The dollar index broke a long-term bull channel and 200-day SMA after the August employment report:
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Next: Is ECB’s Big Bazooka Enough to Save the Eurozone?
|pagebreak|Is ECB’s Big Bazooka Enough to Save the Eurozone?
The ECB was the focus last week, after confirming the details of its bond-buying plan. However, now the market needs to figure out whether this is a real game-changer, and if the worst of the Eurozone crisis is behind us.
We have had “big plans” from the ECB before: at the end of 2011, the ECB’s LTRO program of bank loans was launched to great fanfare, but by March the impact of the €1 trillion of loans was already fading.
So will the Outright Monetary Transactions (OMT—also affectionately called “On Merkel’s Terms” on trading desks!) have a longer effect on peripheral bond markets than the LTRO? Looking at the positives first, there are a couple of things to point out:
- The purchases are unlimited.
- The ECB doesn’t have special creditor status. In the event of a sovereign default on bonds purchased using the OMT program the ECB will be in the same queue as the man on the street when it comes to getting paid back.
Both of these things should make Europe’s peripheral bond markets a more attractive investment choice.
Added to that, there was some concern that the purchases will be “sterilized.” However, sterilization works differently in the Eurozone than it does elsewhere. While money will flow into the sovereign coffers of the most troubled economies, money will be taken out of the stronger economies like Germany, the Netherlands, etc. So while there is no net increase on the ECB’s balance sheet, there will be a boost to ECB funds going to countries like Spain, while they may be reduced in places like Germany.
This has already been reflected in the sovereign bond markets. Spain’s ten-year bond yields fell to 5.75% by the European close on Friday, while German ten-year yields are 30 basis points above their lows reached in July.
The other sticking point is that OMT will only be triggered when Spain or Italy apply for either a full sovereign bailout or a “precautionary” credit line. These will both come with conditions; however we do not know yet what those will be. Likewise, we don’t know if the conditions will be less onerous for a country who applies for a credit line vs. those who apply for full-blown sovereign bailouts. We still need to find out the details, but the distinction regarding conditions could be a diplomatic nightmare for the ECB.
Going forward, the drop in Spanish bond yields proved that the OMT has “worked” before it has even been implemented. If yields can fall to 5% in the next few days and weeks, we could see EUR/USD move towards 1.30.
In the long term, we believe that the ECB has done two things to reduce the tail risk of a member making a disorderly exit. Firstly, it has taken care of banks’ cash requirements by loosening collateral requirements so banks can get loans from the central bank even more easily. Secondly, it has targeted sovereign yields, but is only doing so if fiscal reform is implemented at the same time.
Thus, although the euro looks very overbought in the short term and we could see a pullback at the start of this week, the rally may well continue, especially if we get QE from the Fed on Thursday.
Kathleen Brooks and Eric Viloria, CMT, can be found at Forex.com.
