JPY and GBP to slip further

Market gyrations were relatively limited overnight, with a rise in the VIX fear gauge and rise in Chinese equities the most notable market moves overnight. US data was mixed, with enthusiasm over a solid gain in December durable goods orders tempered by a drop in pending home sales. Notably the Baltic Dry Index has extended its decline over recent days, suggesting that the risk rally is losing some steam.

Nonetheless, core debt yields continue to test important psychological levels, with the 2% barrier in sight for 10 year US Treasuries. Data and events today include a US consumer confidence, for which we expect a slight decline in January, and various European Central Bank speakers. Additionally, the ECB’s main refinancing operation (MRO) will be scrutinised to determine bank’s health following last week’s LTRO payback. Overall, direction looks limited ahead of this week’s Fed FOMC decision and US jobs report.

The JPY’s drop has proven to be relentless. Despite being blamed for instigating a currency war Japanese officials are showing little let up in their push for JPY weakness. Although there has been some widening in the US Treasury and German bunds yield advantage over Japanese JGBs it does not fully account for the sharp JPY move. Interestingly speculative JPY short positions have actually lessened, implying that the drop in the JPY is attributable to other investor classes.

Additionally Japan has registered net portfolio inflows over recent weeks and so cannot explain the JPY’s drop. One factor that is weighing on the JPY is the improvement in risk appetite; USD/JPY is the most correlated currency with our risk barometer over the past 3 months. As risk and yield appetite has picked up JPY has effectively regained its mantle as funding currency. USD/JPY will face some tough resistance levels from around the 91.48 level, but so far the currency pair has made short work of breaking through resistance.

In one respect GBP’s drop against the USD and EUR reflects a reversal of safe haven flows similar to JPY. Notably however, GBP has not been correlated with the JPY. Its decline is more associated with renewed UK economic worries and in turn expectations of further Bank of England asset purchases, especially under the helm of a new governor. Moreover, speculation of a credit ratings downgrade has not been helpful to GBP. The net result is a reduction in speculative interest and further selling pressure.

Fortunately for the UK economy a weaker currency is no bad thing unless it provokes growing inflationary pressures. Given the dovish noises from incoming BoE Governor Carney, it looks as though there is little concern on this front. Manufacturing confidence data at the end of this week is unlikely to dispel economic concerns, leaving GBP vulnerable to further slippage.

Weak USD will not persist, CHF to drop eventually

Risk appetite has deteriorated slightly since the Bernanke fuelled bounce earlier this week but there does not appear to be much of a directional bias for markets either way. Interestingly Treasury yields continue to pull back even while equity markets have softened overnight.

Data has been mixed, with US consumer confidence dipping in March albeit not as much as expected while US house prices also did not drop by as much as anticipated. Data releases on tap today include monetary aggregates in the Eurozone and durable goods orders in the US. The tone will likely continue to be slightly ‘risk off’.

The USD has come under growing pressure since its mid March high, with the EUR in particular taking advantage of its vulnerability. A combination of improving risk appetite and a correction lower in US Treasury yields in the wake of relatively Fed comments have been sufficient to deal the USD a blow.

However, the outlook for the USD is mixed today as on the one hand it will be helped by a reduction in risk appetite but hit on the other by a drop in US Treasury yields overnight. Data today should be a little more constructive for the USD, with a likely bounce back in durable good orders in February.

Overall, I do not expect the weak USD bias to persist especially as it is based on unrealistic expectations that the Fed will still implement more quantitative easing. Indeed, while further Fed easing is possible it may not need to involve an expansion of the Fed’s balance sheet.

EUR/CHF remains pinned to the 1.20 ‘line in the sand’ imposed by the Swiss National Bank while the CHF has strengthened over recent weeks against the USD. Economic data has deteriorated over recent months, with the forward looking Swiss KoF leading indicator pointing to a further weakening.

We will get further news on this front on Friday with the latest KoF release, with a slight a bounce expected. In turn, bad news on the economic front is adding to pressure for CHF weakness. Market positioning in CHF is negative but there is plenty of scope to increase short positioning in the months ahead given that short CHF positions remain well off their all time highs.

Eventually as risk appetite improves and the US yield advantage widens against Switzerland, both EUR/CHF and USD/CHF will move higher.

Risk currencies buoyed

Positive developments helped to buoy markets. Although US durable goods orders were weaker than forecast a jump in US consumer confidence to its highest since February 2011 gave equity markets and risk assets in general a lift. Even in Europe the news was encouraging as Italy managed to auction 10-year debt at a cheaper rate than previously while Portugal passed a third review of its bailout programme and noted that unlike Greece it would need a second bailout.

There was some negative news however, with the European Central Bank (ECB) temporarily suspending the eligibility of Greek bonds as collateral for its funding operations and Ireland calling a referendum on the European fiscal compact. Nonetheless, hopes of a healthy take up at today’s ECB second 3-year Long term refinancing operation (LTRO) will keep markets in positive mood in the short term.

The USD index continues to look restrained when risk assets are rallying. Given the positive equity market mood overnight it is no surprise that the USD came under further pressure while the EUR looks firm ahead of today’s 3-year LTRO by the ECB. Fed Chairman Bernanke’s testimony will give the USD some direction but we do not expect him to deliver any big surprises. EUR/USD will continue to rally if we are correct about a strong EUR 600-700 billion take up at the LTRO but the currency pair will meet resistance around 1.3550.

JPY has lost ground against various cross including USD, EUR and AUD. Much of its weakness is related to widening yield differentials but our models reveal that USD/JPY in particular has overshot its implied value. Unless US yields widen further versus Japan, JPY could even rebound over coming days. EUR/JPY has breached its 200 day moving however, which is a bullish signal for the currency pair. A generally firm EUR tone likely to be maintained in the short term will also be exhibited versus JPY.

Warnings by Swiss National Bank head Jordan reiterating his stance of defending the EUR/CHF floor of 1.20 has done little to push the currency pair higher. EUR/CHF has enjoyed a strong relationship with movements in interest rate differentials. This implies that it will take a relative rise in German yields versus Swiss yields for EUR/CHF to move higher. This is certainly viable given the deterioration in Swiss economic data over recent months. Eventually EUR/CHF will move higher but over the short term it is unlikely to move far from the 1.20 level.

EUR slips, Yen gains

There has been good and bad news in Europe, with leaders’ rubber stamping the permanent bailout mechanism (ESM) and 25 out of 27 EU countries agreeing on the fiscal discipline treaty. Finally, EU leaders agreed that it was not all about austerity, with growth orientated policies as yet undefined, also required.

The bad news is that there has still been no final agreement on Greek debt restructuring and in turn a second Greek aid package said to total around EUR 130 billion while Portugal is increasingly moving into focus as the next casualty. Unsurprisingly the EUR has lost steam so far this week but markets remain short and any downside looks limited at technical support around 1.3077.

A cautious tone will prevail today, with risk assets likely to remain under mild pressure. Developments in Greece and the Eurozone will continue to garner most attention although US data in the form of the January Chicago PMI manufacturing survey and consumer confidence data will also be in focus.

Both surveys will reveal further improvement in confidence as the US economy continues to show signs of gradual recovery. This was supported overnight by a relatively positive Federal Loan Officers survey which revealed an increase in demand for business loans at banks in Q4 2011. Although the USD has been somewhat restrained by a dovish Fed stance the risk off tone to markets will likely bode well for the currency over the short term.

JPY is benefiting from the risk off market tone despite comments by Japanese Finance Minister Azumi who warned about action being taken to combat JPY strength. The JPY has benefited from the Fed’s dovish tone last week which has weighed on US bond yields relative to Japan. While FX intervention risks have increased, officials will remain wary given the underlying upward pressure on the JPY. The near term risk is for USD/JPY to retest the 2011 low around 75.38.

USD, EUR and JPY Outlook This Week

The USD lost more ground last week extending its drop from the early October. Interestingly its latest drop has occurred despite an uptick in risk aversion suggesting other factors are at work. Mixed US data and earnings have not given the USD much direction with a downbeat Beige Book counterbalanced by a firmer Philly Fed manufacturing survey and housing starts.

The data have not been sufficiently weak to fuel expectations of more Fed quantitative easing but some Fed officials including Yellen, Tarullo, Evans and Rosengren in indicating that further QE could be considered. The USD has therefore been somewhat undermined but will take its cue from data releases and events in Europe this week.

This data slate will be mixed but on balance will not support more Fed QE. In particular, Q3 Real GDP is expected to come in sharply higher than in Q2, with a 2.5% annual rate expected to be revealed. Other indicators will be less positive, with October consumer confidence set to slip further and remain at a recessionary level, while September durable goods orders will decline by around 1%.

Despite an expected increase in new home sales in September the overall picture of the US housing market will remain very weak. Overall, the USD may find some respite from the GDP report but the data will be seen as backward looking, with the jury still out on the issue of more quantitative easing.

The EUR struggled to make any headway last week amid a barrage of rumors about the outcome of Sunday’s EU Summit. In the event the summit failed to deliver concrete details although there appeared to be some progress in key areas. Attention will now turn to Wednesday’s summit but once again the risk of disappointment is high. EUR/USD will only extend gains if markets are satisfied at the result but this is by no means guaranteed.

Data releases will not be supportive for the EUR this week, with a further deterioration in ‘flash’ eurozone purchasing managers indices (PMIs) and European Commission confidence surveys expected in October but hopes of a concrete resolution at Wednesday’s EU Summit will keep the EUR/USD supported early in the week although it will find strong resistance around 1.3915.

The sensitivity of the JPY to risk aversion has actually fallen over the last three months while the influence of bond yield differentials also appears to have slipped. The fact that USD/JPY continues to remain in a very tight range with little inclination to break in either direction despite gyrations in risk and yield differentials almost appears if the currency pair has been pegged.
Obviously this is not the case but a break out of the current range does not look imminent.

Speculative JPY positioning has dropped over recent weeks while equity and bond flows have overall been negative but this has not been reflected in JPY weakness resulting in increased frustration by Japanese officials. We continue to look for the JPY to weaken over coming months but much will depend on a widening in US / Japan yield differentials and easing risk appetite as both will regain their hold on the currency. In the meantime, the currency will continue to offer little to get excited about.

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