USD underperforms

The Fed expanded its asset purchases by buying $45 billion in longer dated Treasuries following the end of Operation Twist, with total purchases at USD 85 billion per month. The Fed went a step further by changing the guidance, now anticipating that policy will be maintained at an “exceptionally low range for the Fed Funds rate” as long as the unemployment rate remains above 6 ½ % and inflation no more than ½ % above the Fed 2% goal.

Equity market reaction was limited, with any positive boost dampened by the recognition that the Fed will not be able to offset the blow to the economy from the fiscal cliff. On this front, progress has been limited as the likelihood of a deal by the end of the year is diminishing by the day.

In Europe sentiment is somewhat better as hopes that the EU Council meeting today will yield an agreement on banking union and supervision. Final approval for the delayed Greek loan tranche is likely to be delivered following the completion of Greece’s debt buyback. The better news in Europe will be reflected in a decent reception to the Spanish and Italian bond offerings today.

The USD did not take too kindly to the latest efforts by the Fed to boost the economy although there are clearly diminishing returns as far as FX markets are concerned with regard to Fed QE. Nonetheless, the USD is coming under growing pressure into year end.

Next year assuming that the fiscal cliff in the US is resolved, with a limited fiscal drag on the economy, a relatively positive growth trajectory for the US alongside an expected increase in US bond yields will mean that the USD will still enjoy gains against currencies with weaker growth paths namely the EUR and JPY.

My forecasts for the USD index based on forecasts for its constituents show a gradual strengthening over the course of the next couple of years (82.4 and 85.7 by end-2013 and -2014, respectively) largely due to the USD’s expected appreciation versus EUR and JPY. In reality, this is misleading as improving risk appetite and continued capital inflows to EM and commodity currencies will mean that the USD will underperform.

EUR slides as summit hopes fade

Any boost to confidence following the recent EU Summit is fading fast. Policy easing from the European Central Bank, Bank of England, and PBoC in China, have done little to turn things around. Moreover, the weaker than expected US June jobs report has added to the calls for the Federal Reserve to inject more monetary stimulus via another round of quantitative easing but this is unlikely anytime soon.

Admittedly the jobs data which reported an 80k increase in payrolls and unemployment rate remaining at 8.2%, was disappointing but it was not weak enough to trigger imminent Fed action. Congressional testimony by Fed Chairman Bernanke on July 17 and 18 will provide the next key clues to whether the Fed is moving closer to more QE.

This leaves markets in a miserable state of being. It was hoped that the recent EU Summit would provide much needed breathing space and relief to Eurozone peripheral bond markets. However, renewed policy implementation doubts, concerns that the Summit did not go far enough and opposition from Finland and the Netherlands who appear to have taken an even tougher stance than Germany, have resulted in Spanish and Italian bonds facing significant pressure once again with yields higher than pre summit levels.

A delay in the ESM permanent bailout fund, timing of the setting up of a banking supervisory authority and doubts about the size of the bailout fund given that the ECB appears to have ruled out a banking license as a means of leveraging up the ESM, are just a few of the concerns afflicting markets. Meanwhile, added to this list is the fact that Greece’s next bailout tranche has been delayed to mid September. Many of these issues as well as the bailout of Spanish banks will be discussed at today’s Ecofin meeting but the chances of much progress remain limited.

The EUR which is of course not uncrorrelated with peripheral bond yields has itself fallen sharply. Thin trading conditions have helped to exacerbate the drop in the EUR while the realisation that the EU summit has been no game changer is increasingly weighing on the currency. I had thought that the Summit may have helped to at least provide a floor under the EUR but this now looks like a case of misplaced optimism.

The only supportive factor for the currency is that it looks heavily oversold, with market positioning extremely short. However, if a break below the 2012 EUR/USD low around 1.2288 can be sustained markets will quickly latch onto 1.20 as the next target. Given the lack of major events or data releases over coming days there looks like little to offer the EUR any support.

Is gold losing its lustre?

Hopes and expectations of more Fed quantitative easing in the wake of a run of weak US data, including the US May jobs report, has been attributable to the bounce in gold prices over recent weeks. However, Fed Chairman Bernanke dampened such hopes in his speech to Congress, in which he did not indicate a desire to move towards more QE. The Fed is unlikely in my view to embark on more QE any time soon.

Clearly, should the Fed implement more QE it will help to renew the attraction of gold. Once again markets will see the consequences of Fed QE as a means to debase the USD. A shift in Fed stance cannot be ruled out if US economic conditions worsen further and/or the Eurozone crisis escalates. Assuming no more QE and no more USD debasement, gold prices ought to decline over coming months.

One of the biggest factors putting downward pressure on gold prices has been the strength of the USD. While I do not expect the USD to continue to strengthen at the same pace as it has done recently, further gradual gains in the currency are likely. My FX forecasts predict a further small gain for the USD index by the end of the year but I also believe that the recent run up in the USD may have been too rapid. Assuming that the USD continues on a gradual upward trajectory I expect it to exert a negative influence on gold prices.

Gold appears to have lost its sensitivity to risk aversion. Indeed, gold’s relationship with risk has actually inverted over recent months, with a negative but significant relationship registered over the past 3 months between gold prices and my Risk Aversion Barometer. In other words as risk aversion goes up, gold prices actually drop.

The lack of reaction to higher risk aversion shows that the lustre of gold as a safe haven has faded as investors pull capital out of this as well as many other asset classes. However, gold’s drop is not unusual when compared to other commodity prices, with oil and copper prices falling too and gold maintaining a strong correlation with these commodities.

Some deterioration in sentiment towards gold prices has been reflected in the drop in speculative appetite for the commodity. Speculative demand for gold hit a cyclical high in August 2011 but since then there has been a steady reduction in appetite for gold from these investors. Indeed, CFTC IMM data reveals that speculative gold positioning dropped well below its three-month average. However, positioning is still well above its all time lows reached in February 2005, suggesting if anything, there is scope for more declines.

On top of the drop in speculative appetite for gold the technical picture has turned bearish. Since March 2009 at the height of the financial crisis the 100 day moving average price of gold had been trading above the 200 day moving average. On 27 March 2012 the 100 day moving average crossed below the 200 day moving average. Moreover, gold is now trading below both the 100 and 200 day moving average prices which sends a bearish technical message. Over the near term some key levels to look for are the 100 day moving average around 1658 on the topside and trendline support around the 1530 level on the bottom.

Another determinant of gold prices is demand from India and China. Growth in both countries is slowing, suggesting that gold demand is also weakening. While I certainly do not expect a collapse in demand from either country I have no doubt that compared to last year the strength of demand will be softer over coming months. Although I still look for a soft landing in China the Indian economic picture has clearly deteriorated while the Indian rupee has weakened. A weaker INR means that has become increasingly more expensive to import gold to India for domestic purchasers.

Overall, a weaker real demand picture taken together with reduced speculative appetite implies little support for gold prices. Moreover, a firmer USD in general will continue to weigh on prices. Perhaps a dose of inflation would help gold prices but there is little risk of this given the still sizeable amount of excess capacity in major economies.

Uncertainty about QE will help to limit any downside pressure on gold prices but elevated risk aversion will provide little assistance to gold. If however, the Eurozone and global picture deteriorates further gold will find itself with a lifeline but only if this means more currency debasement and a Fed engineered lower USD. If not, a further decline is on the cards and I forecast a drop in gold prices to around USD 1475 by the end of the year.

Central banks ready to act

Markets are in wait and see mode ahead of Greek elections with range trading likely to dominate market action, albeit with a slightly risk on bias. US data disappointed once again, with jobless claims coming in worse than expected, compounding the growing fears about deterioration in US job market conditions. Perversely the poor jobs data coming against the background of soft May CPI inflation data have fuelled expectations of Fed action at next week’s Federal Reserve FOMC meeting.

It is not only the Fed that markets believe may act, with reports overnight suggesting that there may be some form of coordinated action by central banks should the Greek election outcome prove to be unfavourable. On this front, the news appears to be a little more encouraging as expectations that pro bailout parties will garner relatively more votes has grown as reflected in the 10% rally in Greek shares overnight.

If it takes weak economic data for markets to rally nowadays then there will be plenty available today, with declines expected for the May Empire manufacturing survey and June Michigan confidence, while industrial production is only likely to register a marginal gain in May. While the data may add more fuel to the fire, I suspect it will still be insufficient to result in more Fed balance sheet expansion.

European Central Bank (ECB) President Draghi is scheduled to speak today but I doubt he will suggest a move towards another LTRO or Securities Market Purchases. On the subject of central banks the Bank of Japan will announce its policy decision today but I expect no change in stance despite the fact that the 1% inflation goal remains a long way off. Currencies will remain in ranges but hopes of central bank action and a favourable outcome to the Greek elections will provide support for risk currencies and keep the USD under pressure.

Germany feeling the pressure

Stocks fell back into negative territory following yet more soft US economic data. The 0.4% drop in US retail sales ex-autos was particularly disappointing, once again raising expectations that the Fed may need to deliver another round of quantitative easing. The rally in gold prices overnight was in part related to such expectations. Continued pressure on peripheral Eurozone debt reflects another angle of market pressure, not helped by the downgrading of Spain’s credit ratings by Moodys which effectively highlighted that Spain’s call for external help was a sign of weakness.

A further test of sentiment will be in the form of Italian bond auctions today. Perhaps more worrying is the sell off in German debt over recent sessions, indicating that investors are finally realising that Germany will not be spared from a “Grexit”. Whether this prompts Mrs Merkel into some form of action to help stem the crisis is another question entirely. Ahead of Greek elections on June 17 markets will enter into a state of limbo but the bias remains for elevated risk aversion.

FX markets are similarly rangebound, with the USD capped by hopes/expectations of more Fed QE and the EUR capped by peripheral Eurozone tensions. As a result EUR/USD has struggled to sustain break above resistance around 1.2624 and will continue to fail to the topside given the uncertainty around the Greek elections on June 17th. Bad news in the form of the Spanish debt downgrade and peripheral debt pressures, suggest that the EUR will remain under pressure over coming sessions, making it increasingly difficult to hold above the psychologically important 1.25 level.

The main focus today will be on the Swiss National Bank policy decision. While no policy action is expected attention will focus on the SNB’s stance on its 1.20 EUR/CHF floor. Upward pressure on the CHF has intensified over recent weeks as the situation in the Eurozone has worsened, and latest reserves data highlighted a big jump in reserves during May as the SNB had to buy EUR against the CHF. A shift in the EUR/CHF floor looks unlikely but the recent upward pressure on CHF could pale into insignificant compared to any upward pressure following a Greek Euro exit.

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