USD undermined, CHF and NZD risks

The surprise drop in US Q4 GDP (-0.1% QoQ annualised) and relatively cautious but not much different Fed statement (pause in growth, elevated unemployment, inflation below long term objective) helped to undermine risk assets, and the USD overnight while 10 year Treasury yields slipped back below 2%. Consequently EUR/USD was propelled above the 1.35 level. Gold prices benefitted however, with the precious metal trading above its 200 day moving average.

The Fed showed little indication of pulling back from its USD 85 billion in monthly asset purchases but that did little to prevent stocks from closing lower. The data calendar is limited in terms of first tier releases today, with ranges likely to dominate and markets turning their attention to tomorrow’s US jobs report.

Following an impressive drop of around 3% from around 9 January the CHF appears to have stabilised, at least temporarily versus EUR. I believe this stability will prove short lived. CHF is finally seeing a reversal in safe haven flows while also suffering from its growing use as a funding currency (again). Indeed, recent weeks have seen a decline in speculative CHF appetite, which I expect to continue over coming weeks.

The recent drop in the CHF has done little to placate Swiss government officials however, while economic data such as the 8 month low registered for the January KoF leading indicator give further support for a weaker currency. There is even renewed speculation that the Swiss National Bank should catch markets on the hop by raising the EUR/CHF 1.200 floor. I don’t expect the floor to be raised anytime soon but do expect more weakness in the still overvalued CHF.

My quantitative models now send a ‘strong sell; signal for NZD but maintain a neutral signal for AUD. Is it time to buy AUD/NZD? Technical signals suggest little upside directional impetus in the short term. Moreover, speculative positioning in AUD/NZD looks stretched. In other words expect range trading in the near term and better opportunities once stale longs have been shaken out.

The RBNZ’s decision to keep policy on hold overnight will have little impact on the NZD given that it was widely expected but the concerns expressed about Kiwi strength will not go unnoticed by market players. NZD has benefited more from the risk rally over recent weeks than AUD but gains in risk appetite according to my risk barometer appear to have stalled. I suggest waiting for opportunities to sell kiwi on any move the 0.84 versus USD

Euro firmer, AUD vulnerable to risk gyrations

A surprise drop in US August consumer confidence which dropped to its lowest since November last year put a dampener on markets and notably the VIX index edged higher. Consequently treasuries rose and equities slipped despite a firmer than expected increase in US house prices in June. The confidence data adds the pressure on Fed Chairman Bernanke to give some indication of a further round of quantitative easing during his speech at Jackson Hole on Friday.

An upward revision to US Q2 GDP and a bounce in July pending home sales today are unlikely to change this perspective although the Fed’s Beige Book will likely show some moderate improvement providing the Fed with useful information.

Separately decent debt auctions in Spain and Italy helped to calm Eurozone market nerves further amid hopes of European Central Bank (ECB) action next week despite the news that Spanish region Catalonia formally asked for EUR 5 billion in funding. As a result the EUR retained a firmer tone.

Contrary to expectations, EUR/USD continued to push higher. Just why the currency is strengthening given the significant event risk in the days and weeks ahead is questionable although in part the move is attributable to an ongoing short squeeze. Hopes of constructive ECB action next week taken together with Fed quantitative easing expectations have helped to put the USD on the back foot, allowing the EUR to take advantage.

Admittedly the drop in Eurozone peripheral bond yields is certainly helpful for the EUR, while my short term quantitative ‘fair value’ estimate for EUR/USD suggests more upside too. Nonetheless, given the risk that so much could go wrong in the weeks ahead I am loathe to get on the bullish EUR bandwagon. While EUR/USD and EUR on the crosses will likely remain firm ahead of Jackson Hole I expect the EUR to struggle to hold onto gains into next week.

AUD has lost ground since around 10 August. This has roughly coincided with a rise in risk aversion over recent weeks. Indeed, AUD maintains a strong correlation with risk aversion and is therefore highly susceptible to swings in risk appetite. Additionally renewed China worries have also dampened the attraction of the AUD given the increasing dependency of Australia’s economy to China both directly through trade and indirectly via commodity prices.

While I remain positive on the AUD over the medium term, the high level of speculative positioning in the currency suggests some vulnerability to profit taking over the short term, with AUD/USD vulnerable to a drop to technical support around 1.0282. Much will depend on news out of China in terms of AUD direction, with Chinese stock market gyrations also providing some influence.

EUR/USD edging towards 1.20

There hasn’t been much of a respite before Eurozone concerns have resurfaced. Spain and Greece are once again in the spotlight, with the formal approval of a bank bailout for the former providing little solace as speculation of a full scale sovereign bailout grows. The fact that two Spanish regions have asked for government help, with more likely in the pipeline, has only acted to reinforce such concerns.

As for Greece, the halting of a bailout tranche due to failure to meet targets, the European Central Bank (ECB) decision not to accept Greek debt as collateral and the visit of the Troika (EC, ECB. IMF) will keep markets nervous as default fears intensify. Unsurprisingly Eurozone peripheral bond yield have come under renewed pressure while core Eurozone yields have turned negative in some cases.

Spanish yields have moved above the critical 7% threshold while the EUR has tanked versus USD and on the crosses as it increasingly takes on a funding currency role and makes its way towards the 1.20 level versus USD that I expect it to test soon.

Hopes of further monetary stimulus, especially in the US and China have provided some support to markets recently but the provision of drugs will not cure the patient this time around. Even relatively decent US corporate earnings, with around 2/3 of S&P earnings released beating admittedly lowered expectations so far, have failed to stop the rout.

Big cap defensive and high dividend companies have fared well, giving a degree of resilience to US equities which are up over 8% (S&P 500) this year, but with around 171 companies set to deliver results this week it is not clear that this will continue.

Weakening US data, with a deceleration in US Q2 GDP set to be revealed this week will provide more evidence that US economic momentum is slowing. Nonetheless, as long as US Fed quantitative easing is not an imminent prospect the USD will likely find plenty of support as risk aversion creeps back into the market psyche.

Recovery hopes spoiled by the consumer

News that US Q2 GDP dropped by less than expected, with the 1% fall in GDP over the quarter far smaller than the annualised 6.4% drop in the previous quarter, adds to the plethora of evidence highlighting that the US recession is coming closer to ending.  The bad news, albeit backward looking was revealed in the downward revisions to growth in the previous quarters, which indicated that the recession has been more severe than previously thought.  

Within the Q2 GDP data the details revealed that consumer spending weakened by far more than expected. The recession is also breaking all sorts of records as the annual 3.9% decline in growth was the biggest since WWII and the fourth quarterly decline in a row was the longest on record. Nonetheless, inventories look a lot leaner following their sharp drop over the quarter and the deterioration in business investment appears to be slowing.  The data also showed that the Fed´s preferred gauge of inflation (core PCE deflator) remained relatively well behaved.

The downward revisions to past data and the fact that growth was boosted in Q2 by government spending as well as very weak consumer spending will takes some of the shine off the less than forecast drop in GDP.  Nonetheless, the data is still backward looking.  The evidence of recovery highlighted in recent housing data as well as some bottoming out in manufacturing conditions, taken together with less severe readings in jobs data  are difficult to ignore.  This was echoed in the Fed´s Beige Book which revealed that economic deterioration was becoming less marked.

The most worrying aspect of the report and something that cannot be downplayed however, is consumer spending. Massive wealth loss, rising unemployment, tight credit conditions, reduced income and consumer deleveraging all point to a very subdued outlook for the US consumer in the months ahead and only a gradual pace of economic recovery. The US savings rate is set to move higher even from its current 15 year high and spending on big ticket items will remain fragile at best.   Although the upcoming US jobs report will likely show a less severe pace of Job losses in July, the drop in payrolls will still remain significant and hardly  conducive of a turnaround in spending. 

Although some policy makers have indicated that policy should not be kept too loose for too long the weak consumer outlook suggests that inflation is likely to remain subdued for a long time to come.  So whilst it is easy to get excited about the signs of recovery increasingly being revealed in economic data this should not be taken as a cue to reverse policy. The recovery process remains a “long, hard, slog” and the massive excess capacity in the global economy, especially  in developed countries suggests that interest rates will remain at ultra low levels for many months.

Some clues to central bank thinking will be seen over coming days as interest rate decisions in Australia, UK, and Eurozone move into focus. Although none of the Banks are expected to tighten policy it will be interesting to see whether the rhetoric becomes more hawkish. The RBA in particular will likely indicate that the room for further rate cuts has diminished. In Europe, following the very soft inflation data in July the ECB will be comfortable in its current policy settings.  In the UK attention will focus on the BoE´s asset purchase programme and the possibility of increasing purchases from the current GBP 125 billion, especially after the MPC surprisingly did not increase purchases at its last meeting.

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