Setting the cat among the pigeons

The Fed’s FOMC minutes which raised the spectre of an earlier than anticipated tapering off of asset purchases have really set the cat amongst the pigeons, fuelling selling in equities, commodities and various currencies against the USD. The impact was reinforced overnight following relatively hawkish comments from the Fed’s Bullard and Fisher.

US Treasuries rallied however, as risk aversion crept back into the market following weaker data releases in the Eurozone (manufacturing and service sector purchasing managers indices) and in the US (February Philly Fed manufacturing survey and higher than forecast weekly jobless claims).

The German IFO business survey is the main event on the data calendar today, with a small gain expected. The second 3 year LTRO payback to be announced today and the Italian elections will also be in focus.

In the US attention will turn to a meeting between President Obama and Japanese Prime Minister Abe. Given the IMF’s tacit approval of Japanese policy it is unlikely that any criticism of Japanese FX policy will be forthcoming at the meeting.

Markets are set to trade cautiously around these events but the main theme will be the overriding impact of this week’s Fed minutes, which has really changed the dynamic in markets, especially for currencies, with the risk / reward of selling USDs now looking much less attractive.

USD is set to continue to trade with a firm tone and EUR in particular looks vulnerable. The continued fall out from Fed FOMC minutes, disappointing PMIs yesterday, Italian election uncertainty and likely lower than expected ECB LTRO repayments today suggests that EUR/USD will face more downside risks. Look for a test of support around 1.3140, which if broken will open the door for the psychologically important 1.30 level.

USD/JPY is likely to consolidate further awaiting the announcement of a new Bank of Japan governor, with JPY selling momentum continuing to abate. AUD was lifted by RBA governor Steven’s comments which did not indicate an urgency to cut policy rates further nor to intervene to lower the value of the currency. AUD/NZD continues to look constructive on the upside given the contrasting comments on the AUD and NZD from both central banks.

Please note my blog posts will be a bit sporadic over the next couple of weeks a I am will be traveling.

Contrasting Fed and BoE stance

A contrasting stance in the minutes of the Fed and Bank of England impacted FX markets. Firstly the Fed minutes revealed some unease among officials about maintaining current quantitative easing settings as the economic outlook improved. In contrast the BoE minutes revealed a more dovish than anticipated 6-3 vote in favour of further easing. Consequently GBP/USD dropped sharply while the USD made broad gains. It will take a move higher in US bond yields to reinforce USD strength and notably 10 year Treasury yields have yet to break the 2.0634 high reached on 14 February.

While the JPY is likely to continue to weaken over coming months I maintain the view that the bulk of its cyclical decline has already taken place, with the risks much more balanced. My models continue to show that the magnitude of JPY weakness is not justified by its usual drivers. Risks of a short term JPY correction higher notwithstanding I expect any further weakness to be much more gradual in the months ahead.

Consistent with my model output, the feeling on the ground in Japan is that the currency has indeed fallen too far, too quickly, while there is plenty of scepticism about the fact that so far there has actually been little in terms of actual policy measures to justify the drop in the JPY. In the meantime the new central bank governor will be scrutinised to determine whether he will be sufficiently aggressive to warrant the drop in the JPY. A decision may take place very soon. Whatever the decision USD/JPY looks set to struggle to break above 94.00 in the short term.

Markets will be very data-dependent in terms of determining AUD direction in the weeks ahead. A further batch of soft data will reinforce expectations of further RBA rate cuts and undermine the AUD further. I do not expect this to occur, with some stabilisation in economic data likely, an outcome which ought to restrain AUD bears. My quantitative model suggests that AUD/USD is now looking relatively cheap, with the regression estimate at around 1.07.

AUD’s drop against NZD has been particularly sharp. I do not believe the drop is justified and yesterday’s jump in AUD/NZD based in large part on comments by RBNZ governor Wheeler warning about FX intervention to weaken the kiwi in my view marks a shift in the fortunes of the currency pair. Such comments should not be surprising given the failure of the G20 to chastise Japan on its FX stance. Expect more FX jawboning in the weeks ahead from other central banks.

JPY selling momentum slows

Markets have few leads to trade off following yesterday’s President’s Day holiday in the US. Nonetheless, caution appears to be settling in ahead of this weekend’s Italian elections, especially in Europe.

European Central Bank President Draghi’s address to the EU parliament did little to stir markets as he didn’t elaborate much on his post ECB press conference in February. The most notable comment was that he urged the G20 to have very “strong verbal discipline” on talking about currency movements.

Despite the Italian election caution most risk measures appear to be well behaved. Equity volatility has continued to drop and gold prices have stabilised following the recent sharp decline. The highlight of the data calendar today is a likely gain in the February German ZEW survey.

Currency markets are rangebound but it is notable that USD/JPY has struggled to sustain gains above the 94.00 level, with upward momentum in the currency pair appearing to fade. Comments by Japan’s Finance Minister Aso that the government was not considering changing the central bank law at present or buying foreign bonds helped to dampen USD/JPY.

Although the G20 meeting effectively gave the green light for further JPY declines, a lot is in the price in terms of policy expectations and any further JPY weakness is likely to be much more gradual. USD/JPY 94.46 will offer strong resistance to further upside.

Asian currencies continue to deliver a mixed performance, with JPY sensitive currencies including SGD, KRW and TWD remaining on the back foot. The SGD is the most highly correlated Asian currency with JPY, with a high and significant correlation between the two. Any further drop in JPY will clearly bode badly for SGD but the inability of the JPY to weaken further may help to moderate pressure on the SGD in the near term.

Although the KRW has rebounded over recent days one risk to the currency is continued outflows of equity portfolio capital. South Korea is one of the only countries in Asia to have recorded outflows (around USD 1.2 billion year to date). However, this month the outflow appears to have reversed, with around USD 500 million in inflows registered month to date. In part the outflows of equity capital from South Korea in January reflected concerns about North Korea. Such concerns have receded but the risks remain of more sabre rattling and/or more nuclear tests from the North.

Political events move into focus

The start of the week will be relatively muted due to the US President’s Day holiday although Chinese markets will reopen following the New Year holidays giving a little more impetus to Asian markets.

The main event over the weekend was the G20 meeting. Ultimately it did not target Japanese FX policy, but instead the statement pledged not to “target our exchange rates for competitive purposes”. European Central Bank President Draghi may utter no more than this sentiment on the EUR exchange rate during his dialogue with the European Parliament today.

The lack of specificity will mean that the G20 statement will allow further unobstructed JPY weakness in the months ahead. In the near term markets will probe further downside in the JPY although we suspect that profit taking on long USD/JPY and EUR/JPY positions will restrict further downside potential. Expect plenty of resistance on any break above USD/JPY 94.00.

Attention will now turn to political events, in particular the looming elections in Italy (24th) and the formulation of a bailout for Cyprus in the wake of elections there. In the US the looming sequester may prompt some nervousness for markets over the coming days given the approaching deadline.

Data releases this week will be a little more encouraging following the recent plethora of data revealing a global softening in activity towards the end to 2012. In Europe gains in the German ZEW and IFO investor and business sentiment surveys will bode well for the region although the rest of the Eurozone will not look as upbeat as Germany. Despite the likely firmer German data expected over coming days EUR/USD is likely to remain restrained ahead of Italian elections, with strong resistance seen around 1.3462.

In the US there will likely be little new in the Fed’s FOMC minutes, with no new signal that the Fed is about to shift its policy stance despite a few nervous FOMC members. US Housing indicators will look a little softer but will not detract from the improving trend in housing activity currently underway. Meanwhile, relatively well behaved CPI and PPI inflation releases will pass reasonably quietly, provoking little nervousness in interest rate markets.

Finally in the UK the Bank of England MPC minutes will show a unanimous decision on policy settings. Unfortunately this will give little to help to GBP although it increasingly looks as though EUR/GBP is topping out even if GBP/USD looks vulnerable to further slippage.

No surprises likely from ECB and BoE

Markets appear to be entering into a more nervous period following several weeks of upside for risk assets. While risk appetite measures remain elevated equity markets appear to be running out of momentum in the short term.

A combination of European political concerns as elections approach in Italy, corruption allegations in Spain, currency frictions, the continued impasse in the US over impending spending cuts or simply a market that has overtaken reality, it appears that a pause in the rally in risk assets is on the cards.

A test of sentiment towards Spain will take the form of a Spanish bond auction today while central bank policy decisions in the Eurozone and UK will garner most attention today although no big surprises are expected as both central banks are set to keep policy on hold.

Anyone expecting the European Central Bank to echo the views on some European politicians by taking a stand against the strength of the EUR will be sorely disappointed. While clearly uncomfortable from a growth perspective the rise in EUR will be rationalised as a reflection of better market sentiment towards Eurozone assets. In fact the ECB could be a cause of EUR strength with its shrinking balance sheet playing a role in supporting EUR especially as it contrasts with the Fed’s balance sheet expansion.

Further ECB balance sheet contraction in the months ahead as LTRO payments are made could put into jeopardy my forecast of a lower EUR/USD (1.25 by end 2013). In the past the ECB has verbally intervened by warning on the strong volatility of the EUR but this is unlikely to happen anytime soon as 3 month EUR/USD implied volatility is still close to multi month lows. In any case the market may already be self correcting, with EUR appearing to lose some steam over recent days. Near term consolidation is likely around the ECB meeting.

The Bank of England in contrast to the ECB may be welcoming the moves in GBP over recent weeks given the stimulus provided to the UK economy from a weaker pound. An unchanged BoE policy decision today will have minimal impact on GBP, with more attention on the testimony of incoming governor Carney, especially given his recent comments about tying monetary policy to economic growth during “exceptional times”. The comments had already dealt a blow to GBP but unless Carney elaborates further I do not expect GBP to be hit much more.

Even so, GBP/USD risks remain to the downside given ongoing concerns about a credit ratings downgrade and a negative technical picture. Taking a short EUR/GBP position may offer some better prospects for those wishing to enter GBP long positions as the upside momentum in the currency pair appears to be flagging although I suggest waiting for more concrete signals of a turnaround before entering into such a position.

Risk assets pull back as caution prevails

Risk assets faltered especially in Europe in the wake of renewed political tensions in Italy and Spain. Election uncertainty in the former as former Prime Minister Berlusconi gathers growing support and government corruption allegations in the latter hit equity markets and peripheral bonds.

Consequently the EUR gave back some of its recent gains, with the currency not helped by comments by the French finance minister warning about its strength. EUR/USD downside will be limited to support around 1.3461 in the near term.

Weaker Spanish jobs data did little to help sentiment while service sector confidence indices in the Eurozone today will also provoke further concerns revealing both continued contraction for most countries and divergence in the bigger economies, namely Germany and France. Caution will prevail in the near term as markets begin to question the veracity of the rally in risk assets registered over recent weeks.

AUD has had a fairly erratic start to the year rallying to break 1.06 against the USD but failing to hold gains over recent weeks. The currency has looked a little more stable into February but is still showing little sign of rallying despite the recently firmer risk tone, weaker USD index and firmer Chinese data, all of which would have been supportive for AUD in the past.

Technically AUD/USD looks vulnerable according to the relative strength index (RSI). Moreover, speculative positioning is around the 3 month average suggesting little impetus either way.

The RBA decision today to hold the cash rate unchanged but keep open the door to further rate cuts will inflict more short term pain on AUD but given that the market had already priced in a further rate cut in the cycle any decline in AUD will be limited. A break below the 100 day moving average around 1.0415 will result in a test of support around 1.0381.

Although the AUD is faltering its drop pales into insignificance compared to the sharp decline in JPY over recent weeks. Obviously the drop in the JPY has caused some panic across other currencies, especially in Asia (KRW, TWD, MYR), but this has done little to sway JPY bears. I have some hesitancy in calling the JPY much lower especially as a lot appear to be is in the price (in terms of aggressive policy actions) but technical indicators for both USD/JPY and EUR/JPY remain bullish despite the pull back overnight.

The intensifying hunt for yield means that the JPY will remain on the back foot over coming months but in the short term JPY may find some support from a renewed rise in risk aversion as political tensions in Europe heat up as well as some caution that the risk rally looks overdone. However, speculative positioning is unlikely to get in the way of further JPY declines given that positioning is around the 3-month average and still well above the all time lows reached in June 2007.

EUR/JPY ascent shows no sign of stopping

Data releases globally continue to show that economic conditions are strengthening. The latest indicator to lend support to this view was the January US jobs report, which taken together with past revisions revealed that job market conditions were better than previously thought over recent months. The report labelled as a “goldilocks” outcome also revealed a slight rise in the unemployment report, implying that there is little chance of any consequent shift in the Fed’s highly accommodative stance.

More broadly global manufacturing confidence indices also revealed gains (albeit with some divergence in Europe) and point to expansion in output in the months ahead in many countries. The data also suggest that weakening in economic indicators in Q4 last year including the surprise drop in US Q4 GDP was merely a setback rather than a renewed slide into recession. All of this leaves markets in rather buoyant mood as reflected in the ongoing gains in risk assets over the past few weeks and positive end to last week.

All is not rosy however, and politicians may yet ruin the day as political frictions in the US over spending cuts and a new budget have yet to be resolved. Meanwhile, elections in Italy on 24/25 February will provoke more nervousness as they approach. The EU Summit on 7/8 February will also be in focus as politicians attempt to salvage a deal on the EU budget after talks broke down in November 2012.

A light data calendar this week will mean that central bank decisions will garner most attention over coming days although I expect no change in policy from the European Central Bank, Bank of England and Reserve Bank of Australia. Risk assets will therefore not find any support from central banks this week. In particular the ECB’s stance of contracting its balance sheet continues to run counter to the more aggressive easing from other central banks, with the pain on an already weak Eurozone economy accentuated by a stronger EUR. Indeed, commercial banks’ LTRO repayments to the ECB may have helped to propel the EUR even higher.

Despite the ongoing upward momentum of USD/JPY the USD looks set to remain under downward pressure in general although there was notably some short covering according to the latest CFTC IMM report. The JPY shows no sign of reversing its losses as a combination of official rhetoric, improving risk appetite and growing use as a funding currency intensify the pressure on the currency. In particular, EUR/JPY’s ascent shows not sign of stalling into this week, with speculative longs in this currency pair at their highest level since May 2007.

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