Ready for Fed QE2

September 22, 2010 — Mitul Kotecha

The USD was already under pressure ahead of the Fed FOMC decision last night, with the EUR benefiting in particular from successful debt auctions in Ireland and Spain. The Fed statement resulted in a further lurch lower for the USD index as it fell through the 81.00 level on its way to testing the August low of 80.09. EUR/USD broke important technical resistance levels moving above its 200-day moving average (1.3215). In contrast, gold prices continued to surge hitting a new record high whilst 2-year Treasury yields fell to an all-time low.

The US Federal Reserve confirmed that it was ready to ease if needed. Although the decision to leave the Fed funds target rate at 0% to 0.25% unchanged and commitment to maintain exceptionally low levels of the rate for an “extended period” came as no surprise there was a subtle change in the language of the statement regarding further easing. The Fed noted that it was “prepared to provide additional accommodation if needed” a shift from the previous wording that it “will employ its tools as necessary”.

It appears to be a case of not if but when the Fed embarks on further quantitative easing and/or other policy accommodation. Once again the Fed offered no guideposts to determine the timing of easing and the decision will ultimately be data dependent. Nonetheless, the bias has clearly shifted towards more balance sheet expansion.

We expect core inflation to decline further over the coming months although we do not forecast a drop to as low as 0.5%. Nonetheless, declining core CPI could lead to the Fed’s disinflation concerns intensifying. Indeed, providing further rationale for the Fed’s conditional easing bias was the particularly dovish stance on inflation in the FOMC statement.

If it wasn’t obvious before it has become increasingly clear now that the USD will not relinquish its role as the ultimate funding currency for a long time to come. Although interest rate differentials are not yet the main driver for most currency pairs, with risk aversion retaining this role for now, there is a very high correlation between certain high yielding currencies and their respective interest rate differentials against the USD.

For instance, there is a high and significant correlation between interest rate differentials between Japan, Australia, Canada and the US and their respective currency pairs. AUD/USD is one to watch as the currency hit a fresh 25 month high overnight. Although the AUD looks rich at current levels, the shift in relative yield with the US overnight provides a further underpinning to the currency, with parity being talked about once again.

Even USD/JPY moved lower in the wake of the Fed statement dropping just below 85.00 although the threat of further official Japanese FX intervention will likely prevent a sharp drop in the currency pair. It will be interesting to see how far the market is prepared to go, with further threats of FX intervention by Prime Minister Kan overnight. Despite the threats the narrowing in US / Japan bond yields overnight suggests more downside pressure on USD/JPY and a fresh challenge for the Japanese authorities.

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Exhausted

September 14, 2010 — Mitul Kotecha

No the title is not meant to describe how I felt this morning when I woke up but how I feel the market is looking at present in terms of risk trades. Firmer than feared economic data in the US and China and the agreement in Basel on new bank capital ratios boosted risk appetite but the moves are already beginning to fade. It would be easy to jump on the bandwagon but after the sharp gains registered over recent days I would suggest taking a cautious stance on jumping into risk trades at present.

The EUR has played a degree of catch up to risk currencies, rallying sharply against the USD, helped in part by the European Commission which raised its forecasts for the eurozone economy from 0.9% for 2010 to 1.7%. Although the change in forecasts should come as little surprise give that it is now in line with the European Central Bank’s (ECB) expectations the news bolstered the view of economic resilience in the eurozone. Unfortunately as the ECB noted following its last meeting there are plenty of downside risks to growth next year and upcoming data releases will be viewed to determine how sharply growth momentum will slow into next year.

One currency that strengthened was the JPY and this was mainly due the view that Prime Minister Kan will win the contest for leadership of the governing DPJ party in Japan. The race remains very close, with Prime Minister Kan having a slight lead according to Japanese press. The FX market will pay particular attention to the result given that the other contender Ichiro Ozawa has stated his willingness to drive the JPY lower as well as increase fiscal spending. The results of the election will be known shortly and should Ozawa win USD/JPY will likely find support although the bigger influence is likely to be a shift in relative US/Japan bond yields which due to the sell off in US Treasuries over recent days has become more supportive of a higher USD/JPY.

GBP has lagged the move in many risk currencies, failing to take advantage of the weaker USD. There was some relief overnight from an increase in consumer confidence in August according to the Nationwide index, which rose 5 points to 61, from a 14-month low in July. However, any boost to GBP sentiment will have been outweighed by a fall in UK house prices according to RICS, which revealed the sharpest one-month fall in August since June 2004. The data supports the view that the rally in UK house prices could soon be over. Weaker housing activity will also likely limit any further improvement in consumer confidence. Some of this is already priced into GBP however, and over the short-term EUR/GBP may struggle to breach the 0.8400 level.

Another underperformer overnight was the NZD which was hit by disappointing retail sales data for July, which fell 0.4%. Although the drop followed a strong gain in the previous month the data supports the view that the consumer remains cautious in New Zealand, a factor that will likely play into the view that New Zealand’s central bank, the RBNZ will keep policy on hold when they meet tomorrow. NZD slipped off its highs around 0.7347 overnight and also managed to dampen the upside momentum for AUD/USD which will likely struggle to sustain a break through resistance around 0.9350.

Today’s data will provide further direction for the days ahead, with the September German ZEW survey of investor confidence likely to be closely scrutinized. A drop in the economic sentiment gauge to around 10 is expected from 14 in August, highlighting that eurozone growth momentum is beginning to wane. Hard data in the form of eurozone industrial production will also record a weaker performance, likely to drop 0.3% in July. The data will likely cap the EUR today.

In the US the main release is the August retail sales report for which a 0.3% gain in both headline and ex-autos sales is expected. Sales will have been helped by back to school spending although major discounting will have weighed on retailers’ profits. Nonetheless, any gain even if modest will be a welcome development for Q3 growth in the US.

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US Dollar Tensions

September 6, 2010 — Mitul Kotecha

There was considerable relief, most acutely in the US administration, that the US August jobs report revealed a better than expected outcome. To recap, private sector payrolls increased by 67k vs. an upwardly revised 107k in July whilst total non farm payrolls dropped 54k. The data sets the market up for a positive start to the week in terms of risk appetite despite Friday’s drop in the August US non-manufacturing ISM index, deflating some of the market’s upbeat mood.

Once again I wonder how long positive sentiment can be sustained with so many doubts about recovery prospects and limited ammunition on the fiscal front as well as some reluctance on the monetary front, to provide further stimulus should a double dip become a reality.

Markets will be treated to several major central bank decisions including from the Bank of Japan, Bank of England, Bank of Canada and Reserve Bank of Australia this week. These meetings are set to prove uneventful, with unchanged decisions across the board expected although the Bank of Canada decision is a tough call.

The main US release this week is the Fed’s Beige Book on Wednesday, a report which will help the Fed to prepare for the FOMC meeting on September 21. The evidence contained within it is unlikely to be positive reading, with consumer spending set to be relatively soft and evidence of recovery likely to remain patchy.

On Thursday the US July trade deficit is set to reveal some narrowing and as usual the deficit with China will be of interest given the renewed tensions over FX policy. FX tension seems to be intensifying once again due to the relatively slow pace of CNY appreciation since the June de-pegging as well as political posturing ahead of November US mid-term elections. A deterioration in US trade data, a factor that largely contributed to the soft Q2 GDP outcome in contrast to a strengthening in China’s trade surplus will have added fuel to the fire.

The firmer risk backdrop has put the USD on the back foot, with the USD index dropping sharply overnight. Nonetheless, speculative USD positioning as reflected in the CFTC IMM data reveals further short covering up to the end of August, implying USD speculative sentiment is actually turning less negative.

Another country which has a different sort of tension regarding the USD is Japan. Improving risk appetite will likely prevent the JPY from visiting previous highs against the USD but will do little to reduce FX intervention speculation. Indeed, there was more jawboning over the weekend on the subject, with Japan’s finance minister Noda reiterating that Japan would take decisive action to stem the JPY’s appreciation but adding that coordinated FX intervention was a difficult option. Clearly Japan us unlikely to succeed with unilateral FX intervention.

Political events have added to the debate on FX policy as focus turns to the election for leader of the ruling DPJ party next week, with a battle looming between current Prime Minister Kan and challenger Ozawa. Although Ozawa is unpopular with the electorate he yields plenty of political power, and appea rs to be more inclined towards FX intervention. Having failed to sustain a move above 85.00 the pull back in USD/JPY suggests little appetite to extend gains, likely leaving USD/JPY in a relatively tight range, with strong support around 83.55 and resistance around 85.23.

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What goes down must go up

September 2, 2010 — Mitul Kotecha

What goes down must go up! A day that began with a stronger than forecast increase in China’s purchasing managers index (PMI) and firm Australian Q2 GDP continued with a surprise jump in the August ISM manufacturing index. The ISM rose to 56.3 from 55.5 in July an outcome that contradicted most of the regional US manufacturing surveys. It was not all positive in terms of data, yesterday however, with a weaker UK manufacturing PMI and unexpected drop in the August US ADP employment report casting a shadow over markets.

Nonetheless, for a change the market decided to act on the good news, with risk assets surging. Despite the improvement in risk appetite it still feels as though the market is grasping for direction. The jump in equities is unlikely to prove durable in an environment characterized by various uncertainties about growth and policy, especially the US.

The next hurdle for markets is the US payrolls data tomorrow. Although the ADP jobs report revealed a surprise 10k decline the employment component of the ISM manufacturing survey strengthened to 60.4, suggesting an improvement in August manufacturing payrolls. Ahead of the payrolls release the US data slate today largely consists of second tier releases including July pending home sales, August chain store sales, weekly jobless claims, and factory orders. It is worth paying particular interest to jobless claims given that the four week moving average has been edging higher, suggesting renewed job market deterioration. The consensus is for a 475k increase in claims, which will still leave the 4-week average at an elevated level.

Given that one of the biggest debates raging through markets at present is whether the Fed will embark on further quantitative easing comments by Fed officials overnight were closely scrutinized for further clues. In the event, Fed Governor Kohn highlighted that the Fed’s reinvestment of the proceeds from mortgage-backed securities will not automatically lead to further QE, suggesting some hesitancy on his part. Meanwhile, Dallas Fed President Fisher noted his reluctance to expand the Fed’s balance sheet until fiscal and regulatory uncertainties are cleared up.

Both sets of comments highlight the difficulty in gaining a consensus within the FOMC for a further increase in QE, suggesting that the hurdle for further balance sheet expansion will be set quite high. Moreover, such comments put the onus on Congress to move quickly in clearing up fiscal policy uncertainties.

As markets flip from risk on to risk off almost on a daily basis the question for today is how sustainable the rally in risk trades will prove to be against the background of so much policy and growth uncertainty. Unfortunately today’s data will provide few clues and markets will turn their attention to tomorrow’s US non-farm payrolls report for further direction. To an extent this suggests that it may be a case of treading water until then. Nonetheless, I still maintain that risk trades remain a sell on rallies over coming weeks

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Split personality

August 25, 2010 — Mitul Kotecha

Markets are exhibiting a Strange Case of Dr Jekyll and Mr Hyde, with a clear case of split personality. Intensifying risk aversion initially provoked USD and JPY strength, with most crosses against these currencies under pressure. Both USD/JPY and EUR/JPY breezed through psychological and technical barriers, with the latter hitting a nine-year low. However, this reversed abruptly in the wake of extremely poor US existing home sales, which plunged 27.2% in July, alongside downward revisions to prior months, a much bigger drop than forecast.

Obviously double-dip fears have increased but how realistic are such fears? Whilst much of the drop in home sales can be attributed to the expiry of tax credits, investors can be forgiven for thinking that renewed housing market weakness may lead the way in fuelling a more generalized US economic downdraft. The slow pace of jobs market improvement highlights that the risks to the consumer are still significant, whilst tight credit and weaker equities, suggests that wealth and income effects remain unsupportive.

FX markets will need to determine whether to buy USDs on higher risk aversion or sell USDs on signs of weaker growth and potential quantitative easing. I suspect the former, with the USD likely to remain firm against most risk currencies. The only positive thing to note in relation to the rise in risk aversion is that it is taking place in an orderly manner, with markets not panicking (yet).

European data in the form of June industrial new orders delivered a pleasant surprise, up 2.5%, but sentiment for European markets was delivered a blow from the downgrade of Ireland’s credit rating to AA- from AA which took place after the close. The data suggests that the momentum of European growth in Q3 may not be as soft as initially feared following the robust Q2 GDP outcome.

Japan has rather more to worry about on the growth front, especially given the weaker starting point as revealed in recently soft Q2 GDP data. Japan revealed a wider than expected trade surplus in July but this was caused by a bigger drop in exports than imports, adding to signs of softening domestic activity. The strength of the JPY is clearly making the job of officials harder but so far there has been no sign of imminent official FX action.

Japan’s finance minister Noda highlighted that recent FX moves have been “one sided” and that “appropriate action will be taken when necessary”. The sharp move in JPY crosses resulted in a jump in JPY volatility, a factor that will result in a greater probability of actual FX intervention but the prospects of intervention are likely to remain limited unless the move in the JPY accelerates. USD/JPY hit a low of 83.60 overnight but has recovered some lost ground, with 83.50 seen as the next key support level. JPY crosses may see some support from market wariness on possible BoJ JPY action, but the overall bias remains downwards versus JPY.

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