The Week Ahead

February 20, 2011 — Mitul Kotecha

Housing and durable goods orders data will form the highlights of the US calendar this week. Speeches from several Fed speakers will also give some further guidance to the appetite for completing the Fed’s $600 billion in asset purchases. Overall it will be a slow start for FX markets with liquidity thinned by the Presidents Day holiday and as a result currencies are likely to remain in relatively tight ranges. The heavy tone of the USD seen last week is likely to persist over coming days given the absence of driving factors. Even the unrest in the Middle East has been unable to derail the improving trend in risk appetite, another factor dampening USD sentiment.

The EUR held up well last week recouping its early week losses to end on a firm note. The ability of the EUR to shake off various bits of bad news was impressive but whether it can continue to do so is debatable. Data releases are unlikely to provide much of a boost. Whilst eurozone business surveys set to remain at high levels, consistent with a rebound in Q1 GDP growth, further improvements are unlikely. The week kicks off with the February German IFO business confidence survey but at best this will reveal stable reading. The EUR may find some support from signs of higher and in Germany and an above consensus reading for M3 money supply growth though this is not usually a market mover. The data will likely feed nervousness about European Central Bank (ECB) tightening. Ireland could rock the boat however, with general elections likely to keep markets nervous about potential renegotiations of Ireland’s bailout terms.

Although deflationary pressures are easing in Japan there is a long way before the spectre of inflation will emerge. Nonetheless, the Bank of Japan (BoJ) revised up its growth outlook last week, suggesting that the likelihood of more aggressive measures to combat deflation is narrowing. A reminder of ongoing deflation will come with the release of January CPI data this week whilst trade data will be watched to determine what impact the strength of the JPY is having on exports. Both EUR/JPY and USD/JPY are close to the top of their recent ranges and the data are unlikely to provoke a break higher. USD/JPY will likely remain capped around 84.51 whilst EUR/JPY will find tough resistance around 114.02.

GBP performed even better than the EUR last week helped by an even more hawkish sounding than usual BoE Monetary Policy Committee (MPC) member Sentance and a letter from the BoE governor hinting at rate hikes. Even a relatively more slightly dovish Quarterly Inflation Report failed to halt GBP’s ascent. Further direction will come from the February MPC minutes in which we expect to see two dissenters, namely Sentence and Weale who likely voted for a rate hike. However, there is a risk that they may have been joined by at least one other, with speculation that MPC member Bean may have joined the dissenters. Such speculation alongside the jump in January UK retail sales at the end of last week will likely add to more upside potential for GBP, setting it up for another gain this week. Its upward momentum may however, be hampered by the large net long GBP positioning overhang.

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Talk but no action

January 19, 2011 — Mitul Kotecha

The eurozone periphery remains in the eye of the storm but markets may have to wait before any concrete action is taken. The possibility of increasing the size of the bailout fund (EFSF), preparation of new European bank stress tests and/or allowing the EFSF to purchase eurozone government debt are all on the table but so far agreement has been lacking. Ministers apparently rejected the idea of increasing the size of the fund from EUR 440 billion to EUR 750 billion whilst disagreement over stricter criteria may also be hampering any progress.

Nonetheless, the EUR has found renewed support, helped by the firm German IFO investor confidence survey and news that Russia is looking to buy EFSF bonds. EUR/USD upside may be face a hurdle around 1.3500 over the short term and gains above this level are likely to be difficult to sustain given the ongoing uncertainties about the EFSF none of which are likely to be resolved anytime soon. The bottom line is that talk but not action will not be sufficient to keep the EUR supported.

GBP is also doing well, partly on the coat tails of a firmer EUR but also in the wake of an acceleration in UK CPI inflation which came in at 3.7% YoY a two year high, surpassing the Bank of England’s (BoE) ceiling for the 10th straight month. Inflation is likely to remain elevated pushing closer to 4% due to the VAT hike to 20% which came into effect at the beginning of this year. The data puts the BoE in a difficult situation testing the Monetary Policy Committee (MPC) expectation that the jump in inflation will prove temporary. However, the market is increasing taking the stance that a rate hike is going to take placer sooner rather than later, with a growing probability of a rate hike.

Since the end of last year there has been a 25bps spread widening (between 2nd contract rate futures) as markets have become more hawkish on UK interest rate expectations. This has coincided with an increasing correlation with GBP/USD resulting in the currency pair cracking above the psychologically important 1.60 level. Much will depend on whether the BoE’s predictions come true. If inflation remains sticky on the upside the Bank may be forced into an earlier tightening. Whether this is good news for GBP will depend on the economy. The worst case scenario is premature monetary tightening just as austerity measures start to bite.

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Data and earnings focus

January 17, 2011 — Mitul Kotecha

Friday’s round of US data were generally upbeat, highlighting that consumer spending is coming back to life. Inflation pressures however, remain benign at least on the core reading highlighting the Fed’s concern that inflation is running below the level consistent with its mandate. In other words it will be a long time, probably late into 2012 before policy rates increase.

While the Fed is no hurry to raise rates despite a few hawkish rumblings within the FOMC the European Central Bank (ECB) in contrast appears to have become more eager to pull the trigger for higher rates. ECB President Trichet’s hawkish press conference last week set the cat amongst the pigeons and marked a clear shift in ECB rhetoric towards a more hawkish stance.

A very big problem for the ECB is that the eurozone economy is not performing along the lines that its hawkish rhetoric would suggest, especially in the periphery. Growth momentum in the core in contrast, as likely reflected in the January ZEW investor confidence and IFO business confidence survey data this week in Germany, remains positive. Both surveys are likely to stabilize at healthy levels but how long can the likes of Germany drag along the eurozone periphery?

There will be relatively more attention on the meeting of Eurogroup/Ecofin officials, with focus on issues such as enlarging the size of the European Financial Stability Facility (EFSF) bailout fund and development of a “comprehensive plan” to contain the eurozone crisis. Don’t look for any conclusive agreements as this may have to wait until the European Union (EU) Council meeting on 4 February assuming (optimistically given ongoing German resistance) some agreement can even be reached.

Following the success (albeit at relatively high yields) of the eurozone debt auctions last week, sentiment for peripheral debt will face further tests this week in the form of debt sales in Spain, Belgium and Portugal.

The US Martin Luther King Jr. holiday will result in a quiet start to the week for markets but there will be plenty to chew on. This week’s key earnings reports include several banks scheduled to release Q4 earnings. Financials are a leading sector in the rally in equities at present and these earnings will be critical to determine whether the rally has legs.

The US data slate includes January manufacturing surveys in the form of the Empire and Philly Fed, both of which are likely to post healthy gains whilst existing home sales are also likely to rise. This will not change the generally weak picture of the US housing market, with high inventories and elevated foreclosures characterizing conditions. As if to prove this, housing starts are set to drop in December. On the rates front, the Bank of Canada is likely to keep its policy rates on hold this week.

After coming under pressure last week much for the USD will depend on the eurozone’s travails to determine further direction. Concrete evidence of progress at the Ecofin may bolster the EUR further, with resistance seen around 1.3500 but don’t bank on it. The ability of eurozone officials to let down often lofty expectations should not be ignored. In any case following sharp gains last week progress over coming days for the EUR will be harder to achieve.

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Temporary Euro Relief

January 12, 2011 — Mitul Kotecha

Eurozone peripheral country travails continue to garner most market attention. There was at least a semblance of improvement on this front as peripheral bond spreads with German bunds narrowed on Tuesday but this was largely due to European Central Bank (ECB) bond buying than any improvement in sentiment. The fact that German bund yields also rose helped to narrow bund-peripheral spreads further.

A clearer test of sentiment will be today’s debt sales by Portugal followed by actions by Spain and Italy tomorrow. ECB buying of Portuguese bonds has given some relief to other debt, with Spanish and Italian debt spreads narrowing too. Even Greece managed to sell short term debt (EUR 1.95 bn of 26 week T-bills) but at a higher cost than the previous sale.

Perhaps a stronger boost to sentiment will come from the news that European Union (EU) governments are discussing an increase in the EUR 440 billion bailout fund in recognition of the fact that the fund may prove too small to cope if the crisis spreads to Spain. However, don’t expect a decision anytime soon, with next week’s meeting of EU finance ministers unlikely to agree to such a move. Support (or lack) of from Germany may prove to be a sticking point against the background of domestic political pressure.

Other options being considered include the possibility of the EFSF (European Financial Stability Facility) purchasing bonds in the secondary market and lowering interest rates on EFSF bailout loans. News that Japan will buy 20% of EFSF bonds this month as well as recent supportive comments from China suggest that an increase in the size of the EFSF may be easily funded by such investors. The EUR will gain some support against the background of such speculation but its upside may be restrained around its 200-day moving average at EUR/USD 1.3071.

In the US the economic news was not so positive for a change as the National Federation of Independent Business (NFIB) small business optimism survey came in weaker than expected in December, an outcome that will come as a blow given that it suggests some stuttering in the recovery process as well as hiring.

There is only secondary data scheduled today, with most attention on the Fed’s Beige Book later tonight. The survey of Federal Reserve districts will likely reveal a broad based but moderate improvement in economic conditions with the exception of housing activity. A speech by the Fed’s Fisher on Monetary policy will also be in focus. Like the Fed’s Plosser overnight he may highlight some caution about the impact of Fed quantitative easing (QE).

The AUD is increasingly feeling the impact of the flooding in Queensland Australia as the extent of economic damage is revealed. Reserve Bank of Australia (RBA) board member McKibbin estimated that it could knock off at least 1% from economic growth. This may prove too negative and although the flooding will result in a significantly negative impact on growth in Q1 rebuilding and reconstruction will mean that overall growth for 2011 will not be as significantly impacted. Nonetheless, a paring back in RBA policy tightening expectations will see the AUD come under further pressure, with a move down to around AUD/USD 0.9634 on the cards over the short-term.

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Euro Problems Intensify

January 10, 2011 — Mitul Kotecha

Following the bullish build up and increasingly lofty expectations for the US December jobs report the actual outcome was disappointing, at least on the headline reading. Non farm payrolls rose 103k which in reality was not that much less than initial forecasts but the real consensus was somewhat higher following the robust ADP private sector jobs report earlier in the week. There was some mitigation in the 70k upward revisions to October and November and surprisingly large decline in the unemployment rate to 9.4%. Consequently the market impact was less severe than it could have been and even the USD ended higher on the day.

Nonetheless, the data provided a dose of reality to markets’ optimistic expectations and this was reinforced by Fed Chairman Bernanke in testimony on Friday. He highlighted that it will take “considerable time” before the unemployment rate drops to a normal level, which could threaten recovery. Even the drop in the unemployment rate revealed in the December is report is vulnerable to a reversal given it was in part due to a drop in the labour force. This reality provided support to bond markets which may undermine the USD given the drop in bond yields. However, the USD’s anti-EUR credentials suggest that it will remain resilient.

Eurozone’s woes continued to heat up last week as the holiday season relief proved temporary. Stress in peripheral debt markets increased despite buying from the ECB last week and faced with debt sales in Italy, Portugal and Spain this week the pressure is likely to continue over coming days. Whether its worries about a resolution to funding issues and investor haircuts and/or the growing divergence in growth across the eurozone, the EUR continues to look vulnerable in the absence of any resolution to these issues. Having easily slipped below its 200-day moving average EUR/USD will eye support around 1.2767.

US data this week will look upbeat and provide more support for the USD, with December retail sales likely to record a healthy increase both on the headline and ex-autos readings as indicated by strong holiday sales. Similarly industrial production will reveal a solid gain whilst the Beige Book will highlight that economic conditions across the Federal Reserve districts, have continued to improve. The weak spot will remain housing but despite this consumer spending and sentiment are likely to be reported as resilient. The Beige Book is unlikely to reveal much of an inflation threat despite higher commodity prices. This will be echoed in the core CPI reading this week.

Although headline inflation in the eurozone breached the 2.0% threshold in December the ECB is unlikely to use it as an excuse to move towards tighter monetary conditions any time soon. The ECB meeting this week will nonetheless likely note the increase in various inflation gauges in President Trichet’s press statement. Most attention will be focused on any comments that Trichet makes regarding peripheral bond strains. In reality there is little that he can say that will alter market sentiment. Whilst an ongoing commitment to buy debt will help on the margin it will do little to stem the growing tide of negative sentiment towards eurozone assets.

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