Still waiting for Greece

The USD has taken a steady path of recent days, with little move in either direction, reflecting the general malaise in currency markets waiting for an outcome to the Greek debt talks. However, hopes that an agreement will be announced shortly saw the USD lurch lower overnight. The conflicting forces of firming US economic data on the one hand and uncertainties in Greece on the other have left market participants in a bind.

The USD has at least purchased some solace from reduced expectations of quantitative easing but as we noted earlier in the week the Fed may still carry out QE despite of better data. The USD could also suffer from the fact that US bond yields remain relatively low compared to some other major countries.

Indeed, the Fed’s commitment to maintain accommodative monetary policy until the end of 2014 suggests that the USD’s use as a funding currency could continue for a while longer. We look for the USD index to consolidate around the 78.50-79.00 level over the short term.

GBP’s recovery from its lows around 1.5233 on 13 January has been impressive. GBP’s gains are not as strong as that of commodity and Scandinavian currencies but it has outperformed the EUR. We expect this to continue.

Like other currencies GBP has benefited from a widening yield gap between the UK and the US. This has little to do with UK policy expectations given that the Bank of England is expected to initiate more quantitative easing this week. The move in relative US–UK yield differentials has more to do with the rally in US interest rate futures since the start of the year, supported by the recent dovish FOMC statement, which has put the USD under a degree of pressure.

GBP gains will be limited ahead of the BoE meeting tomorrow, with technical resistance seen around 1.5931 vs USD. Against the EUR much will depend on Greek debt talks but eventually we look for a retest of the EUR/GBP January lows around 0.82213.

Euro edging towards year highs, GBP lagging

Contrary to most expectations at the beginning of this week EUR has managed to claw back its losses and more, with the currency edging towards its year-to-date highs around 1.3069. The resilience of the currency to bad news in Europe has been impressive and its gains have reflected a speculative market that has been extremely short. The end of the week sees no key data of note so markets will have to contend with digesting the outcome of the relatively positive Spanish and French debt auctions while keeping one eye on Greek debt talks with private investors.

Unless there is yet another breakdown of talks in Greece the EUR will end the week on a positive note. I suspect it won’t last further out especially given the pitfalls ahead but at a time when investors have become increasingly bearish on the EUR it may just extend its bounce over the short term. One country to watch is Portugal whose bonds have underperformed recently as markets speculate that it could be the next contender for any debt writedown.

Retail sales data in the UK will capture local market attention today. Sales are set to have bounced back in December but the improvement is likely to be short-lived, suggesting any support to GBP will be fleeting. GBP has underperformed even against the firmer EUR recently but this is providing better levels for investors to take long positions versus EUR. In part this reflects the move in relative European/US interest rate differentials, which has been correlated with the move in EUR/GBP.

I expect GBP to outperform EUR over coming months to around 0.80, with the former continuing to benefit from the simple fact that it is not in the Eurozone and has therefore acquired a quasi safe haven status. Nonetheless, as reflected in the drop in Nationwide consumer confidence in December, this year will be particularly difficult for the UK economy. GBP will be restrained by the prospects of more quantitative easing by the Bank of England as inflation eases further

All Eyes On Europe

EUR looks range bound ahead of key events including the European Central Bank (ECB) meeting, European Union Summit and release of bank stress test results. A senior German official poured cold water over expectations of a concrete outcome from the EU Summit, dampening EUR sentiment as a result.

There will be plenty of attention on the ECB to determine whether they will give a little more ground and provide further assistance to the Eurozone periphery. While a refi policy rate cut is highly likely as well as additional liquidity measures I do not expect any move in the direction of more aggressive action to support peripheral bonds in terms of becoming “lender of the last resort’.

If however, the ECB hints at intensifying its securities market purchases of Eurozone bonds this will likely bode well for the EUR. Indeed, reports overnight suggest that the ECB will announce a set of measures to stimulate bank lending including easing collateral requirements for banks.

More weak UK data in the form a bigger than consensus drop in manufacturing and industrial production in October add to the soft BRC retail sales and house price data, in putting pressure on the Bank of England (BoE) to increase its quantitative easing at today’s policy meeting. While the BoE is set to keep policy unchanged it is only a matter of time before additional asset purchases are announced.

Despite the weaker IP data GBP has held up relatively well against the USD although downside risks appear to be intensifying. If I am correct in the view of no change by the BoE today we expect little change in GBP although there could be a risk of a push higher in EUR/GBP if the ECB delivers some positive news, with resistance seen around 0.8665.

The RBNZ unsurprisingly left policy rates unchanged at 2.5%, sounded less hawkish than the previous meeting and also lowered growth forecasts. The NZD was left unmoved by the rate decision and looks well supported at current levels perhaps due to relief that the statement was not more dovish. The kiwi has been an underperformer over the year but unlike the AUD it has not been particularly influenced by gyrations in risk aversion.

Interest rate futures differentials have seen a renewed widening versus the US over recent weeks. This is significant given that the NZ-US interest rate differentials have a very strong correlation with the performance of NZD/USD. If this widening is sustained it will point to upside potential for the Kiwi.

High Hopes for the EU Summit

Following the knock to the EUR from the S&P ratings news on Eurozone countries yesterday the currency has managed to regain a semblance of stability ahead of the European Union Summit beginning tomorrow. Expectations that the Franco-German deal announced late Monday (Fiscal compact etc) will be rubber stamped at the summit are high and the warning shot by S&P suggests that the stakes are even higher should there be no further progress this week.

Aside from putting the ratings of 15 Eurozone countries on negative watch S&P stated overnight that the EFSF bailout fund could be downgraded too. The EUR however, looks supported ahead of the summit and European Central Bank (ECB) meeting tomorrow, with news of discussions to beef up the bailout fund to two separate entities likely to further underpin the currency. EUR/USD short term support is seen around 1.3330.

The cut in the Reserve Bank Australia (RBA) cash rate piled on the pressure on the AUD, especially as a rate cut was not fully priced in although its weakness was limited by the relatively neutral RBA policy statement. The statement did not support expectations of more significant easing in the months ahead and data this morning in the form of a much stronger than expected Q3 GDP reading reinforced our view that markets are too dovish on Australian interest rate expectations.

Next it’s the turn of the Reserve Bank of New Zealand (RBNZ) but unlike the RBA we do not expect an interest rate cut. The room for policy easing in New Zealand is limited, especially given that inflation is above the Bank’s 1-3% target band. Both the AUD and NZD are highly correlated with interest rate differentials and therefore any shift in rate expectations will have an important bearing. AUD and NZD have benefitted from a widening in yield differentials with the US and are likely to find garner some resilience from this fact over coming sessions.

EUR/GBP has continued to grind lower over recent months while GBP/USD appears to have settled into a range. GBP sentiment has clearly worsened over recent weeks as reflected in the deterioration in speculative positioning in the currency, with the market becoming increasingly short. Data releases have not been particularly helpful, with data yesterday revealing that UK house prices fell in November and retail sales dropped more than expected.

There will be more disappointment, with October industrial production likely to drop today. Our forecast of a 0.8% monthly highlights the downside risks to consensus expectations and in turn to GBP today. The data releases will if anything add to pressure on the Bank of England to embark on more quantitative easing, which will be another factor that restrains GBP over coming weeks. We continue to look for more GBP strength versus EUR but weakness against the USD over the short term. A move to support around GBP/USD 1.5469 is on the cards over the near term.

Sell into Euro rallies

The USD will have found the news that Fitch Ratings lowered its outlook on the US AAA long term ratings to negative unwelcome. Nonetheless, USD sentiment has been recently as reflected in the jump in CFTC IMM USD positioning to multi week highs. The USD will however, face some headwinds from speculation that the Federal Reserve is about to embark on a fresh round of quantitative easing by purchasing mortgage backed securities.

The firm start to the week in terms of risk appetite helped the EUR to recover some ground but the currency remains vulnerable to event risk. High among the event risk is the Eurogroup and Ecofin meetings today, which will decide whether or not to approve Greece’s next loan tranche as well as EFSF leveraging options. Progress on the latter is likely to be limited leaving the EUR vulnerable to disappointment.

Attention will also focus on Italy’s sale of up to EUR 8 billion of BTPs and the likelihood that the country may have to face a yield above the critical 7% threshold. An increase in funding costs will not bode well for EUR sentiment especially following warnings by Moody’s about potential downgrades to sovereign ratings across the region.

EUR/USD failed to follow through on gains overnight but as reflected in the IMM speculative positioning there may be some scope for further short covering given that the net EUR short position reached its highest since June 2010 last week. Nonetheless, upside potential for EUR/USD is likely to be restricted to resistance around 1.3415.

Relatively dovish comments by Bank of England officials and weak data will keep GBP on the back foot over the short term. BoE governor King highlighted the risk of an inflation undershoot while Fisher noted that the BoE expanded QE by a minimum in October and can do more.

The Office for Budget Responsibility is set to cut UK growth forecasts significantly today. Against this background prospects for more BoE QE remain high. In the short term GBP will likely struggle against both the USD and EUR although we expect weakness versus EUR to be short lived, and would sell into any EUR/GBP rally to around 0.8665 support.

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