Consolidation

The overall tone to markets remains a positive one. Core bonds (Treasuries, bunds) have taken on a bearish tone in the wake of strengthening economic data and have established the usual bullish equities / bearish bonds relationship. Meanwhile volatility measures both in equity and currency markets have dropped to historically low levels.

The USD has been propelled by higher US bond yields but looks vulnerable as US Treasuries consolidate in the short term. Data this week is fairly light, suggesting that direction will be limited as only housing data in the US and purchasing managers’ indices in Europe will be of interest. Overall, the start to the week will see markets in consolidation mood.

The USD index had made up plenty of ground since hitting its lows around 78.095 at the end of February. Higher US bond yields in the wake of strengthening economic data and receding expectations of more Fed money printing have boosted the USD. Nonetheless, US Treasuries appear to be consolidating their losses (ie yields have failed to push higher recently), limiting the ability of the USD to strengthen further.

Data releases in the US this week will be mainly centred on the housing market and are unlikely to be strong enough to warrant a further strengthening in the currency. Much will also depend on gyrations in risk. My Risk Barometer has moved into ‘risk loving’ territory, which plays negatively for the USD versus many high beta currencies. The USD will struggle to make further gains in the short term.

The agreement to furnish Greece with a second bailout gave the EUR no help whatsoever. Instead, higher US Treasury yields relative to bunds dealt the EUR a strong blow and the currency came dangerously close to dropping below the 1.3000 psychologically important level versus USD. Even a narrowing in peripheral bond spreads against the core has failed to give the EUR a lift. Further EUR losses will be limited over coming days but only because US yields have not pushed higher.

Nonetheless, the technical picture has turned bearish and any relief could prove temporary. A mixed batch of data releases including ‘flash’ purchasing managers’ indices which overall will reveal the composite PMI below the 50 boom/bust level for a second month in a row, will not be particularly helpful for the EUR. EUR/USD is likely to be stuck in a 1.2974 – 1.3291 range over coming sessions.

Euro and Swiss franc under pressure

Positive momentum in risk assets slowed, with higher core bond yields in the US and Europe weighing on sentiment. The USD in particular has been buoyed by higher US bond yields, with the move in line with my long held medium term view of a firmer yield led gain in the USD. Commodity prices in contrast have come under growing pressure, with gold and copper prices sliding in particular. Risk measures continue to improve including my risk barometer, suggesting that the overall tone to risk assets will remain positive.

The main focus today will be on a plethora of US data releases including industrial production, Philly Fed and Empire manufacturing confidence while in Europe attention will be on Spanish and French bond auctions. US data will likely remain upbeat, while the auctions should be well received.

EUR has pulled back sharply over recent not just against the USD but also on the crosses, with EUR/GBP finally playing some catch up yesterday. It’s interesting that the drop in the EUR has occurred despite generally improving conditions for peripheral Eurozone as reflected in narrowing yield spreads between peripheral countries and Germany.

The bottom line is that the EUR is suffering from a widening in the US / Europe (Germany) bond yield differential as it is becoming increasingly clear that the US economy will strongly outperform the Eurozone economy this year. As noted at the beginning of the week EUR/USD was set to drop to below support around 1.3055. Having hit this level, strong support around the 1.2974 level moves into sight.

Ahead of today’s quarterly Swiss National Bank meeting at which no change in policy is widely expected, EUR/CHF has taken a sharp lurch higher, finally moving away from around the 1.2050 level it has been trading at over recent weeks. While I am bearish on the CHF over the medium term further upside in EUR/CHF will be limited over the short term given that the move in the currency is at odds with interest rate differentials which have actually narrowed between the Eurozone and Switzerland. Technical resistance around 1.2298 will cap gains over coming sessions.

As for USD/CHF the picture remains a bullish one, with general USD strength driven by higher yields, pushing the currency pair higher. I look for a test of resistance around 0.9393 over coming sessions.

FX outlook this week

Direction in FX markets will largely hinge on developments at the beginning of the week in Europe but a US holiday (Presidents’ Day) will mean a subdued start. US data has continued to beat expectations as revealed by the recent gains in core retail sales, manufacturing surveys, jobless claims and industrial production. US recovery is taking shape and the USD is finally showing some signs of perking up on the news.

Rising US bond yields have provided the USD with some support although the impact has been muted by higher bond yields elsewhere. Nonetheless, despite ongoing speculation of more Fed quantitative easing the USD looks set to be on a slightly firmer footing over coming days. In a relatively light week of data releases housing data will be the major focus of attention.

Assuming approval for a second Greek bailout goes ahead (after much procrastination) the week will at least begin on a positive note for the EUR. Whether the EUR will extend gains will partly be determined by the release of flash February purchasing managers’ indices (PMI) and the German IFO business confidence survey. Our forecasts of weak service sector readings but firm manufacturing indices will be a mixed blessing for the EUR but overall data will remain consistent with mild recession.

Failure of EUR/USD to sustain a move below the psychologically important 1.30 level suggests a bit more resilience over coming days. Nonetheless, speculation of a Greek euro exit will not fade quickly and markets will likely gyrate between ‘risk on’ and ‘risk off’ depending on the latest comments from Greek or European officials. All in all, the EUR will continue to struggle to move higher.

For a change one of the bigger movers in currency markets over recent days has been the JPY. Its decline following more aggressive monetary policy action by the Bank of Japan has extended further. The move by the BoJ helped to suppress Japanese government bond yields (JGBs) allowing USD/JPY to move higher in line with relatively higher US yields. This week’s release of January trade data will support the case for more JPY weakness given the deteriorating trend.

The data will also strengthen the resolve of the Japanese authorities to intervene in FX markets should the JPY strengthen anew. Immediate focus will be whether USD/JPY can break through the psychologically important 80 level where JPY weakness will be met by plenty of exporters offloading USDs. I suspect the upside momentum in USD/JPY will fade over coming days unless US bond yields continue their ascent.

USD in a lose-lose situation, AUD caution

News that Moody’s Investor service cut the debt ratings on six European countries while revising its outlook on the UK’s and France’s AAA rating to “negative” dampened sentiment for the EUR. Markets will likely trade cautiously ahead of tomorrow’s meeting of European Union Finance Ministers especially as it appears that at least Germany and Netherlands remain sceptical of Greece’s austerity plans, which could frustrate the approval of a second EUR 130 billion bailout package.

The USD is firmer overnight but still struggling to make headway in an environment of improving risk appetite. The fact that USD speculative positioning has dropped sharply to its lowest level since September last year highlights a major shift in USD sentiment. The USD is currently in a lose-lose situation helped neither by economic data or risk appetite. For example a healthy gain in January retail sales expected today, will help to boost risk appetite which in turn will help maintain pressure on the USD.

Encouragingly for the USD, 2 year bond yields have been rising since the start of February in line with firmer economic data. However, rather than giving the USD a boost (except vs. JPY) it has been outweighed by the fact that bond yields elsewhere have risen even more aggressively. The net result is that the prospects for the USD to strengthen further look somewhat restrained over the short term.

AUD has benefited from a firmer tone to risk appetite at the start of the week but for a currency in which speculative positioning is fast approaching all time highs I would be cautious of adding to long positions at current levels. Remaining one of the most sensitive currencies to gyrations in risk appetite the AUD will continue to be mainly driven by global events especially the Greek saga.

Nonetheless, there a few data releases at home that will capture market attention, in particular the January jobs report on Thursday. After a surprisingly large 29.3k fall in December a bounce is expected in January, with around a 15k increase likely. The report will provide clues to just how long the RBA will pause in its rate cutting cycle. I suspect that even a positive outcome will have a briefly positive impact on AUD, with the currency set to struggle to break above resistance around its 2012 high at 1.0845 versus USD.

US Dollar Under Broad Based Pressure

ThE USD has registered broad based losses over recent days and the longer the stalemate with regard to extending the US debt ceiling the bigger the problem for the currency. Indeed, it appears that the USD is taking the brunt of the pressure compared to other assets. For example, although US treasury yields have edged higher there is still no sense of panic in US bond markets.

Failure to raise the debt ceiling does not automatically imply a debt default but it will raise the prospect should an agreement not be reached in the weeks after. However, the impact on US bonds maybe countered by the increased potential for QE3 or safe haven flows in the event that no agreement is reached.

The worst case scenario for the USD remains no agreement on the debt ceiling ahead of the August 2 deadline but a short term solution that appears to be favored by some in the US Congress may not be that much better as it would effectively be seen as ‘kicking the can down the road’.

The better than hoped for agreement to help resolve Greece’s debt problems at the end of last week came as a blow to the USD given the almost perfect negative correlation between the USD and EUR over recent months. Moreover, the debt ceiling stalemeate is pouring salt into the wound. However, the situation is highly fluid and should officials pull a rabbit out of the hat and find agreement the USD could rally sharply.

All is not rosy for the EUR either and its gains have largely come by courtesy of a weaker USD rather than positive EUR sentiment. Economic news hardly bodes well for the EUR, with data in the eurozone looking somewhat downbeat. For instance, the Belgian July business confidence indicator dropped to a 9-month low in line with the weaker than expected outcome of the July German IFO survey last week.

Moreover, there are still several questions about last week’s second Greek bailout agreement and contagion containment measures including parliamentary approvals and lack of enlargement of the EFSF which could keep markets nervous until there are clear signs that implementation is taking place successfully.

A clear sign that the EU agreement has failed to inspire as much confidence as officials had hoped for is the lack of traction in terms of narrowing peripheral bond spreads, with the exception of Greece. This partly reflects a renewed ‘risk off’ tone to markets but this is not the sole reason.

EUR/USD has extended gains benefiting from USD weakness rather than any positive sentiment towards EUR, breaking above 1.4446, the strong multi-month corrective channel resistance, signalling a bullish move. The next level of technical resistance is around 1.4568 but direction will continue to come from the debt ceiling talks.

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