The loss of a great forecaster

October 27, 2010 — Mitul Kotecha

Forecasters around the world will mourn the loss of one of their finest following the death of Paul the Octopus at the age of 2 ½ (apparently an average age for Octopi). Although Paul had various threats to his life and insults to his mother’s honour he passed away from natural causes. Many forecasters envious of Paul’s record will look now a successor being groomed to take his place. Markets could do with Paul’s abilities in trying to ascertain the magnitude of Fed quantitative easing (QE) to be announced on 3 November. Conflicting comments from the Fed’s Hoenig (hawkish) and Dudley (dovish) yesterday will keep the market’s guessing.

Interestingly US bond yields are backing up and although yields elsewhere are also rising US yields are beginning to move relatively higher. The FX impact is evident in the growing resilience of the USD. Major Currencies with the highest correlations with bond yield differentials are EUR/USD, AUD/USD, EUR/CAD and USD/CHF although USD/JPY correlations have also been pushing higher. These currencies will ultimately suffer the most if US yields back up further.

Part of the reason for the shift higher in US bond yields is growing speculation that the Fed will take a more measured approach to asset purchases whilst recent data, particularly in the US housing market is showing some stabilisation as revealed in existing home sales data on Monday and a surprise gain in the August US FHFA home price index overnight. September new homes sales will be closely watched today to determine whether this stability is becoming broader based.

US consumer confidence continued this pattern, with the Conference Board index rising to 50.2 in October. Perhaps more interesting was the outcome of the US 5-year TIPS auction at a negative yield (-0.55%). The increased demand for inflation protection hints at QE2 working even before it has been carried out but there is a long way to go on this road and it would be premature to read too much into the auction outcome.

It’s worth noting that UK bond yields bucked the trend versus US bond yields following the release of stronger than expected UK GDP. The data alongside persistently above target inflation will likely dampen expectations that the Bank of England (BoE) will follow the path of the Fed into more QE. Consequently GBP has been a key outperformer. EUR/GBP in particular underwent a sharp reversal and technically the currency pair is showing a negative divergence from the 9-day RSI and the MACD is turning lower from overbought levels. The cross needs to drop below 0.8696 to confirm the technical signals.

Closer to home Australian CPI data this morning played into the hands of those looking for the Reserve Bank of Australia (RBA) to remain on hold next week. Although CPI was slightly softer than expected at 0.6% QoQ in Q3, the AUD took the news badly. The RBA has kept the cash rate on hold at 4.5% since May and at the last meeting there was little indication of an urgency to hike. Nonetheless, recent data plays towards a rate hike next week though the outcome is now a much closer call

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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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Week Ahead

August 23, 2010 — Mitul Kotecha

The market mood can be characterised as uncertain and somewhat downbeat, as reflected by the downdraft in US equity markets which posted their second weekly loss last week. Conversely, there has been a bullish run in government bonds, with the notable exception of peripheral debt. Over the last week markets had to contend with more data disappointment, in the wake of soft Japanese Q2 GDP, and a plunge in the August Philly Fed into negative territory, its first contraction since July 2009. Additionally a jump in jobless claims, which hit 500k highlighted the slow improvement in US job market conditions currently underway.

Despite all of this, the USD proved resilient and instead of the usual sell-off in the wake of soft data it benefited instead from increased risk aversion. The USD is set to retain some of this resilience though range-trading is likely to dominate over much of the weak. Reflecting the USD’s firmer stance, speculative positioning in the form of the CFTC IMM data revealed a reduction in aggregate USD short positioning in the latest week and although positioning is well below the three-month average, the improvement over the latest week and current magnitude of short positioning, highlights the potential and scope for further short-covering.

Negative data surprises have forced many to downgrade their forecasts for growth and policy implications, especially in the US. Markets will look for further clarity on the economic outlook this week but it is not clear that anything conclusive will be delivered. At the end of the week Q2 GDP will be revised sharply lower and whilst the data is backward looking it will reveal the weaker momentum of growth going into the second half of the year.

US Housing data will be mixed, with existing home sales set to drop in July as the impact of the expiration of home buyers tax credits continues to sink in whilst new home sales will likely increase but only marginally and will remain well below the April levels. Overall the picture of housing market activity remains bleak and this week’s data will do little to shake this off. On a more positive note July durable goods orders and August Michigan confidence will rise, the latter only marginally though. There will be plenty of attention on Fed Chairman Bernanke’s speech at the Jackson Hole Fed conference at the end of the week, especially given speculation of more quantitative easing in the pipeline.

The European data slate kicks off today with the release of manufacturing and service sector PMIs. Both are likely to register small declines, albeit from high levels. Nonetheless, taken together with a likely drop in the August German IFO survey on Wednesday and weaker June industrial orders tomorrow, the data will highlight that the momentum of growth in the region is coming off the boil, with the robust GDP outcome registered in Q2 2010 highly unlikely to be repeated. Against this background EUR/USD will find it difficult to make any headway. Technically further donwnside is likely over the short-term, with a test of 1.2605 support on the cards

Japan releases its slate of month end releases including jobs data, household spending and CPI. A slight improvement in job market conditions and increased spending will be insufficient to allay growth and deflation concerns, especially with CPI remaining firmly in negative territory. The onus will remain on the authorities to try to engineer a weaker JPY, which remains stubbornly around the 85.00 level versus USD. Talk of a BoJ / MoF meeting today has been dismissed, suggesting the prospect of imminent action is small. Meanwhile, speculative JPY positioning has dropped slightly in the last week but remain close to historical highs.

Aside from various data releases this week markets will digest the outcome of Australia’s federal elections. From the point of view of markets the outcome was the worst possible, with no clear winner as both the incumbent Prime Minister of the ruling Labour Party and opposition Liberal-National Party leader Tony Abbot failed to gain an outright majority. The outcome of a hung parliament will likely keep the AUD on the back foot, with trading in the currency likely be somewhat volatile until a clear outcome is established as both candidates try to garner the support of a handful of independents. However, it is notable that apart from an initial drop the AUD has managed to hold its ground. Nonetheless, the given the fluidity of the political situation there will be few investors wanted to take long positions at current levels around 0.8900 versus USD.

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EUR strength is overdone

July 19, 2010 — Mitul Kotecha

The latest in a long line of disappointing US data was released on Friday. University of Michigan consumer confidence sent an alarming signal about the propensity of the US consumer to contribute to economic recovery. Confidence dropped much more than expected, to its lowest level since August 2009, fuelling yet more angst about a double-dip in growth.

The Fed’s relatively dovish FOMC minutes last week contributed to the malaise and undermined the USD in the process as attention switched from the timing of exit strategies to whether the Fed will expand quantitative easing. Friday’s benign June CPI report left no doubt that the Fed has plenty of room on its hands, with core inflation remaining below 1% and likely to decelerate further over the coming months. Against this background Fed Chairman Bernanke’s semi-annual testimony to the US Congress (Wed/Thu) will be a particular focus, especially if he hints at potential for further QE, a possibility that appears remote, but could harm the USD.

Arguably the biggest event of the week is the European bank stress test results on Friday. Although several European governments have suggested that the banks in their countries will pass the tests there is still a considerable event risk surrounding the announcement. 91 banks are being tested and much will depend on how rigorous the tests are perceived to be. Should they be seen not to be sufficiently thorough, for instance in determining a realistic haircut on sovereign debt holdings, the potential for pressure on the EUR to increase once again will be high. Similarly debt auctions across Europe this week will also garner interest but similar success to last week’s Spanish auction cannot be guaranteed.

The big question in FX markets is whether the EUR can hold onto its recent gains and whether the USD will be punished further amidst growing double-dip worries. Interestingly the USD’s reaction on Friday to the soft consumer confidence data was not as negative as has been the case recently, with higher risk aversion once again outweighing negative cyclical influences. Various risk currencies actually came under pressure against the USD and this is likely to extend into this week. Despite a threat to the USD from any QE hints by Bernanke, speculative positioning has turned net short USD once again suggesting potential for less USD selling.

The bigger risk this week is to the EUR, which could face pressure on any disappointment from the bank stress test results. The EUR was strong against most major currencies last week, suggesting that the strengthening in EUR/USD is less to do with USD weakness, but more related to EUR strength. This strength in the EUR is hard to tally with the worsening economic outlook in the eurozone and the fact that a stronger EUR from an already overvalued level will crimp eurozone growth further. The latest CFTC IMM data has revealed a further covering of short positions, but this is likely to be close to running its course. Technically EUR/USD has broken above its ‘thick’ Ichimoku cloud, and the weekly MACD is turning above its signal line from oversold levels suggesting a period of further strength but its gains are set to be short-lived.

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Unloved US Dollar

July 16, 2010 — Mitul Kotecha

The USD index is now at its lowest level since May 3 and is showing little sign of turning around. The bulk of USD index weakness overnight came via the EUR and GBP, both of which rose sharply against the USD, with EUR/USD breaching its 90 day moving, hitting a high of 1.2955 and GBP/USD on its way to testing its 200 day moving average, reaching a high of 1.5472. Commodity currencies fared far less positively, perhaps feeling the after effects of the weaker Chinese data this week, with the NZD also dented by weaker than expected inflation data in Q2.

The USD was once again hit by US growth worries. To recap, the US data slate revealed a soft reading for PPI, whilst the July Empire manufacturing index dropped 14.5 points, a far bigger drop than forecast. The Philly Fed index also dropped further in July despite expectations of a small gain. In contrast, June industrial production edged higher, but manufacturing output actually fell. There was a bit of good news in the fact that weekly jobless claims fell more than forecast.

The releases extended the run of weak US data, keeping double-dip fears very much alive. The data have acted to validate the Fed’s cautious growth outlook expressed in the latest FOMC minutes but a double-dip is unlikely. Today’s releases include June CPI, May TIC securities flows, and July Michigan confidence. Another benign inflation report is expected. Consumer confidence is set to slip further against the background of soft data and volatility in equity markets whilst TICS data is forecast to reveal that long term securities flows declined in May compared to the $83 billion inflows registered in April.

The move in the EUR is a making a mockery out of forecasts including my own that had expected renewed downside. The relatively successful Spanish bond auction yesterday helped to ease eurozone sovereign debt concerns further, with a likely strong element of Asian participation. I have still not given up on my EUR negative view given the likelihood of a deteriorating economic outlook in the eurozone and outperfomance of the US economy, but over the short-term the EUR short squeeze may have further to go, with EUR/USD resistance seen at 1.3077.

Equity markets were saved from too much of a beating following the release of better than expected earnings from JP Morgan, a $550mn agreement between Goldman Sachs and the SEC to settle a regulatory case, and news from BP that it has temporarily stemmed the flow of oil from the leak from its Gulf well. Agreement on the US financial reform bill, passed by the Senate yesterday and likely to be signed into law by US President Obama next week, likely helped too.

The tone of the market is likely to be mixed today, with US growth concerns casting a shadow on risk trades. Earnings remain in focus and the big name releases today include BoA, GE and Citigroup but early direction could be negative following news after the US close that Google Inc. profits came in below analysts’ expectations. Data in the US today is unlikely to help sentiment given expectations of more weak outcomes, leaving the USD vulnerable to further selling pressure.

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