USD undermined by data, Gold under pressure

Risk measures remain generally well supported, with markets remaining fairly resilient to Eurozone concerns as the European Central Bank (ECB) OMT threat continues to do its work to deflate tail risks. Even the EUR continues to sit stubbornly around 1.31 versus USD while Eurozone peripheral bonds remain supported.

The Eurogroup and Ecofin announcement of an extension of Irish and Portuguese loans and the revelation that Cyprus will need even more funds than previous estimates (EUR 23 billion compared to EUR 17.5 billion previously) has been taken in its stride by markets. Eurozone inflation and the April German ZEW investor confidence survey will be the highlights of the calendar in the region this week although neither should dent the generally supportive tone.

Firm risk appetite is contributing to some of the pressure on commodity prices, with the CRB commodities index losing further ground as precious metals slide. Gold prices have now entered a bear market given the more than 20% fall since September 2011 as ETF and speculative investors continue to exit. There is little sign that investors are about to let up the selling pressure, with the trend continuing to be lower.

Data releases this week in the US will be of particular focus to determine whether the economy is entering into renewed downward lurch or is facing a mere blip along the way to recovery. Indeed, the recent run of softer data including weaker than expected March retail sales and April consumer confidence data released at the end of last week have reinforced growth concerns while supporting US Treasuries and undermining the USD.

The Fed’s Beige Book will help give some indication of how growth is faring across the US while industrial production and housing starts ought to show some gains. Q1 13 earnings reports will also be in focus. The weakness in US data over recent weeks is likely to be merely a blip on the path to recovery but nonetheless the impact of the Sequester may be accentuating the softening in the growth indicators.

Elsewhere Japanese FX policy will come under scrutiny at the G20 meeting this week, with officials likely to press Japan to refrain from competitive currency devaluation echoing the message from the US Treasury’s semi-annual currency report to Congress at the end of last week. USD/JPY has lost some upside momentum as a result and is set to slip further, with support seen around 96.71.

Edging Towards A Bailout

A confluence of factors have come together to sour market sentiment although there appeared to be some relief, with a soft US inflation reading (core CPI now at 0.6% YoY) and plunge in US October housing starts reinforcing the view that the Fed will remain committed to carry out its full QE2 program, if not more.

However any market relief looks tenuous. Commodity prices remain weak, with the CRB commodities index down 7.4% in just over a week whilst the Baltic Dry Index (a pretty good forward indicator of activity and sentiment) continues to drop, down around 21% since its recent high on 27 October. Moreover, oil prices are also sharply lower. Increasingly the drop in risk assets is taking on the form of a rout and many who were looking for the rally to be sustained into year end are getting their fingers burnt.

Worries about eurozone peripheral countries debt problems remains the main cause of market angst, with plenty of attention on whether Ireland accepts a bailout rumoured to be up EUR 100 billion. Unfortunately Ireland’s reluctance to accept assistance has turned into a wider problem across the eurozone with debt in Portugal, Greece and also Spain suffering. An Irish bailout increasingly has the sense of inevitability about it. When it happens it may offer some short term relief to eurozone markets but Ireland will hardly be inspired by the fact that Greece’s bailout has had little sustainable impact on its debt markets.

Ireland remains the primary focus with discussions being enlarged to include the IMF a well as ECB and EU. What appears to be becoming clearer is that any agreement is likely to involve some form of bank restructuring, with the IMF likely to go over bank’s books during its visit. Irish banks have increasingly relied on ECB funding and a bailout would help reduce this reliance. Notably the UK which didn’t contribute to Greece’s aid package has said that it will back support for Ireland, a likely reaction to potential spillover to UK banks should the Irish situation spiral out of control. Any bailout will likely arrive quite quickly once agreed.

Although accepting a bailout may give Ireland some breathing room its and other peripheral county problems will be far from over. Uncertainties about the cost of recapitalising Ireland’s bank will remain whilst there remains no guarantee that the country’s budget on December 7 (or earlier if speculation proves correct) will be passed. Should Ireland agree to a bailout if may provide the EUR will some temporary relief but FX markets are likely to battle between attention on Fed QE2 and renewed concerns about the eurozone periphery, suggesting some volatile price action in the days and weeks ahead.

Reports of food price controls of and other measures to limit hot money inflows into China as well as prospects for further Chinese monetary tightening, are attacking sentiment from another angle. China’s markets have been hit hard over against the background of such worries, with the Shanghai Composite down around 10% over the past week whilst the impact is also being felt in many China sensitive markets across Asia as well as Australia. For instance the Hang Seng index is down around 7% since its 8 November high.

Money Printing

It was a day of surprises on Tuesday as the Bank of Japan (BoJ) not only created a JPY 5 trillion fund to buy domestic assets including JGBs but also cut interest rates to zero. Expect more measures to come in the fight against a stronger JPY and deflation. The Reserve Bank of Australia (RBA) also surprised markets by leaving its policy rate unchanged at 4.5% delaying another rate hike yet again despite expectations by many including ourselves of a 25bps rate hike.

The easier policy stance from the BoJ and RBA taken together with firmer service sector purchasing managers indices – including the September US ISM non-manufacturing survey, which came in at 53.2 from 51.5 – gave risk appetite a solid lift. Even the AUD which dropped sharply following the RBA decision, managed to recoup all of its losses and more overnight.

Japan’s decision could have set the ball rolling for a fresh round of quantitative easing (QE) from central banks as they combat sluggish growth prospects ahead and ongoing deflation risks. The US Fed as has been much speculated on and the Bank of England (BoE) are likely candidates for more QE. Whilst the European Central Bank (ECB) is unlikely to adopt such measures there are reports that board members are split over the timing of exit policy. The BoE decision on Thursday may provoke more interest than usual against this background although the Bank is unlikely to act so quickly. The Fed on the other hand appears to be gearing up for a November move.

Growing prospects of fresh QE looks likely to provide further impetus for risk trades. Notably commodity prices jumped higher, with the CRB commodities index at its highest level since the beginning of the year. Although there is plenty of attention on the gold price which yet a fresh record high above $1340 per troy ounce as well as tin which also hit new highs, the real stars were soft commodities including the likes of sugar, coffee and orange juice up sharply.

The main loser once again is the US dollar and this beleaguered currency appears to be finding no solace, with any rally continuing to be sold into, a pattern that is set to continue. Although arguably a lot is in the price in terms of QE expectations, clearly the fact that the USD continues to drop (alongside US bond yields) highlights that a lot does not mean that all is in the price.

The USD is set to remain under pressure against most currencies ahead of anticipated Fed QE. The fact that the USD has already dropped sharply suggests a less pronounced negative USD reaction once the Fed starts buying assets but the currency is still set to retain a weaker trajectory once the Fed USD printing press kicks into life again as a simple case of growing global USD supply will push the currency weaker.

USD weakness will only spur many central banks including across Asia to intervene more aggressively to prevent their respective currencies from strengthening. A “currency war” looms, a fact that could provoke some strong comments at this weekend’s IMF and World Bank meetings. In the meantime intervention by central banks will imply more reserves recycling, something that will continue to benefit currencies such as EUR and AUD.

High yield / commodity currencies take the lead

Although equity markets continue to tread water the appetite for risk looks untarnished. So far into the new-year the winners are commodity / high yield plays as well as emerging market assets. The AUD, NOK, NZD and CAD have been the stars on the major currency front, with only GBP registering losses against the USD so far this year. The move in these currencies has been well supported by resurgent commodity prices; the CRB commodities index is up close to 10% since its low on 9 December.

There is little reason to go against this trend and the USD index is set to continue to lose ground as risk appetite improves further. I highlighted the upside potential in high yield / commodity currencies in a post titled “FX Prospects for 2010” and stick with the view that there is much further upside. I still prefer to play long positions in these currencies versus JPY which I believe will come under growing pressure as the year progresses.

Economic data has also been supportive, especially in Australia, supporting the AUD’s yield advantage. Although comments from the central bank towards the end of last year downplayed expectations of much further tightening, data releases support the case for another rate hike at the 2 February RBA meeting, with a fourth consecutive hike of 25bps to 4.00% likely at the meeting.

There will be some important clues from next week’s jobs data in Australia but judging by the solid gain in November retail sales, which rose 1.4% versus consensus expectations of 0.3%, and 5.9% jump in building approvals, the case for a rate hike has strengthened.  AUD/USD will now set its sights on technical resistance around 0.9326. 

AUD/USD has the highest sensitivity with relative interest rate differentials – correlation of 0.85 with Australia/US interest rate futures differentials over the past month – and so unsurprisingly the AUD rallied further as markets reacted to the strong retail sales data. I believe Australian interest rates will eventually get back up to 6% – pointing to more upside for AUD/USD as this is more than is priced in by the market.

It is fortunate for the USD that the correlation between the USD index and interest rate expectations remains low but nonetheless the December 15 FOMC minutes may have provided another excuse to sell the currency. The minutes were interpreted as slightly dovish by the market, with many latching on to the comments that some members of the FOMC debated the potential to expand the scale of asset purchases and continuing them beyond the first quarter.

All eyes on Chinese stocks

Equity markets extended their declines overnight as European and US stocks were smacked across the board.  One of the biggest pull backs has occurred in the Chinese stock market where stocks are down by around 17% since early (3rd) August although stocks are still up close to 73% on the year.  Some of this could be on fears of monetary tightening in China as well as missed profit estimates. 

Risk trades were sold and the dollar and yen strengthened whilst bond markets continued to rally.  News that contributed to the move could have included a sharp 35.7% YoY decline in FDI flows to China in July as well as a broad tightening of lending standards in Q2 according to the latest Senior Loan Officer survey by the Fed.  In contrast there was some positive news on the manufacturing front as the US Empire manufacturing survey jumped 13 points to its highest reading since November 2007. 

The Fed announced that the TALF with a capacity of as much as $1 trillion will expire on June 30 rather than December 31 but for other asset backed securities and CMBS sold before January the plan was extended by three months.   This extension failed to prevent a drop in financial shares overnight with the S&P financials index down 4.2%. 

Commodity prices also extended their drop, with the CRB index now down by around 5.6% since 5 August.   This will continue to play negatively for commodity currencies including the Australian, NZ and Canadian dollars, with the currencies looking vulnerable to more downside today.   Expectations of rising oil inventories and a firmer dollar tone are also playing negatively for commodities. 

Some relief may come today from firmer economic data expected in the US and Eurozone.   US housing starts and building permits are set to reveal further signs of stabilisation in the US housing market whilst the German ZEW survey will rise in August on the back of better economic data and past stronger equity market performance.  It is debatable how much economic data can help counter the worsening in equity sentiment but it may at least provide a semblance of relief.  

The dollar index is trading around the top of its recent range and sentiment for the currency has clearly become less negative as reflected in the latest CFTC Commitments of Traders Report which showed a sharp pull back in net aggregate dollar short positions in the latest week.  

Nonetheless, the dollar is likely to show little inclination to break out of its recent ranges against most currencies.  Overall FX market attention will focus on the Shanghai composite to lead the way in terms of risk appetite and overall direction. Thin holiday trading will leave the markets prone to exaggerated moves over the near term.

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