USD boosted by bond yields, AUD vulnerable

The USD rallied further overnight helped by a Fed FOMC statement that was less downbeat than in January, with no hint of any further quantitative easing. In combination with a solid February retail sales report and upward revisions to December and January, US bond yields pushed higher. US 2-year Treasury yields hit their highest since the beginning of August 2011, which given the strong correlation with the USD, provided further support to the currency.

The highest FX sensitivity to yield differentials is found in JPY, AUD, SEK, and CAD over the past 3-months. However, among these US yields have only widened against Japan over recent days meaning this currency is the most vulnerable. For the other currencies their yields have actually been widening against the USD. Over the near term, the USD is set to remain well supported, especially as data releases over the rest of the week will maintain the tone of strengthening economic activity.

AUD looks increasingly vulnerable to further short term slippage. At least partly explaining the recent drop in AUD/USD is a narrowing in Australia’s yield advantage over the US. A spate of weaker data over recent weeks has helped to undermine the currency including Q4 GDP data which revealed a far slower pace of growth than had been expected. Weak jobs data reinforced the view that the economy is spluttering.

The net result is that Australian interest rate futures have rallied and implied yields have dropped in contrast to the US where futures have sold off in the wake of strengthening economic data. The casualty of all of this is the AUD and it appears that further downside risks are in store for the currency. Indeed my quantitative models show that the AUD continues to trade well above its short term ‘fair value’. For those wanting to take medium term long positions in the AUD I would suggest rebuilding longs around 1.03-1.04 versus USD.

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All Eyes on Greece

The USD is in a lose-lose situation courtesy of the Federal Reserve’s ultra easy stance. Positive economic data releases have been met with USD selling pressure as the data helps to fuel a rally in risk appetite. Although the USD benefited from the better than expected US January jobs report gains will prove fleeting as it is does not change expectations of more Fed quantitative easing (note the drop in the participation rate).

Following the jobs report, there is little on the data front over coming days (only December trade data for which a widening is likely and February Michigan confidence where a gain is expected) to shift USD direction. At best the USD will consolidate giving USD bulls some time to nurse their bruises.

A disaster in the Eurozone (e.g. Greek disorderly debt default) could help the USD but it appears that markets have become resilient to bad news giving officials in the region the benefit of the doubt. In particular, the ECB’s 3-year LTRO has calmed nerves somewhat.

The lack of a final deal on Greek debt restructuring has failed to dent the EUR although notably EUR/USD failed to extend gains above 1.32 and has drifted lower. EUR/USD will remain on tenterhooks ahead of a midday deadline today set by Greek PM Papademos for party leaders to accept strong terms to qualify for a second bail out.

In the absence of agreement prospects of a disorderly debt default will loom large especially given that there is a EUR 14.5 billion bond repayment on March 20. Such an outcome will undoubtedly derail the EUR. Moreover, a meeting of Eurozone Finance ministers this week will give some direction to the EUR while the ECB’s likely status quo on Thursday suggests that there will limited EUR reaction following the meeting.

The risk of JPY intervention has increased significantly as USD/JPY brushes the psychologically important 76.0 level. However, the feeling on the ground is that USD/JPY will need to broach 75.0 before intervention is actually seen. Jawboning by Japanese officials has intensified suggesting increased official concern.

However, in the short term the ability of the authorities to engineer a sustained drop in the JPY is limited given the compression in US – Japan bond yields. This appears to be outweighing even the drop in risk aversion, which in theory should be playing for a weaker JPY. USD/JPY will struggle to make any headway, with strong multi day resistance seen around 77.49.

Ratings agencies spoil the party

Just as I thought that attention may finally switch to the US along comes the ratings agencies to spoil the party once again. Moody’s and Fitch Ratings criticised last week’s European Union Summit outcome for falling short of a comprehensive solution to Eurozone ills. Consequently the risk of further sovereign credit downgrades across Europe remains high over coming weeks especially as economic growth weakens. Moody’s also put 8 Spanish banks and two bank holding companies on review for a possible downgrade.

The EUR and Eurozone bonds came under pressure as a result, with EUR/USD verging on its strong support level around 1.3146. Further pressure is likely into year end although the fact that the speculative market is still very short EUR may limit its downside potential in the short term. Disappointment that the ECB has not stepped up to the plate to support the Eurozone bond market more aggressively is also having a damaging effect on confidence. A test of sentiment will come from today’s EFSF and Spanish bill auctions while on the data front we look for a below consensus outcome for the German December ZEW survey, which will deteriorate further.

The comments from the ratings agencies resulted in risk assets coming under pressure once again, leaving the market open to further selling today given the lack of positives. US data and events will at least garner some attention, with the Federal Reserve FOMC meeting and November retail sales on tap. We do not look for any big surprise from either of these, but at least the Fed may sound a little more positive in light of firmer data over recent weeks. Even so, speculation of more Fed QE early next year will remain in place. In the current environment demand for US Treasuries remains strong with a Treasury auction yesterday receiving the highest bid/cover ratio since 1993.

Risk Appetite Buoyed by Central Banks

Co-ordinated central bank action led by the Federal Reserve to lower the rate on USD liquidity by 50bps was accompanied by a cut in China’s reserve requirements and an easing by Brazil of its benchmark Selic rate. Unsurprisingly risk assets have rallied strongly overnight but once the announcement effect wares off the reality that the underlying tensions in the Eurozone remain in place will see any boost to sentiment wane. The move by the Fed will be a boon to the banking sector but should actually not have been too surprising as this tool was an easy one to use and one that should have been expected given the ample room to cut pricing on USD liquidity swap arrangements.

The other boost to markets overnight was the strong November ADP jobs report, which came in at 206k in November, and will lead to upward revisions to Friday’s payrolls data. Indeed, we now look for a 175k increase in non-farm payrolls from 120k previously. The trend of better than expected US data continued with a stronger than forecast reading for November Chicago PMI at 62.6. We expect this to be echoed by an increase in the ISM manufacturing survey today and the Fed’s Beige Book, all of which will at least allay concerns of a renewed US recession.

What will be important is whether the Fed move will be followed up by other measures from governments and central banks over coming days. Although European Union (EU) leaders have agreed to enhance their bailout fund attention is centred on French and German leaders, with hints that there could be a strong announcement over coming days. At the least, the upcoming EU Summit on 8/9 December will be expected to deliver concrete results otherwise the market rout will continue.

The USD will remain under pressure following the moves by central banks in line with the improvement in risk appetite. High beta risk currencies ie those with the highest correlation to risk over the past 3-months will benefit the most. These include RUB, AUD, TRY, CNH, KRW, GBP and CAD in respective order of correlation. All of these currencies are likely to register gains over the short term, especially given anticipation of further announcements from European officials and a reasonable US jobs report tomorrow.

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.

Contrasting US and European data

While the week is likely to commence in a positive mood as political uncertainties in Greece and Italy ease somewhat, there are still plenty of uncertainties that could derail risk appetite. In particular, there has been little progress on agreeing on further details on leveraging the EFSF bailout fund. Moreover, many are looking to the European Central Bank (ECB) to take up the role as lender of the last resort. Indeed, the difficulty of the EFSF debt issue last week to garner demand puts the onus firmly on the ECB.

While it is likely that the ECB will have to step up its bond purchases especially given the heavy bond supply this week from Italy, France and Spain, the ECB is very reluctant to take up this mantle. As a result, peripheral and increasingly core bond market sentiment will remain fragile while the EUR will be vulnerable to a drop lower, especially given how rich it looks around current levels close to 1.38 versus USD. The week will likely be one of selling risk on rallies.

Data releases this week will show some contrasts between the US and Europe. US data will further dampen expectations of more Fed quantitative easing, with October retail sales and industrial production set to register gains and November manufacturing surveys likely to bounce. Several Federal Reserve speeches this week will shed more light on the FOMC’s stance and likely some support for purchases of mortgage backed securities will be reiterated.

In contrast eurozone data will show further deceleration. Industrial production in September is likely to have dropped sharply while the German ZEW investor confidence survey is set to have dropped further in November. Even an expected bounce in eurozone Q3 GDP will do little to stave off recession concerns given that growth in the final quarter of the year will have been much weaker. Banking sector develeraging will only add to growth concerns as credit expansion in curtailed.

In FX markets, the risk currencies will be vulnerable to selling pressure. EUR/USD has rebounded having tested highs around 1.3815 this morning but its gains look increasingly fragile. USD/JPY continues to grind lower, with no sign of further intervention from the Japanese authorities. Elevated risk aversion and the narrow US yield advantage continues to support the JPY making the job of weakening the currency harder. GBP has done well although it has lagged the EUR against the USD over recent days. A likely dovish stance in the Bank of England (BoE) quarterly inflation report will see GBP struggle to extend gains above 1.60 against the USD.

Dollar firmer, Euro vulnerable, Yen wary

multitude of market moving events last week led to severe gyrations in risk appetite but with no clear direction for currencies. Indeed, currency markets were whipsawed as the news flow shifted back and forth. Major events such as the European Central Bank (ECB) and US Federal Reserve meetings, and US jobs data provided plenty of volatility points for markets. This week’s US data slate is less littered with first tier data, with trade data and Michigan confidence, the highlights of the week. Against this background the USD will take direction from events in the eurozone and in our view will likely trade with a firmer bias given that eurozone tensions will not ease quickly.

The EUR was relatively resilient despite a referendum (later cancelled) that could have spelled the beginning of the end of Greece’s membership in the eurozone. Nonetheless, the currency still dropped over the week. This week will be no different as markets sift through various pieces of news regarding Greece and the EU rescue plan. Although the Greek Prime Minister survived a confidence vote the EUR will remain vulnerable to a lack of detail about the EU rescue plan including but not limited to how the mechanism for leveraging the EFSF bailout fund. The longer the delay in providing such details the bigger the risk to the EUR. Data releases will be unhelpful for the EUR, with hard data such as German industrial production confirming a slowdown in activity.

Japan’s FX intervention at the beginning of last week has all but been forgotten among the plethora of other market moving news. Expectations that it would be followed up by more intervention proved incorrect as the Japanese authorities refrained from more action. Perhaps the onset of the G20 meeting stayed their hand but markets will be wary of more intervention this week. However, as the strengthening current account data in Japan will likely reveal this week, Japan’s strong external position continues to feed the underlying upward pressure on the JPY for the time being.

Interestingly FX markets appear to be reacting to growth orientated central bank policy rather than yield as reflected in the fact that EUR and GBP both strengthened despite additional quantitative easing from Bank of England at its last meeting and a rate cut from the ECB last week. This week however, inaction from the BoE will provide little direction to GBP while a likely drop in industrial production will raise fears that the economy continues to be in need of more remedial action from the central bank. GBP continues to be favoured but after having made up a lot of ground versus EUR it could lose some steam this week.

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