Interest rate and FX gyrations

January 27, 2011 — Mitul Kotecha

Following a brief rally at the start of the year the USD has found itself under growing pressure in the wake of widening interest rate differentials versus many other currencies. In particular, the contrasting stance between the hawkish rhetoric (bias for tighter monetary conditions) from European Central Bank (ECB) President Trichet and the relatively dovish US Federal Reserve stance as highlighted in the 26th January FOMC statement has provided more fuel to the widening in interest rate expectations between the US and eurozone. Since the end of last year interest rate differentials have widened by around 31 basis points in favour of the EUR (second general interest rate futures contract).

The Fed remains committed to carrying out its full $600 billion of asset purchases by end Q2 2011 whilst the ECB appears to be priming the market for a scaling back of its liquidity operations. Whilst there may be more juice in EUR over the short term based on the move in interest rate differentials as well as improved sentiment towards the eurozone periphery the upside potential for EUR/USD is looking increasingly limited. Even European officials are beginning to inject a dose of caution, with the ECB’s Nowotny stating that markets are too euphoric over a potential enlargement of the European Financial Stability Facility (EFSF) bailout fund. Indeed, it is highly likely that the euphoria fades quickly once it becomes apparent that enlarging the bailout fund is by no means a panacea to the region’s ailments.

GBP is another currency that has undergone sharp gyrations over recent days in the wake of a shift in interest rate expectations. A surprise 0.5% quarterly drop in UK Q4 GDP (which could not all be blamed on poor weather) set the cat amongst the pigeons and gave a GBP a thrashing but much of this was reversed following the release of Bank of England Monetary Policy Committee (MPC) minutes which revealed a hawkish shift within the MPC, with two dissenters voting for a rate hike and most members agreeing that the risks to inflation has probably shifted higher.

Does this imply an imminent rate hike? No, a policy rate hike closer to the end of the year appears more likely. BoE Governor King provided support to this view, in a speech that was interpreted as dovish, with the governor once again highlighting the temporary nature of the current rise in inflation pressure. Consequently UK interest rate expectations have shifted back and forth over recent days, but still remain wider relative to the US since the start of the year. GBP/USD has of course benefitted, but given worries about growth and the dovish message from King, it is unlikely that rate differentials will widen much further. Consequently GBP/USD is unlikely to make much if any headway above 1.6000.

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Euro Sentiment Jumps, USD Sentiment Dives

January 24, 2011 — Mitul Kotecha

The bounce in the EUR against a broad range of currencies as well as a shift in speculative positioning highlights a sharp improvement in eurozone sentiment. Indeed, the CFTC IMM data reveals that net speculative positioning has turned positive for the first time since mid-November. A rise in the German IFO business confidence survey last week, reasonable success in peripheral bond auctions (albeit at unsustainable yields), hawkish ECB comments and talk of more German support for eurozone peripheral countries, have helped.

A big driver for EUR at present appears to be interest rate differentials. In the wake of recent commentary from Eurozone Central Bank (ECB) President Trichet following the last ECB meeting there has been a sharp move in interest rate differentials between the US and eurozone. This week’s European data releases are unlikely to reverse this move, with firm readings from the flash eurozone country purchasing managers indices (PMI) today and January eurozone economic sentiment gauges expected.

Two big events will dictate US market activity alongside more Q4 earnings reports. President Obama’s State of The Union address is likely to pay particular attention on the US budget outlook. Although the recent fiscal agreement to extend the Bush era tax cuts is positive for the path of the economy this year the lack of a medium to long term solution to an expanding budget deficit could come back to haunt the USD and US bonds.

The Fed FOMC meeting on Wednesday will likely keep markets treading water over the early part of the week. The Fed will maintain its commitment to its $600 billion asset purchase program. Although there is plenty of debate about the effectiveness of QE2 the program is set to be fully implemented by the end of Q2 2011. The FOMC statement will likely note some improvement in the economy whilst retaining a cautious tone. Markets will also be able to gauge the effects of the rotation of FOMC members, with new member Plosser possibly another dissenter.

These events will likely overshadow US data releases including Q4 real GDP, Jan consumer confidence, new home sales, and durable goods orders. GDP is likely to have accelerated in Q4, confidence is set to have improved, but at a low level, housing market activity will remain burdened by high inventories and durable goods orders will be boosted by transport orders. Overall, the encouraging tone of US data will likely continue but markets will also keep one eye on earnings. Unfortunately for the USD, firm US data are being overshadowed by rising inflation concerns elsewhere.

Against the background of intensifying inflation tensions several rate decisions this week will be of interest including the RBNZ in New Zealand, Norges Bank in Norway and the Bank of Japan. All three are likely to keep policy rates on hold. There will also be plenty of attention on the Bank of England (BoE) MPC minutes to determine their reaction to rising inflation pressures, with a slightly more hawkish voting pattern likely as MPC member Posen could have dropped his call for more quantitative easing (QE). There will also be more clues to RBA policy, with the release of Q4 inflation data tomorrow.

Both the EUR and GBP have benefitted from a widening in interest rate futures differentials. In contrast USD sentiment has clearly deteriorated over recent weeks as highlighted in the shift in IMM positioning, with net short positions increasing sharply. It is difficult to see this trend reversing over the short-term, especially as the Fed will likely maintain its dovish stance at its FOMC meeting this week. This suggests that the USD will remain on the back foot.

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Data and earnings focus

January 17, 2011 — Mitul Kotecha

Friday’s round of US data were generally upbeat, highlighting that consumer spending is coming back to life. Inflation pressures however, remain benign at least on the core reading highlighting the Fed’s concern that inflation is running below the level consistent with its mandate. In other words it will be a long time, probably late into 2012 before policy rates increase.

While the Fed is no hurry to raise rates despite a few hawkish rumblings within the FOMC the European Central Bank (ECB) in contrast appears to have become more eager to pull the trigger for higher rates. ECB President Trichet’s hawkish press conference last week set the cat amongst the pigeons and marked a clear shift in ECB rhetoric towards a more hawkish stance.

A very big problem for the ECB is that the eurozone economy is not performing along the lines that its hawkish rhetoric would suggest, especially in the periphery. Growth momentum in the core in contrast, as likely reflected in the January ZEW investor confidence and IFO business confidence survey data this week in Germany, remains positive. Both surveys are likely to stabilize at healthy levels but how long can the likes of Germany drag along the eurozone periphery?

There will be relatively more attention on the meeting of Eurogroup/Ecofin officials, with focus on issues such as enlarging the size of the European Financial Stability Facility (EFSF) bailout fund and development of a “comprehensive plan” to contain the eurozone crisis. Don’t look for any conclusive agreements as this may have to wait until the European Union (EU) Council meeting on 4 February assuming (optimistically given ongoing German resistance) some agreement can even be reached.

Following the success (albeit at relatively high yields) of the eurozone debt auctions last week, sentiment for peripheral debt will face further tests this week in the form of debt sales in Spain, Belgium and Portugal.

The US Martin Luther King Jr. holiday will result in a quiet start to the week for markets but there will be plenty to chew on. This week’s key earnings reports include several banks scheduled to release Q4 earnings. Financials are a leading sector in the rally in equities at present and these earnings will be critical to determine whether the rally has legs.

The US data slate includes January manufacturing surveys in the form of the Empire and Philly Fed, both of which are likely to post healthy gains whilst existing home sales are also likely to rise. This will not change the generally weak picture of the US housing market, with high inventories and elevated foreclosures characterizing conditions. As if to prove this, housing starts are set to drop in December. On the rates front, the Bank of Canada is likely to keep its policy rates on hold this week.

After coming under pressure last week much for the USD will depend on the eurozone’s travails to determine further direction. Concrete evidence of progress at the Ecofin may bolster the EUR further, with resistance seen around 1.3500 but don’t bank on it. The ability of eurozone officials to let down often lofty expectations should not be ignored. In any case following sharp gains last week progress over coming days for the EUR will be harder to achieve.

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Positive Data Run Continues

January 5, 2011 — Mitul Kotecha

The batch of data releases in Tuesday’s trading session was generally positive. Leading the way was a stronger than expected increase in the UK manufacturing purchasing managers index (PMI) for December at 58.3 which coming in at a 16-year high. The data gave a boost to GBP though GBP/USD is unlikely to gain much of a foothold above 1.5600.

In the US, factory orders surprisingly jumped 0.7% in November and whilst the data is second tier it does maintain the run of generally upbeat US data. Meanwhile eurozone inflation came in higher than forecast at 2.2% YoY, above the European Central Bank (ECB) target level for the first time in two years. The outcome is unlikely to trigger a response from the ECB especially given that core inflation remains well behaved. After hitting a post CPI release high of 1.3433 EUR/USD is likely to drift lower in the short term.

Separately the Fed FOMC minutes of the December 14 meeting revealed little to surprise. Of note, FOMC members highlighted that the improvement in economic conditions was insufficient to warrant any change to the asset purchase program. The bottom line for the Fed is that the dual mandate of maximum employment and price stability is still not in reach and therefore they will keep the pedal to the floor in terms of policy stimulus. Although a further round of quantitative easing seems unlikely the Fed is likely to stick it out in terms of the $600 billion in planned asset purchases whilst an actual rate hike is unlikely until well into 2012.

Commodity prices dropped sharply overnight with soft commodities and energy prices in particular leading the declines. Commodity currencies fell as a result, with the AUD also impacted by growing worries about the impact of the Queensland floods. Initial estimates suggest that total damage from the flooding could reach AUD 6 billion and as Queensland represents around 19% of Australian GDP, the impact on growth could be significant. Growth could drop by a sharp -0.8% YoY in Q1 GDP. This is based on the assumptions that 40% of all exports will experience a 30% reduction

Today’s data slate in the US will be crucial to provide the final clues to Friday’s December payrolls report. The ADP jobs report, ISM non-manufacturing survey and Challenger job cuts data are all scheduled for release. The run of positive US data will help the USD to trade on a firm footing over the short term but clearer direction will await the outcome of the December jobs report whilst the beginning of the Q4 earnings season next week will also be influential. The exception to USD strength will continue to be Asian currencies where more upside is likely, but I prefer to play this via short EUR/Asian FX than the USD.

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All Eyes On US Jobs Data

January 3, 2011 — Mitul Kotecha

Happy New Year!

2010 ended on a sour note especially for eurozone equity markets (and the Australian cricket team) where there has yet to be a resolution to ongoing growth/fiscal/debt tensions.  The EUR strengthened into year end but this looked more like position adjustment than a shift in sentiment and EUR/USD is likely to face stiff resistance around the 1.3500 level this week, with a drop back towards 1.3000 more likely.  In the US there was some disappointment in the form of a surprise drop in December consumer confidence data but pending home sales and the Chicago PMI beat expectations, with the overall tone of US data remaining positive.

There will be plenty to chew on this week in terms of data and events which will provide some much needed direction at the beginning of the year.  The main event is the December US jobs report at the end of the week.   Ahead of this there will be clues from various other job market indicators including the Challenger jobs survey, ADP employment report, and the ISM manufacturing and non-manufacturing surveys.  The data will reflect a modest improvement in job market conditions and the preliminary forecast for December payrolls is for a 135k increase, with private payrolls set to rise by 145k and the unemployment rate likely to fall slightly to 9.7%.

The minutes of the 14 December Fed FOMC meeting (Tue) will also come under scrutiny against the background of rising US bond yields.  In addition, Fed Chairman Bernanke will speak on the monetary and fiscal outlook as well as the US economy to the Senate Budget Panel.   Bernanke will once again defend the use of quantitative easing whilst keeping his options open to extend it if needed.  However, the changing composition of the FOMC with four new members added in 2011 suggests a more hawkish tinge, which will likely make it more difficult to agree on further QE.   In any case, the tax/payroll holiday package agreed by the US administration means that more QE will not be necessary. 

It’s probably not the most auspicious time for new member Estonia to be joining the eurozone especially as much of the speculation last year focussed on a potential break up.  The beginning of the year will likely see ongoing attention on the tribulations of Ireland after its bailout, with looming elections in the country.  Portugal and Spain will also remain in focus as the “two-speed” recovery in 2011 takes shape.  Data releases this week include monetary data in the form of the eurozone December CPI estimate and M3 money supply.  Inflation will tick up to 2% but this ought to be of little concern for the ECB.  Final PMI data and confidence indices will likely paint a picture of slight moderation.   

The USD ended the year on a soft note, with year lows against the CHF and multi year lows vs. AUD registered, but its weakness is unlikely to extend much further.  The key driver will remain relative bond yields and on this front given the prospects for relative US yields to move higher, the USD will likely gain support.  There maybe a soft spot for the USD in Q1 2011 but for most of the rest of the year the USD is set to strengthen especially against the EUR which will increasingly comer under pressure as peripheral tensions and growth divergence weigh on the currency.

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