Risk currencies rally

Following the disappointment from the lack of US Federal Reserve and European Central Bank (ECB) action last week, the US July jobs report provided a fillip for markets. The stronger than expected jump in payrolls (163k) dampened worries about the pace of jobs recovery while the increase in the unemployment rate (to 8.3%) kept alive hopes of more Fed quantitative easing.

Indeed, even the ECB’s decision and statement last week have been interpreted as merely delaying the inevitable, with stronger action expected from the central bank over coming weeks. Against this backdrop, markets will begin the week in positive tone and risk assets are likely to extend gains early in the week.

The highlights on the data calendar this week include two central bank meetings, Bank of Japan (BoJ) and Reserve Bank of Australia (RBA), and the Bannk of England (BoE) Quarterly Inflation Report (QIR). Major policy changes from the former two central banks are unlikely although the BoJ may decide to abolish the 0.1% minimum bidding rate on JGB operations.

As for the BoE QIR a dovish reading is likely which will help to support expectations of further policy action in the UK, which in turn will mean that GBP will underperform. Data releases are fairly thin on the ground, with US trade data, Q2 non farm productivity, German factory orders and industrial production releases across Europe. Overall, we see little to detract from the positive tone to asset markets.

Risk currencies begin the week on the front foot. The EUR/USD reaction to the US jobs data was particularly interesting, hitting a high of 1.2444 as stop losses were triggered on the upside. Further EUR gains will be difficult to achieve, however. Speculative market positioning reveals that EUR short positions have dropped to their lowest level in several weeks, suggesting less scope for further short covering.

The lack of major data releases over coming days within the Eurozone mean that direction will come from Spain and whether the country formally asks for financial support from the EFSF. In the meantime, EUR/USD is likely to edge back to around technical support around 1.2218.

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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.

Australian dollar hit by weak jobs data

The USD’s bounce since the beginning of the month appears to be gaining more traction, with the USD index up over 3% from its recent lows. I’m still cautious about whether this move can extend much further in the absence of a back up in US bond yields especially given ongoing asset purchases / global USD liquidity injections by the US Federal Reserve at least until the end of June.

Nonetheless, given the magnitude of USD short positioning, which had moved ever close to revisiting record levels, the potential for short-covering was significant. US data today could provide some influence, with attention on April retail sales data, PPI inflation and jobless claims. A relatively positive outcome for retail sales could give the USD further support.

The day has started badly for the AUD, with the currency hit by an awful jobs report, with employment dropping by 22.1k in April compared to consensus expectations of +17k. The details were even more negative than the headline reading, with full time employment dropping by 49.1k and only partially mitigated by a 26.9k rise in part time employment.

The Reserve Bank of Australia will likely pay close attention to the data and it will likely result in any residual expectation of a rate hike by the RBA next month being taken off the table. Already today there has been a sharp rally in bank bill futures as markets pare back interest rate expectations and markets are not even pricing in a further full 25bps rate hike by year end.

The data weighed heavily on the AUD, with AUD/USD hitting a low below 1.06. AUD is likely to trade with a heavy tone over coming sessions, with the currency already under pressure from a generally firmer USD. Moreover, the rally in Australian bank bill futures will add further pressure to the currency as Australia’s favourable rate differential narrows further with the US.

Taken together with the fact that AUD positioning is close to its all time highs and that even compared to interest rate differentials its gains look overdone, it suggests more downside risks over the short-term, with AUD/USD 1.0537 seen as a near term technical support level.

In contrast GBP benefitted from a back up in UK bond yields in reaction to the Bank of England’s Quarterly Inflation Report. Inflation forecasts were revised higher but growth forecasts were revised lower as expected. The In truth, the reaction looked overdone but GBP has gained some momentum versus EUR and looks set to extend its gains, with focus on the 200 day moving average level of 0.8558.

Position Unwinding Boosts USD

The USD’s multi-month fall has come to an abrupt halt, with the currency registering gains in reaction to what appears to be a major position unwinding across asset markets, led by a drop in commodity prices.

Will it continue? Whilst I am amongst the more bullish forecasters on the USD over the medium term, the current rally could prove to be short-lived in the absence of a shift in Federal Reserve rhetoric or end to quantitative easing (QE2). Nonetheless, the market had got itself very short USDs (as reflected in the CFTC IMM data as of early last week which showed an increase in net short positions) and the rally in the USD last week was likely spurred by major short-covering which could extend further into this week.

The move in the USD gained momentum as European Central Bank (ECB) President Trichet proved to be less hawkish than many expected in the press conference following last Thursday’s ECB meeting. Moreover, renewed worries about Greece at the end of last week, with a report in the German Der Spiegel, later denied by Greek officials, that the country was planning to leave the Eurozone dented the EUR,

Taken together with the improving trend in US April non-farm payrolls (April registered +244k increase, with private payrolls 268k), these factors colluded to provide further positive stimulus to the USD and negative fallout on the EUR. The room for EUR downside is evident in the net long EUR speculative position, which rose to its highest since December 2007 as of 3rd May.

This week’s batch of US releases including March trade data, April retail sales and CPI, are unlikely to result in a reversal in last week’s trend though a trend like reading for core CPI, with the annual rate below the Fed’s comfort zone will reinforce expectations of dovish Fed policy being maintained, which could inject a dose of caution into the USD’s rally.

Against the background of a likely widening in the US trade deficit in March there will plenty of attention on the annual strategic and economic dialogue beginning today, with markets interested in discussions on Chinese worries about the gaping US fiscal deficit and US concerns about China’s exchange rate policy.

Greece’s denial of plans to leave the eurozone and discussions over a further adjustment to Greece’s bail out package, may help limit any drop in the EUR this week though it will by no means mark the end of such speculation about the periphery especially with this weeks’ Q1 GDP data releases across the eurozone likely to further highlight the divergence between the core and the periphery even if the headline eurozone reading rebounds strongly as we expect.

In the UK the Bank of England Quarterly Inflation Report will be the main influence on GBP. Downward growth revisions will play into the view that inflation will eventually moderate, capping expectation of higher interest rates over the coming months. However, the likely upward revision to near term inflation forecasts will help limit any damage to GBP.

GBP has lost ground to the USD but it should be noted that it has outperformed the EUR over recent days, reversing some of the recent run up in EUR/GBP. Given that EUR sentiment is likely to remain fragile this week, GBP may continue to capitalise, with a test of EUR/GBP 0.8672 on the cards.

ECB to Hike, BoJ, BoE & RBA on Hold

The better than expected March US jobs report will likely help to shift the debate further towards the hawkish camp in the Fed. There is little this week to match the potency of payrolls in terms of market moving data this week. Instead attention will focus on a raft of Fed speakers over coming days as well as the minutes of the March 15 FOMC meeting.

This week’s Fed speakers include Lockhart, Evans, Bernanke, Kocherlakota, Plosser and Lacker. Of these only Lockhart and Lacker are non voters. Given the intense focus on recent Fed comments FX markets will be on the lookout for anything that hints a broader Fed support for a quicker hike to interest rates and/or reduction in the Fed’s balance sheet.

In any case the USD may struggle to make much headway ahead of an anticipated European Central Bank (ECB) rate hike of 25 basis point on Thursday. Much will depend on the press statement, however. If the ECB merely validates market expectations of around 75bps of policy rate hikes this year the EUR will struggle to rally.

It may also be possible that once the ECB meeting is out of the way the EUR may finally be susceptible to pressure related to ongoing peripheral tensions. Last week the outcome of the Irish bank stress tests, and political vacuum in Portugal ahead of elections set for June 5 were well absorbed by the EUR but it is questionable whether the dichotomy between widening peripheral bond spreads and the EUR can continue.

The Tankan survey in Japan released today unsurprisingly revealed a deterioration in sentiment. The survey will provide important clues for the Bank of Japan (BoJ) at its meeting on April 6 & 7th. Although a shift in Japan’s ultra easy monetary policy is unlikely whilst strong liquidity provision is set to continue, pressure to do more will likely grow. This will be accentuated by a likely downward revision in the economic outlook by the BoJ.

The JPY will not take much direction from this meeting. Nonetheless, its soft tone may continue helped by foreign securities outflows (particularly out of bonds), with USD/JPY eyeing the 16 December high around 84.51. Speculative positioning as reflected in the CFTC IMM data reveals a sharp deterioration in JPY sentiment as the currency evidence that finally the currency maybe regaining its mantle of funding currency.

It is still too early for the Bank of England to hike rates despite elevated inflation readings and MPC members are likely to wait for the May Quarterly Inflation Report before there is decisive shift in favour of raising policy rates. Even then, members will have to grapple with the fact that economic data remains relatively downbeat as reflected in the weaker than expected March manufacturing purchasing managers index (PMI) data.

Today’s PMI construction data will likely paint a similar picture. The fact that a rate hike is not expected by the market will mean GBP should not suffer in the event of a no change decision by the BoE this week but instead will find more direction from a host of data releases including industrial production. GBP has come under growing pressure against the EUR since mid February and a test of the 25 October high of 0.89415 is on the cards this week.

Finally, congratulations to the Indian cricket team who won a well deserved victory in the Cricket World Cup final over the weekend. The celebrations by Indians around the world will go on for a long while yet.

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