A Host Of Global Risks

Last week was a tumultuous one to say the least.  It’s been a long time since so many risk factors have come together at the same time.  The list is a long one and includes the escalation of the US-China trade war, which last week saw President Trump announce further tariffs on the remaining $300bn of Chinese exports to the US that do not already have tariffs levied on them, a break of USDCNY 7.00 and the US officially naming China as a currency manipulator.

The list of risk factors afflicting sentiment also includes intensifying Japan-Korea trade tensions, growing potential for a no-deal Brexit, demonstrations in Hong Kong, risks of a fresh election in Italy, growing fears of another Argentina default, ongoing tensions with Iran and escalating tensions between India and Pakistan over Kashmir.

All of this is taking place against the background of weakening global growth, with officials globally cutting their growth forecasts and sharply lower yields in G10 bond markets.  The latest country to miss its growth estimates is Singapore, a highly trade driven economy and bellwether of global trade, which today slashed its GDP forecasts.

Central banks are reacting by easing policy.  Last week, the New Zealand’s RBNZ, cut its policy rate by a bigger than expected 50 basis points, India cut its policy rate by a bigger than expected 35 basis points and Thailand surprisingly cutting by 25 basis points.  More rate cuts/policy easing is in the pipeline globally in the weeks and months ahead, with all eyes on the next moves by the Fed.  Moving into focus in this respect will be the Jackson Hole central bankers’ symposium on 22/23 August and Fed FOMC minutes on 21 August.

After the abrupt and sharp depreciation in China’s currency CNY, last week and break of USDCNY 7.00 there is evidence that China wants to control/slow the pace of depreciation to avoid a repeat, even as the overall path of the currency remains a weaker one. Firstly, CNY fixings have been generally stronger than expected over recent days and secondly, the spread between CNY and CNH has widened sharply, with the former stronger than the latter by a wider margin than usual.  Thirdly, comments from Chinese officials suggest that they are no keen on sharp pace of depreciation.

Markets will remain on tenterhooks given all the factors above and it finally seems that equity markets are succumbing to pressure, with stocks broadly lower over the last month, even as gains for the year remain relatively healthy.  The US dollar has remained a beneficiary of higher risk aversion though safe havens including Japanese yen and Swiss Franc are the main gainers in line with the move into safe assets globally.  Unfortunately there is little chance of any turnaround anytime soon given the potential for any one or more of the above risk factors to worsen.

NZD outperforms

NZD has been the best performing major currency so far this year outshining other currencies by a wide margin. We expect further NZD/USD appreciation, albeit at a much more gradual pace over the coming months.

The kiwi has been propelled higher by a host of positive economic indicators including jobs data which has revealed an improving trend against the background of strengthening consumer and business confidence.

Economic growth is on track to reach our forecast of 3% this year. Additionally supportive of the NZD is the fact that NZ’s major commodity exports especially dairy products have remained high. NZD will also be helped by a likely healthy reading for Q4 GDP expected to come in at 3.7% YoY on Thursday.

NZD/USD looks set to target the 2013 high of 0.8676 as the next key target, a level that will provide strong resistance.

NZD hit by FX intervention

Following previous warnings threatening intervention to weaken the NZD the Reserve Bank of New Zealand (RBNZ) intervened to sell the currency. The impact was sharp, with NZD falling versus USD and against key crosses including AUD. The NZD has been one of the best performing major currencies this year although its appreciation of 1.33% is not dramatic. However, going back to its cyclical low in March 2009 NZD had appreciated by a massive 72.6% versus USD prior to today’s intervention.

Previous warnings by RBNZ governor Wheeler include a speech in February when he noted that the “kiwi is not a one-way bet”. However, he noted that while the central bank is prepared to intervene to weaken the NZD any intervention would “only attempt to smooth the peaks”.

The last time that the RBNZ confirmed that it had intervened was way back in June 2007 when NZD/USD was trading around 0.75. The intervention failed to prevent further NZD strengthening until late July 2007 when the kiwi slid around 17% against the USD but this fall was notably not due to FX intervention.

Although Wheeler noted today that the RBNZ is capable of more intervention he added the intervention is “designed to take the top off the currency” consistent with his earlier comments. The bottom line is that more smoothing is likely but a significant push to change NZD direction is highly unlikely. The overall trend in NZD is likely to remain gradually upwards although gains will likely be more gradual given likely market caution over further RBNZ smoothing operations.

Taking a broader view the RBNZ is playing a similar game to many other central banks in attempting to weaken or at least prevent strength in their currencies. The Bank of Japan (BoJ) is clearly succeeding in finally weakening the JPY, while the RBA in part cut policy rates yesterday due to the strength of the AUD. While a full blown currency war remains unlikely currency frictions are picking up. I prefer to play the latest move in NZD by selling it versus AUD where we I see more value.

High Hopes for the EU Summit

Following the knock to the EUR from the S&P ratings news on Eurozone countries yesterday the currency has managed to regain a semblance of stability ahead of the European Union Summit beginning tomorrow. Expectations that the Franco-German deal announced late Monday (Fiscal compact etc) will be rubber stamped at the summit are high and the warning shot by S&P suggests that the stakes are even higher should there be no further progress this week.

Aside from putting the ratings of 15 Eurozone countries on negative watch S&P stated overnight that the EFSF bailout fund could be downgraded too. The EUR however, looks supported ahead of the summit and European Central Bank (ECB) meeting tomorrow, with news of discussions to beef up the bailout fund to two separate entities likely to further underpin the currency. EUR/USD short term support is seen around 1.3330.

The cut in the Reserve Bank Australia (RBA) cash rate piled on the pressure on the AUD, especially as a rate cut was not fully priced in although its weakness was limited by the relatively neutral RBA policy statement. The statement did not support expectations of more significant easing in the months ahead and data this morning in the form of a much stronger than expected Q3 GDP reading reinforced our view that markets are too dovish on Australian interest rate expectations.

Next it’s the turn of the Reserve Bank of New Zealand (RBNZ) but unlike the RBA we do not expect an interest rate cut. The room for policy easing in New Zealand is limited, especially given that inflation is above the Bank’s 1-3% target band. Both the AUD and NZD are highly correlated with interest rate differentials and therefore any shift in rate expectations will have an important bearing. AUD and NZD have benefitted from a widening in yield differentials with the US and are likely to find garner some resilience from this fact over coming sessions.

EUR/GBP has continued to grind lower over recent months while GBP/USD appears to have settled into a range. GBP sentiment has clearly worsened over recent weeks as reflected in the deterioration in speculative positioning in the currency, with the market becoming increasingly short. Data releases have not been particularly helpful, with data yesterday revealing that UK house prices fell in November and retail sales dropped more than expected.

There will be more disappointment, with October industrial production likely to drop today. Our forecast of a 0.8% monthly highlights the downside risks to consensus expectations and in turn to GBP today. The data releases will if anything add to pressure on the Bank of England to embark on more quantitative easing, which will be another factor that restrains GBP over coming weeks. We continue to look for more GBP strength versus EUR but weakness against the USD over the short term. A move to support around GBP/USD 1.5469 is on the cards over the near term.

EUR Supported, AUD dives, NZD jumps

Today is probably not the best day to sell EUR given that the ECB policy decision looms on the horizon. Whilst there is a risk of a ‘buy on rumour, sell on fact’ impact on the EUR following the European Central Bank (ECB) decision later today the relatively high probability that the ECB flags a rate hike in July will likely give further support to the EUR especially as it is not fully priced in by the market.

Of course should ECB President Trichet fail to mention “strong vigilance” in his press conference the EUR could suffer but this is likely to be a lower probability event. Some justification for higher rates will come from an upward revision in the ECB’s inflation forecasts. Consequently EUR/USD looks well supported around 1.4450.

The Bank of England is unlikely to deliver any surprises today, with an unchanged policy rate outcome and asset purchases target likely. The outcome will keep GBP restrained versus USD but given the likely contrast with the ECB, EUR/GBP could head higher as the currency pair continues to set its sights on the 0.90 level.

Even against the USD, GBP is unlikely to extend its gains, with 1.6474 likely providing a near term technical cap. The dichotomy of weaker activity and higher inflation is clearly causing a problem for policy makers but we still believe a rate hike is likely later in the year. In the meantime GBP remains vulnerable to further data disappointments over coming weeks.

There was more bad news for the AUD today in the form of a weak than forecast May employment report. The data will reinforce expectations that the RBA will not hike interest rates over coming months, with July and August effectively ruled out, though a hike in September remains probable.

The data had major impact on AUD which dropped sharply below the 1.0600 handle versus USD. Clearly the combination of the RBA statement and weak jobs data has resulted in a major headwind against further near term AUD appreciation. AUD will remain under downward pressure in the short-term, with technical support seen at 1.0440.

Unlike the RBA the Reserve Bank of New Zealand (RBNZ) opened the door for higher interest rates following its unchanged policy decision today, with the Bank stating that “a gradual increase in the overnight cash rate over the next two years will be required”. Despite noting some caution about the strength of the NZD and its impact on the economy the Kiwi strengthened versus the USD

Interest Rate Decisions Galore

The Reserve Bank of New Zealand (RBNZ) decision to cut policy rates by a bigger than expected 50bps does not necessarily mark the onset of a new wave of NZD selling. Indeed, whilst the NZD was hit by the rate cut it recovered quickly.

The NZD was aided by comments from the RBNZ Governor Bollard that short term inflation may spike due to the earthquake but this tempered by another RBNZ official who stated that the central bank may hold rates at 2.5% at least until January 2012. The post meeting statement indicated that the RBNZ will not embark on a series of rate cuts, a fact that will provide some relief to the Kiwi. Moreover, the currency looks increasingly oversold especially relative to the AUD as indicated by relative positioning.

Weaker than expected employment data in Australia will also help to stem AUD strength versus NZD. After many months of positive surprises the labour market is showing signs of cracking. Admittedly full time employment rose but this was outweighed by an even bigger drop in part time employment, resulting in a 10.1k fall in overall employment.

Although the AUD is unlikely to face too much downside markets the data will likely dampen expectations of possible rate hikes in the months ahead. My preferred way of playing possible AUD underperformance is via the NZD. AUD/NZD is likely to face plenty of resistance around the 1.3800 level and eventually as indicated by our quantitative models the currency pair is likely to move lower over coming weeks.

In sharp contrast to the RBNZ, the Bank of Korea hiked interest rates by 25bps in a further move to normalize policy. The decision was not much of a surprise and the statement indicated that more rate hikes should be expected. The KRW remains rangebound but the currency remains on path for further appreciation over coming months. The surprise trade deficit in China has weighed on Asian currencies in general but weakness is likely to be limited.

The Bank of England is the next central bank on tap today but is unlikely to hike rates despite the hawkish shift within the Monetary Policy Committee. A rate hike is moving closer but the Bank will likely wait until at least May before moving. Further details about today’s decision will as usual wait for the minutes in two weeks time. GBP looks vulnerable and whilst a rate move today is not expected the currency may lose ground over coming days against the background of a firmer USD.

Euro Sentiment Jumps, USD Sentiment Dives

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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