Euro weaker despite hawkish ECB

The bounce in EUR/USD following the European Central Bank (ECB) press statement following its unchanged rate decision proved short-lived with the currency dropping sharply as longs were quickly unwound, with EUR/USD hitting a low around 1.4478. The sell off occurred despite the fact that the ECB delivered on expectations that it would flag a July rate hike, with the insertion of “strong vigilance” in the press statement.

The reaction was a classic ‘buy on rumour, sell on fact’ outcome and highlights just how long EUR the market was ahead of the ECB meeting. Interestingly the interest rate differential (2nd futures contract) has not widened versus the USD despite the hawkish ECB message and in any case interest rate differentials are not driving EUR/USD at present as reflected in low correlations.

This leaves the EUR susceptible to Greek developments and the news on this front is less positive. ECB President Trichet ruled out any direct participation (ie no rollover of ECB Greek debt holdings) in a second Greek bailout whilst potentially accepting a plan of voluntary private participation in any debt rollover. The ECB’s stance is at odds with that put forward by German Finance Minister Schaeuble pressuring investors to accept longer maturities on their Greek debt holdings.

In contrast the USD appears to be finding growing relief from the fact that the Federal Reserve is putting up a high hurdle before QE3 is considered. As highlighted by Fed Chairman Bernanke earlier this week the Fed is not considering QE3 despite a spate of weak US data. This was echoed overnight by the Fed’s Lockhart and Plosser, with the former noting that there would need to be a substantially weaker economy and the latter noting that there would have to be a “pretty extraordinary” deterioration in the economy to support QE3.

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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

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.

Central bank decisions and US payrolls in focus

The USD’s troubles are far from over. Data and events this week will do little to stop the rot. As US Federal Reserve Chairman Bernanke made clear last week the Fed is committed to completing its asset purchase programme by the end of June though there is plenty of debate about what comes after. Reduced growth forecasts and the Fed’s view that price pressures are “transitory” have been sufficient to keep the USD on its knees.

The weaker than expected reading for Q1 US GDP growth at 1.8% QoQ clearly did nothing to alleviate pressure on the USD even though it is widely believed that the soft growth outcome will prove fleeting, with recovery set to pick up pace over the coming months. In truth much will depend on the trajectory for oil prices, especially as petrol prices in the US verge on the psychologically important $4 per gallon mark. Even higher energy prices could dent growth further but lower or stable prices will keep the recovery on track.

The highlight in this holiday shortened week for many countries this week is the US April jobs report at the tail end of the week. Estimates centre on around a 200k gain in payrolls but forecasts will be refined with the release of the ADP private sector jobs report and ISM manufacturing survey earlier in the week. The unemployment rate may prove sticky and will likely remain at 8.8%, a disappointment to those looking for a quicker recovery. The elevated unemployment rate will only reinforce expectations that the Fed will not be quick to reverse policy, with the USD continuing to suffer as a result.

Central bank meetings will be plentiful this week, with the European Central Bank (ECB) and Bank of England (BoE) likely to garner most attention. Recent data in the Eurozone has provided further evidence of growth divergence between North and South, but the EUR has remained resilient to this as well as to increased concerns about the periphery. This make the ECB’s job even tougher than usual when it meets this week and it is unlikely that the Bank will hike rates again so soon, especially given the strength of the EUR. Nonetheless, Trichet will continue to sound hawkish, limiting any damage to the EUR (if any) of no move in policy rates.

Similarly the Bank of England will also remain on the sidelines though this should come as little surprise in the wake of disappointing data recently and a surprise drop in inflation, albeit to still well above the BoE’s target. GBP has made up ground against a generally weak USD but judged against other currencies it has been an underperformer as expectations of monetary tightening have been pared back. Finally, the Reserve Bank of Australia (RBA) is set to remain on hold, but a hike over coming months remains likely even with the AUD at such a high level. Quite frankly although the USD is looking increasingly oversold there is nothing this week that would suggest it will recover quickly.

Australian Dollar Looking Stretched

Central bank decisions in Japan, Europe and UK will dictate FX market direction today. No surprises are expected by the Bank of Japan (BoJ) and Bank of England (BoE) leaving the European Central Bank (ECB) decision and press conference to provide the main market impetus. Although a hawkish message from ECB President Trichet is likely the market has already priced in a total of 75 basis points of tightening this year. We retain some caution about whether the EUR will be able to make further headway following the ECB meeting unless the central bank is even more hawkish than already priced in.

EUR/USD easily breached the 1.4250 resistance level and will now eye resistance around 1.4500. News that Portugal formally requested European Union (EU) aid came as no surprise whilst strong German factory orders provided further support to the EUR. The data highlights upside risks to today’s February German industrial production data. The EUR will find further support versus the USD from comments by Atlanta Fed’s Lockhart who noted that he doesn’t expect the Fed to hike interest rates by year end.

USD/JPY is now around 7.5% higher than its post earthquake lows. Japanese authorities will undoubtedly see a measure of success from their joint FX intervention. To a large degree they have been helped by a shift in relative bond yields (2-year US / Japan yield differentials have widened by close to 30 basis points since mid March, and are finally having some impact on USD/JPY as reflected in the strengthening in short-term correlations. Whilst the BoJ is unlikely to alter its policy settings today the fact that it is providing plenty of liquidity to money markets, having injected around JPY 23 trillion or about 5% of nominal GDP since the earthquake, is likely playing a role in dampening JPY demand.

AUD/USD has appreciated by close to 6% since mid March and whilst I would not recommend selling as yet I would be cautious about adding to long positions. My quantitative model based on interest rate / yield differentials, commodity prices and risk aversion reveals a major divergence between AUD/USD and its regression estimate. Clearly the AUD has benefitted from diversification flows as Asian central banks intervene and recycle intervention USDs. However, at current levels I question the value of such diversification into AUD.

Speculative AUD/USD positioning as indicated by the CFTC IMM data reveals that net long positions are verging on all time highs, suggesting plenty of scope for profit taking / position squaring in the event of a turn in sentiment. Moreover, AUD gains do not match the performance of economic data, which have been coming in worse than expected over recent weeks. Consequently the risks of a correction have increased.

US Dollar On A Slippery Path

The USD has been a on a slippery path over recent weeks, weighed down by adverse interest rate differentials despite improving US economic data. Adding to the run of encouraging US data releases the February jobs report revealed a 192k increase in jobs and a drop in the unemployment rate to 8.9%.

In particular the Fed’s dovish tone highlights that whilst asset purchases under QE2 will stop at the end of June, the failure to hit the Fed’s dual mandate of maximum employment and stable prices, implies that the Fed Funds rate will not be hiked for a long while yet. This dovish slant has undermined the USD to the extent that USD speculative positioning as reflected in the CFTC IMM data dropped to all time low in the week to 1 March. There is certainly plenty of scope for short-covering but the market is no mood to buy the USD yet.

This week’s releases will provide less direction, with a slight widening in the trade deficit likely in January, a healthy gain in February retail sales and a small drop in the preliminary reading of March Michigan sentiment.

In contrast, even the generally hawkish market expectations for the European Central Bank (ECB) proved too timid at last week’s Council meeting as Trichet & Co. strongly implied via “strong vigilance” that the refi rate would be hiked by 25bps in April. EUR/USD lurched higher after the ECB bombshell breaking the psychologically important 1.4000 barrier but appeared to lose some momentum at this level. Should EUR/USD sustain a break of 1.4000, the next level of resistance is at 1.4281 (November high), with support seen around 1.3747.

The lack of major eurozone data releases this week, with only industrial production data in Germany and France of interest, suggests that EUR may consolidate over the short-term with the main interest on the informal Heads of State meeting at the end of the week to determine whether credible plans can be drawn up to restore confidence in the periphery.

This week it is the turn of the Bank of England (BoE) to decide on monetary policy but unlike the ECB we do not expect any surprises with an unchanged decision likely. Further clues will only be available in the Monetary Policy Committee (MPC) minutes on 23 March. However, markets may be nervous given that it could feasibly only take another two voters aside from the three hawkish dissenters last month, to result in a policy rate hike. Notably one possible hawkish dissenter, Charles Bean did not sound overly keen on higher rates in a speech last week, a factor that weighed on GBP alongside some weaker service sector Purchasing Managers Index (PMI) data.

UK manufacturing data will be the main data highlight of the calendar but this will be overshadowed by the BoE meeting. GBP/USD could continue to lag the EUR and given a generally bullish EUR backdrop, our preferred method of playing GBP downside remains via a long EUR/GBP position.

Losing Your Addiction

An interesting thing happened to me last week. On a business trip to Europe my blackberry broke and failed to work for the rest of the week. I felt like an addict coming off an addiction. The first couple of days were very tough; my usual instinct to constantly check for messages resulted in constant fidgeting and major withdrawal symptoms.

Once this had worn off I must admit I felt liberated. My addiction gone, it felt great to be weaned off my crackberry. The message here is that life goes on without access to mail. It’s an experience I would recommend to all users of such devices.

Back to reality and my view from Hong Kong this week is as follows. The risk-off tone as reflected in related to the turmoil in Libya and the increase in oil prices (as supply concerns intensify), may help to limit the pressure on the USD this week, but the overall tone is set to remain weak.

Much will depend on this week’s key US data releases and a testimony by Fed Chairman Bernanke to the US Senate, to determine whether the USD will find a more stable footing. Clearly the more hawkish tone of the European Central Bank (ECB) and Bank of England (BoE) in contrast to the lack of inclination by the Fed towards a tighter monetary policy stance could undermine the USD.

In this respect, it is doubtful that Bernanke will change his stance of the Fed failing to meet its dual mandate due to too low inflation. The main event is the February US jobs report at the tail end of the week. The consensus expectation of a 190k increase in payrolls will be finalised after gaining more clues from the US February ISM surveys and ADP jobs report earlier in the week. The week’s releases will likely reveal further improvements in US economic data, but given that this will do little to budge the Fed’s stance, the USD may be left somewhat underwhelmed.

The intensification in risk aversion over recent days has also been felt in the Eurozone periphery where bond market pressures have resumed. Nonetheless, the fallout on the EUR has been limited by hawkish ECB jawboning. Thursday’s ECB meeting will surely maintain this stance, and following the release of data on Tuesday likely to show a further increase in inflation in February, upside inflation risks are likely to be highlighted by ECB President Trichet in the press conference.

A likely pre-emptive strike from the ECB cannot be ruled out. Two rate hikes in H2 2011 are now likely even as the Bank maintains liquidity support for weaker peripherals. No change in policy but a hawkish press statement on Thursday will on the face of it play for a firmer EUR but i) the fact that the market has already discounted the possibility of early rate hikes and ii) the proximity of the US payrolls data on Friday and iii) uncertainty over the impact of the Irish election outcome in which the Fine Gael party won a clear victory, suggest that EUR risks are asymmetric. The net long positioning overhang also points to some downside risks to EUR.

There are plenty of other events and data on the calendar this week including Japan’s slate of month end releases, interest rate decisions by the Reserve Bank of Australia and Bank of Canada, UK PMI manufacturing survey data and Swedish Q4 GDP data.

The bottom line is that currencies will be driven by the conflicting influences of improving economic data on the one hand and elevated risk aversion on the other. The main beneficiaries of higher risk aversion will be the CHF and JPY though both have risen far whilst the USD will be restrained by a dovish Fed.

In contrast the EUR and GBP may yet extend gains but in both cases, markets have already shifted policy tightening expectations sharply over recent weeks and we suspect EUR/USD will be capped at resistance around 1.3860, whilst GBP/USD will similarly struggle to break its year high around 1.6279.

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