The final week of July saw mixed price action among asset classes, as better than expected data from outside the US was mostly offset by weaker US data. US stocks finished slightly weaker while the MSCI world stock index gained some ground. The CRB commodity index continued to advance, but WTI crude and spot gold both suffered small losses. JPY-crosses, the primary FX risk barometer, finished out the week unchanged to slightly down. The one clear mover of the week was the USD, which lost ground against all other major currencies. The reasons for USD weakness were so manifold, the real question is not why did the buck weaken, but rather why did it only weaken relatively mildly?
The main source of USD weakness is growing evidence of a US slowdown as we move into the 2H of 2010, in contrast with far more resilient data coming out of the rest of the G-10, the eurozone and the UK in particular. Signs of slowing in the US have also reignited deflation fears, even prompting one usually hawkish Fed member, St. Louis Fed Pres. Bullard, to suggest that the Fed may need to resume buying US Treasuries. Both those factors have led to a drop in US Treasury yields to new/recent lows, adding further pressure on the buck. Then we have comments from Moody's senior sovereign credit analyst suggesting that the US's Aaa rating may come under scrutiny unless the US presents a credible plan to cut deficits and stabilize debt levels. While the Moody's comments could re-focus market attention on US deficits in the short-run, we would note that the comments referred to a period several years away, and also echo prior credit rating agency warnings on US deficits from 2009. (We'll have more to say about this story following the November US mid-term elections.) Lastly, month-end portfolio rebalancing flows resulted in net USD selling over the course of last week, adding to the pressure on the greenback. These last two factors (Moody's comments and month-end USD selling) will likely cease to be factor in the week ahead, but the larger issue of a slowing US economy and potential deflation keep the outlook for the USD on the downside.
As the US economy increasingly shows signs of slowing, however, it raises several questions that will only be answered over time. First off, how much will the US economy slow and how much of that slowdown is priced-in to markets already. Opinion here varies, but we're inclined to think fears of a major US slowdown (i.e. double-dip recession) are overblown and that a slowdown to a 2H 1.5-2.0% annualized GDP rate is most likely. The second question that arises is what effects will a US slowdown have on other developed economies? Clearly, a slowing US is a headwind for the rest of the world, not to mention further potential moderation out of China. Coupled with impending adoption of austerity measures in the UK, the eurozone, and elsewhere, we think there are significant risks that economic data from outside the US will soon begin to show weakness. However, it may take several months for that data to materialize, during which the USD will remain vulnerable. But anticipation of such a slowdown outside of the US is likely to constrain the upside for EUR, GBP, and CAD over the next several weeks.
In terms of price levels, the USD index fell to a key technical level at 81.40/45, which is the 50% retracement of the USD advance from Nov. 2009 and the 100-week moving average. A decline below this level would suggest further weakness of around 2% in the USD index, at least initially. In EUR/USD, the pair has effectively retraced 38.2% of its decline over that same time period (1.3124), which also marks the measured-move objective for the inverted head-and-shoulders pattern triggered at the beginning of July. As well, recent highs in AUD/USD/lows in USD/CAD have held going into the week's close, this in an environment where the USD could easily have broken down. In light of these USD support levels, and in view of summer trading conditions, we think there is solid potential for a short-term USD recovery and consolidation. But we are under no illusion that the deck is also stacked against the dollar in the short-run, and if the levels highlighted above are exceeded, we would be compelled to expect fresh USD weakness.
Sterling Waits to See If H2 Will Be as Difficult as Feared
Cable is showing some reluctance to push above the USD1.5700 area hindered by a reduction in risk appetite and a fall in July GfK consumer confidence. That said the pound has staged a decent rally in recent sessions supported by stronger Q2 GDP data and by stronger than expected retail sales numbers. While the growth of the UK economy in the spring was better than had been expected the consensus foresees fiscal austerity to moderate growth potential in H2. The forthcoming July PMI releases will give a taste of how the economy is panning out in the early stages of Q3. Recent gains for the pound do make it more vulnerable to poor data, though given the consensus view that the economy will struggle in H2 the pound is still well positioned to perform well on strong data. Crucial support for EUR/GBP lies at 0.8300/20 area, a fall below this level could signal another leg lower. The August MPC meeting is likely to pass without event.
ECB Policy Normalization May Provide Additional Near-Term Support for the EUR
Flash estimates of eurozone July PMI data were better than expected – led by Germany. The final estimates are expected to confirm this trend. It has become increasingly difficult to ignore the improvement in Germany’s economic recovery and it will be interesting to see the response of ECB President Trichet to this following the ECB’s August policy meeting. Last week, the ECB bought the lowest amount of bonds since the bond buying programme started in May and Euribor has ticked higher since the spring; although it has moderated slightly in recent sessions. While inflation is still relatively moderate at 1.7% YOY it is at the highest level since the end of 2008. There is little chance of the ECB hiking interest rates until well into 2011. However, there is presently a contrast between the ongoing policy normalisation at the ECB and the Fed’s decision to leave the door open to further easing. Although the medium-term outlook for the EUR is still clouded by the possibility that Greece could be forced to re-structure its debt, near-term, there may still be a squeeze higher in the EUR above USD 1.3125, which would target gains into the 1.3350/3400 area.
The RBA Likely to Pause in August but Continued Hikes Likely in Later months
Consensus market opinion for the RBA Cash Target on Tuesday is for rates to remain steady at 4.5%. The main determinant in the RBA’s decision being benign Q2 CPI, .6% versus expectations of 1% QOQ, as outlined in the July RBA meeting minutes. Underlying inflation now back inside the RBA’s 2-3% target range at 2.7% coupled with developing global growth concerns will almost certainly lead to a pause in the RBA’s tightening cycle but potential tightening still remains a likely possibility for the September and October meetings . The labor market in Australia should continue to strengthen as June employment saw a gain of 45.9k and a slightly lower June unemployment rate of 5.1%. Consumer confidence rebounded in July to 11.1% from the -5.6% print in June improving the near term outlook for consumer spending. The strengthening labor sector and confidence numbers point towards an above trend growth outlook for the remainder of the year. The August Monetary Policy statement, due on Friday, will publish updated GDP growth and inflation forecasts with a probable emphasis on the potential for underlying inflation to drift higher to the top of the 2-3% target range.
As the RBA is widely expected to keep the cash rate on hold, the Tuesday meeting will most likely be a non-event. The risk though exists in a possible hike which would most certainly take the market by surprise. An unexpected hike should see a knee jerk reaction higher followed by a corrective move lower close to pre-statement levels. The longer-term outlook should see higher growth and consumer price expectations support AUDUSD towards 0.9400 although short to medium term price pressure on commodities may see the Aussie drift back towards its 100-day SMA, currently around 0.8850.
Key Data and Events to Watch Next Week
The calendar in the US is very important in the week ahead. Monday kicks off the data with the release of July ISM manufacturing index and prices paid, June construction spending, and remarks on the economy by Fed Chairman Bernanke. Tuesday is heavier with June personal income and spending, personal consumption expenditure (PCE) numbers, pending home sales, and July vehicle sales. On Wednesday we see weekly MBA mortgage applications, July challenger job cuts, ADP employment change, and ISM non-manufacturing. Thursday sees the usual weekly jobless claims. Friday rounds out the week with the important July employment report which includes the change in non-farm payrolls (NFP), unemployment rate, and average hourly earnings.
The eurozone calendar is moderately busy. Monday sees final July manufacturing PMI numbers out of France, Germany, and the eurozone. Jean-Claude Juncker is set to speak and June EZ PPI is due out on Tuesday while French, German, and EZ final July Services PMI is released on Wednesday. Also due out Wednesday is EZ retail sales for June. Thursday is an important day and starts with German June factory orders ahead of the ECB interest rate announcement. This will be followed up by commentary from Jean-Claude Trichet. Friday closes things out with France’s June trade balance and German industrial production.
The UK starts off the action on Monday with July manufacturing PMI followed by July construction PMI on Tuesday. July services PMI are scheduled for Wednesday followed by the BoE interest rate and asset purchase announcement on Thursday. Friday closes things out with July PPI along with June industrial and manufacturing production.
Japan looks characteristically light. July vehicle sales and monetary base start off the week on Monday. The next report of note will be Thursday’s release of July official reserve assets. Friday’s leading and coincident index finishes up the week for Japan.
Canada gets a late start to the week as it is on holiday Monday. The calendar looks anemic until Thursday’s building permits for June. Friday is an important day with July employment data and Ivey PMI on the schedule.
The calendar down under is somewhat busy. Monday starts the week with Australia’s June retail sales and building approvals while New Zealand sees July ANZ commodity price, 2Q private wages and average hourly earnings. Tuesday will see the RBA’s interest rate decision, followed by July AiG performance of services index, June trade balance, and 2Q house price index. New Zealand 2Q unemployment rate and employment change are set for release on Wednesday. The RBA’s quarterly monetary policy statement is on tap for Thursday.
Be on the lookout for important China data as well. Sunday sees July PMI manufacturing while Monday has July HSBC manufacturing PMI on deck. Tuesday will see July non-manufacturing PMI and July HSBC services PMI is due out on Wednesday.
Disclosure: No positions