USD weakness now extreme, but no signs of a reversal
The greenback took a further dive this past week, with a sharp drop in Tuesday's US September Consumer Confidence acting as the catalyst for a break higher in EUR/USD above the key 1.3500/20 price level. The euro continued to gain ground and reached the 1.3750/3800 area we highlighted last week, closing the week on the highs around 1.3770/80. The market is increasingly convinced that the Fed will pursue additional easing, egged on most recently by dovish comments from the Boston Fed's Rosengren and the NY Fed's Dudley. 2-year interest rate spreads between Germany and the US, which had shown signs of narrowing last week, widened out to new highs in favor of EUR at -44 bps, supporting EUR gains. USD/JPY also remained heavy with no sign of the BOJ/MOF in the market, though Friday heard talk that Japanese banks were asked to stay late and were reported bidding below the 83.20 level. With the USD down, risk was also 'on' and stock markets finished out a strong September and started October with additional gains. JPY-crosses reflected positive risk sentiment and are at multi-month highs.
While we would note there is little to suggest any imminent reversal higher for the USD/lower for the EUR, we think the moves have become overdone and are ripe for a correction. In particular, this past week's USD weakness was propelled in part by month-end/quarter-end USD selling, including Japanese repatriation at the financial semester end (selling USD/buying JPY). We're also puzzled by seemingly contradictory investor behavior: selling the USD because the US outlook is so bleak the Fed will be forced into QE2, but buying US risk at the same time the US outlook is deteriorating. It seems USD correlations are the main drivers here, e.g. commodities/gold higher, rather than any coherent investor view.
Still, the inertia is currently for a lower USD and we have to respect that. We think EUR/USD still has upside potential to the 1.3880/3920 area (1.3880 weekly cloud bottom; 1.3897 =61.8%% retracement of November high-June low; 1.3915 200-week sma) at the minimum, and many will be targeting gains above 1.4000 (weekly cloud top is at 1.4015). A drop below 1.3570/3600 area would likely signal consolidation at the minimum ahead of US NFP next Friday, but potentially a more significant correction lower. In JPY-crosses, breaks above multi-month highs (115.00 in EUR/JPY is a good proxy) are likely to see additional multi-JPY gains in those pairs.
Irish fiscal problems put to bed for now, but Spain remains a simmering concern
The Irish government’s announcement that the final cost of winding down Anglo Irish Bank will top nearly EUR30bn seems to have calmed the market, and 10-year yields on Irish bonds have eased from record highs. Even though this has pushed up Ireland’s total fiscal deficit to more than 30 per cent this year, the markets seem to be giving Ireland a rest for now. This is most likely because the government is fully funded into next year – giving it time to try and restore confidence before it has to return to the capital markets in 2011.
The focus may now turn to the largest of the peripheral economies, Spain. The markets have so far not targeted the Iberian nation, although its economy was also thrown into disarray due to the popping of a massive property bubble. This has placed its financial sector under considerable stress; however the troubles have mainly been located in the domestic lenders known as the “cajas” rather than the large multi-national banks, which remain well capitalised.
In contrast to Ireland, the Spanish authorities have been less transparent about the extent of bad debts sitting on the cajas’ books. There are an estimated two million unsold homes in Spain, which could turn into a lot of bad debt. Spain’s budget deficit is already estimated at 11.2 per cent of GDP for this year, but so far the markets have given Spain the benefit of the doubt and not targeted their bonds as they have the other peripheral economies. For example, the yield on 10-year Spanish bonds is 4.1 per cent compared to Ireland, where the yield is 6.3 per cent.
But financial markets can be fickle, and if they turn on Spain as they did on Greece and Ireland it would be a disaster for the eurozone. Spain makes up nearly 10 per cent of the eurozone’s entire economy, just below Italy. A market assault on Spain in the near future is not out of the question, high debt, 20 per cent unemployment and anaemic growth is a toxic mix that can lead to meltdown a la Greece. If this was to happen to an economy the size of Spain’s, it makes the chances of a break-up of the eurozone a real possibility. Ireland and Greece are drops in the ocean compared to the tidal wave a Spanish default would cause. All in all, Spain may turn out to be the real canary in the coalmine.
RBA rate hike likely
On Tuesday, October 5, the Reserve Bank of Australia meets to decide on interest rates. We agree with the market consensus for the bank to hike rates by 25bps to 4.75%. This would be the first hike since the RBA paused after raising rates in May. Better economic data out of Australia and its top trade partner, China, support the view that the bank is likely to tighten with an increase in its target rate. Moreover, recent RBA rhetoric has turned more hawkish.
Australia fundamentals of late have been robust. 2Q GDP advanced by 1.2% from the first quarter’s 0.7% with a 5.6% QoQ increase in exports adding 1.1 percentage points to GDP. Household spending was also a main contributor, adding 0.9 percentage points to GDP. Labor remains strong as highlighted by the falling unemployment rate, currently at 5.1%.
China’s demand for iron ore and coal (the top exports of Australia) has had a positive impact on the Australian economy. The recent trade surpluses of the country which historically experiences trade deficits underscore this beneficial relationship. While Australia is vulnerable to a slowdown in China, Chinese data releases have continued to exhibit a positive tone. Friday’s manufacturing PMI rose to 53.8 for September from the prior month’s 51.7. Retail sales and industrial production have also gained from prior months suggesting demand for raw materials remains strong.
Higher rates will work to restrain household consumption. RBA Governor Glenn Stevens stated that “the task ahead is likely to be one of managing a fairly robust upswing. Part of that task will, clearly, fall to monetary policy”. The risk here is that the RBA does not hike rates. This would likely be due to external factors (i.e. the increasing uncertainty surrounding the global economic outlook). Also, be cautious of a rate hike followed by a dovish statement as this may see Aussie weakness. The adage, “buy the rumor, sell the fact” can certainly be applied in this scenario as market prices generally reflect future expectations.
AUD/USD is trading above the 2010 and 2009 highs of around the 0.9400 area as the market prices in a potential rate hike. The key level to the upside is 0.9850 which is the 2008 highs (also the highest level for the past 27 years). A break above here brings parity into sight. To the downside, we see the daily Tenkan line around 0.9600 and below that sees the psychologically significant 0.9500 level ahead of the prior highs around 0.9400.
BoJ Watch Here to Stay
This week’s Japanese data releases exemplify the deteriorating growth outlook evident on the global stage. August Industrial Production disappointed with a -0.3% decline versus expectations for a rise of +1.1%. The much anticipated Tankan Large Manufacturers Index printed better than expected at +8 against expectations of +7 but was offset by the negative Outlook print of -1 versus an expected +3. The bleak headline Outlook number highlighted the growing pessimism within Japanese companies for future business conditions but even more concerning was its industry wide reciprocation. Particularly gloomy was the outlook from the auto industry, evidenced by the steep decline from +32 to a -6. This has spurred unconfirmed reports from Japanese media that the BOJ prefers to combat yen appreciation via easing in monetary policy as opposed to direct currency intervention. The reports suggest that the BOJ is likely to further increase its loan facility from 30-trillion yen to 50-trillion yen in efforts to encourage bank lending and reduce yen demand at its October 4-5 meeting.
The Ministry of Finance recently released the total intervention amount for the period from August 30th to September 28th at 2.124 trillion yen (approximately $25 billion). This total is modest in comparison to the potential 20 trillion yen (10x larger than the total intervention amount) increase in the loan facility and suggests recent intervention efforts may have been more of a political gesture to appease domestic criticism of Prime Minister Kan.
However, the noticeable deterioration in exports and consumption coupled with persistent yen strength despite intervention indicate the BOJ may have to respond with additional easing in concert with direct intervention in order to effectively combat yen appreciation. We believe that the BOJ is likely to announce the suspected loan facility increase in its next meeting considering the deterioration in the real economy but may also turn to direct intervention methods if and when yen appreciation drives USD/JPY to undesired levels. The market has been on constant BOJ watch after the most recent September 15th occurrence and it seems this theme may be a recurring one.
Bank of England QE2 unlikely this week
The Bank of England’s Monetary Policy Committee meets this Thursday and is expected to keep rates on hold. But the debate at the Bank of England is heating up. Last week Adam Posen was the first MPC member since November 2009 to explicitly call for more monetary stimulus. This puts him at odds with arch hawk Andrew Sentance, who has been calling for higher interest rates since June. Although Posen back-pedalled on his extremely dovish stance when questioned during a speech in the north of England when he said that more QE is not a foregone conclusion, the minutes of this Thursday’s meeting, released on 20 October, will be closely read by the market to see if anyone joins Posen in calling for further QE.
Economic data releases this week will help determine whether the economic recovery is flagging enough to require another dose of monetary stimulus. The crucial report will be Tuesday’s CIPS/Markit report on services for September. Analyst expectations are for a reading of 51.0, down from 51.3 in August. This was the lowest level since April 2009, and points to little or no growth in the largest sector of the UK’s economy. Combined with weakness in the housing market and consumption, the outlook for the UK continues to deteriorate. Although the MPC is not expected to vote for further QE this week, it doesn’t look far off.
Key data and events to watch next week
U.S. data starts off on Monday with the August factory orders, August pending home sales and Bernanke speaks in Rhode Island. Tuesday sees the September ISM non-manufacturing and October ABC consumer confidence. Wednesday sees the October MBA mortgage applications, September Challenger job cuts and September ADP employment change. Thursday follows with jobless claims, September ICSC Chain store sales, August consumer credit and the Fed’s Fisher speaks. Friday wraps up the week with the September employment report (NFP), August wholesale inventories and a speech by the Fed’s Tarullo.
The eurozone kicks off the week on Monday with the October Sentix Investor confidence and EZ August PPI. EC September PMI and EZ August retail sales will be released on Tuesday. Wednesday sees the EZ 2Q final GDP and German August factory orders. There is German August industrial production and ECB October interest rate announcement on Thursday. Friday finishes off the week with German August trade balance and current account.
The U.K. economic data begins with Monday’s September PMI construction and a speech by the BOE’s Paul Tucker. Tuesday sees September PMI services and BRC September shop price index. On Thursday there is August industrial & manufacturing production, September Halifax house prices and the BOE interest rate & asset purchase target announcement. Friday closes out the week with September PPI.
Japan’s economic data begins on Sunday with the August labor cash earnings. Monday begins the October BOJ monetary policy meeting and is followed on Tuesday with the BOJ’s target rate announcement. Wednesday sees September official reserve assets and Thursday wraps up the week with August coincident & leading index, September machine tool orders, August current account and trade balance.
Canada’s calendar starts off with a speech by BOC’s Macklem on Tuesday. Wednesday sees the September Ivey purchasing manager’s index. Thursday follows with August building permits. Friday rounds out the week with the September employment report and September housing starts.
The calendar down under is extremely light, but starts on Monday with Australia’s August trade balance, August retail sales and the RBA cash target announcement. Wednesday wraps up the week with the Australian September employment report.
Also be on the lookout for China’s September HSBC services PMI which is due on Monday.
Disclosure: No positions