Week In FX Europe - Yields Are Making FX Interesting

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 |  Includes: FXB, FXE, FXF
by: Dean Popplewell

By Dean Popplewell

    • BoE's Carney "new" norm is 2.5%
    • US Bull Flattener will force USD lower
    • Asian appetite for Euro paper supports EUR
    • Bund/Periphery spreads beginning to be squeezed

Interest rates are the key to unlocking the forex market’s contained range trading. Investors require a divergence in central bank interest rate policies to provide opportunity. So far, a low-rate environment is affecting market volume and volatility -- the new 'norm' that dealers have had to adhere to for the past few years. Alas, there is hope: central banks will need to stay ahead of a squeeze in prices, a phenomenon that will eventually be created by so much liquidity. A subtle change in rhetoric from Governor Mark Carney at the Bank of England (BoE) to Governor Graeme Wheeler at the Reserve Bank of New Zealand is giving the market a heads up to change, albeit this year or next. U.K. data is strong and it’s reasonable for the BoE to forewarn, however, when you have a governor that can sometimes ask questions off script (why is a market not pricing hikes in 2014?), it provides GBP volatility and hence opportunity (look at the pound's move over the past few weeks -- most of it equates to various Carney and Monetary Policy Committee speeches). So, it's imperative to understand central bank rates and specifically how they interact with other neighboring policies to understand market movement. In a low rate and low volume market the "carry" trade gets special attention.

Listening to central bank rhetoric and watching the yields certainly provides some market direction. For the mighty dollar, analysts will continue to note that as long as U.S. bond yields are in retreat and the U.S. yield curve continues its bullish steepening (shorter rates fall faster than longer), then the USD should stay offered and perhaps push volatility even lower. However, something is always being priced more aggressively, nothing stays static. Currently, GBP is providing market intraday opportunity.

British Rate-Hike Guesses Persist

GBP continues to be well supported but remains below the pivotal financial crisis level of £1.7050 level. Market expectations for an early rate hike will likely remain in place, especially after Friday's numbers. Final gross domestic product data was largely in line with expectations but saw a healthy upward revision in business investment. With the BoE's Carney continuing to "clarify" his view on the first rate hike, it continues to pique the market’s interest in sterling outright or on the crosses.

The BoE sees the "new" normal on rates at +2.50% rather than the previous historical average at +5%. Carney expects to hit "normal" levels around early 2017. U.K. policymakers are basically trying to cement the "limited and gradual" script for households and businesses so there are no shocks to the system. This is in contrast to directly signaling to the market to where rates are going. Carney is doing what every good central banker should be doing by adjusting households’ and firms’ expectations.

The 18-member single currency, the EUR, remains locked into a tight range while holding above the psychological €1.36 level. The euro’s rigidity is owed mostly to U.S. dollar weakness, and the European Union’s Economic and Monetary Union inflation data which is showing signs of stabilizing this month, and it might suggest that the European Central Bank is in a wait-and-see mode following the recent policy measures to combat "deflationary" concerns. When it comes to euro interest rate spreads, the market focuses on Germany and the peripheries.

Asian Investors Boost the Euro

Asia’s appetite for euro paper, particularly that of the peripheral eurozone nations, has managed to tighten the bund/periphery spread aggressively, so much so that Spain, Italy, and Ireland have all traded recently through the U.S. curve at one time or other. By default and indirectly, Asian appetite has supported the single unit (€1.3600) to an extent. Currently, it seems accounts are getting a bit wary of how tight euro spreads are again. This has instigated some decent selling interest of emerging market exchange-traded funds at their multi-year highs, with investors happy to take some profit on longs as well as initiating new 'shorts' up at these levels.

The market's general view is that peripheral nation (Spain, Ireland, Italy, Portugal, Greece, etc.) spreads have run their course for the time being and that everything is looking a bit stretched. If investors are looking for yield, perhaps taking on more "duration" risk is a safer and smarter strategy at these spread levels than taking on more "credit" risk. By selling Spanish five-year bonds and buying German bunds, investors maintain the same safe credit and pick-up similar yield. This scenario will provide headwind for further euro periphery tightening. U.S. yields will be dragged down by higher bund prices as their spreads begin to narrow -- again a scenario that does not provide support for the dollar!

On tap for next week:

Despite it being a holiday shortened week in North America in particular, there is a plethora of data that should make for an interesting week.

In particular, circle July 3 on your calendar. That’s the date the U.S. nonfarm payrolls report will be issued one day earlier than usual because of the July 4 holiday. Also on July 3, Canada and the U.S. will publish their respective trade numbers, and there will be a European Central Bank rate decision and press conference. As if that wasn’t enough data to make an investor’s head spin, the U.K. services purchasing managers index (PMI), an American jobless claims report, and the Institute of Supply Management’s non-manufacturing PMI are all due on the same date.

WEEK AHEAD

* EUR Eurozone Consumer Price Index

* CAD Gross Domestic Product

* CAD GDP

* AUD Reserve Bank of Australia Rate Decision

* USD ISM Manufacturing

* EUR European Central Bank Rate Decision

* USD Change in Non-farm Payrolls

* USD Unemployment Rate