Does QE2 doom the USD?
On its own, probably not. But it certainly doesn't help the beleaguered greenback, which is primarily suffering from the protracted weakness in the US economy contrasted with relative strength in other major economies, especially Asian regional and other emerging markets. The price action in recent weeks highlights our view that its relative growth prospects that are driving central bank policy expectations, which in turn are driving key currencies.
As one indication, the USD index at 76.55 is only slightly lower than the 76.70 level at the time of the Fed announcement, with EUR/USD similarly nearly unchanged. Yes, the USD weakened between the Fed's decision and Friday's NFP report, but that's the point: the USD recovered after Oct. jobs surprised to the upside, suggesting improving US growth prospects. GBP/USD is only about 100 points higher than pre-Fed levels, but this stems more from the surprising resilience in 3Q UK GDP reported 2 weeks ago, which led the BOE to refrain from its own QE2 this past week. AUD and NZD have similarly outperformed both the USD and other major currencies after surprising strength in NZ 3Q employment and an unexpected rate hike from the RBA, again due to strong growth prospects and limited spare capacity.
So we hesitate to conclude that QE2 in and of itself will lead to further USD weakness. More important will be the evolution of incoming US data, and to the extent it improves, the USD has the potential to stabilize. The better than expected Oct. jobs report, while far from cause for exuberance, does hold out the prospect for further improvement in consumer confidence, and with it US consumption.
Now that QE2 is out of the way, other major currencies are at risk of coming under the microscope, especially if incoming data begins to disappoint. In particular, we think EUR and GBP strength against the USD is especially vulnerable to data setbacks and the strong likelihood of slower growth in the months ahead.
EUR is also vulnerable to renewed peripheral stressors (see below). On the technical side, we would note a daily bearish engulfing candlestick in EUR/USD on Friday, potentially suggesting a reversal lower, and we would highlight the daily Ichimoku Tenkan and Kijun lines at 1.4008 and 1.3951 as a critical support zone that must hold for the EUR/USD to strengthen further.
The USD index also has long-term trendline support at 75.60/65 as another indicator of whether USD weakness is extending. GBP/USD has long-term trendline resistance at 1.6300/10, above which we would expect gains to extend. AUD, NZD, and CAD (to a lesser extent) seem most likely to continue to outperform (see below), not just against the USD, but also EUR, GBP and JPY. Should the USD recover more quickly than expected, rapid gains in Gold, Silver and crude oil are at risk of a sharp sell-off. We go into next week cautiously optimistic for a USD recovery overall.
G20 Summit not likely to resolve much
The G20 Summit in Seoul, South Korea is set for November 11 and 12 in the coming week and while there are many issues to be discussed, the likely outcome will be one of inaction. Current account limits, as proposed by U.S. Treasury Secretary Timothy Geithner in an attempt to rebalance the global economy, are expected to be debated at the summit. No resolution is anticipated as the two countries with the largest current account surpluses (China and Germany, respectively) have been vocal in rejecting the proposal.
German Finance Minister Wolfgang Schaeuble, like many others have criticized current account ceilings as well as the Fed’s policy decision to expand its balance sheet in another round of quantitative easing. While the Federal Reserve’s objectives are to promote a high level of employment and low, stable inflation (the dual mandate set by Congress), the dollar has weakened as a result of monetary policy actions. The depreciation of the dollar raises concerns among world leaders who agreed at the last meeting to refrain from “competitive devaluation” of currencies.
Leaders of emerging economies have also expressed concern as they are seeing strong capital inflows. At a time when protectionism is intensifying and tensions are high, the leaders of the G20 nations (which account for 85% of the global economy) are prepared to display a united front in sustaining the global economic recovery. Without any concrete resolutions, the impact on financial markets will be relatively muted. There is the risk of further US dollar weakness if markets conclude that the G-20 is giving the US a free pass to allow its currency to weaken. We will be watching for statements from Geithner or Pres. Obama in support of the USD to offset that risk.
BOE Inflation Report key to more QE
The Bank of England’s November meeting was the least eventful central bank meeting of the week. But it was a mere prelude to next week’s much more important Inflation Report. This will include the crucial BOE forecasts for inflation and growth for the next two years. This Report is loaded with extra significance since it is the last one before year-end and it comes at a critical time for the UK economy. From 2011 public spending cuts will start to be implemented and VAT is scheduled to rise in January. Interestingly, back in August when the BOE published its last report, its inflation forecast for 2013 was between 1-2 per cent, which suggested that the Bank thought there would be a deflationary trend in the UK. This would support the case for more quantitative easing in the coming months.
But growth surprised to the upside in the third quarter and commodity prices have risen – the oil price is up 20 per cent in the last three months. If future inflation expectations are revised up on Tuesday then the prospect of the BOE following the Fed and offering more policy support to the UK economy is drastically reduced. This could fuel a rally in the GBPUSD as we lead up to year-end, with 1.63 the first target leading to 1.65 - the 2009 high. However, after recent gains the main risk is that the BOE maintains its dovish outlook on inflation, potentially sending Sterling lower after testing long-term trend line resistance at 1.6300/10. We would also note BRC retail sales and industrial production as potential data catalysts to a weaker GBP, should they soften as expected.
Will sovereign risks return to haunt the euro?
Fears over the solvency of some of Europe’s troubled peripheral economies are coming to the fore as we head into the last stretch of the year. This was always going to be the case as governments got closer to having to pass tough budgets that could kill political careers.
Portugal’s government managed to pass its budget this week, but not without a fight from the opposition. This has taken the focus off the Iberian nation for now as Ireland and Greece take centre stage. Ireland is seemingly running into similar problems that Greece faced back in May: persistent selling pressure on its bond yields. Not even EUR6bn in spending cuts for 2011 was enough to placate investors. At the rate that its bond yields are rising, the Irish government must be wondering if it can make it to 7 December when it is scheduled to announce its 2011 budget without resorting to the IMF/ECB stabilization fund.
Likewise, elections in Greece this weekend will be pivotal. Any sign that the current socialist government is losing its grip on power may spook investors causing a second act in the Greek debt tragedy. Meanwhile, ECB President Jean-Claude Trichet is trying to stage-manage balancing the needs of the debt-ridden peripheral economies, with those of the fast-growing core. On Thursday’s meeting the ECB kept interest rates on hold at 1 per cent, and maintained its slightly hawkish bias. In the short-term, as long as the ECB keeps firm to its exit strategy and the Fed pumps the US economy with dollars then EURUSD is likely to continue to strengthen. However, we believe it will be difficult for the single currency to sustain gains above 1.45 – a level last reached in December 2009.
RBA surprise rate hike & New Zealand’s positive outlook
Earlier this week the RBA surprised the market with a 25bp hike in their cash rate which now stands at 4.75%. Initially economists were expecting this rise to come at their December meeting, however the RBA cited upside risks to the inflation outlook and decided to take pre-emptive action. (Our 4Q Market Outlook correctly called for the Nov. RBA hike.) Additionally, on Friday, the RBA released their quarterly statement in monetary policy where they mentioned that strength of the Aussie exchange rate “is playing a stabilizing role for the economy as a whole”, however if it appreciates too rapidly then “both growth and inflation would likely be lower than in the central scenario” – Central Scenario: GDP is expected to expand by 3.5% in 2010, and 3.75% in 2011 & 2012, while inflation is expected to remain around 2.5% until 1H of 2011 and gradually rise to 3.0% in 2012. Currently the market has priced in only one rate hike through 1H of 2011. However we believe the recent expansion of QE2 in the U.S. may lead to a further rise of commodity prices and therefore potential for higher inflation in Australia than currently anticipated. Under such a scenario the RBA would likely have to raise their cash rate to 5.25% (+50bps) by the end of 1H, which is currently greater than most economists expect.
Another currency we would like to highlight is the strengthening NZD. Earlier in the week New Zealand’s 3Q unemployment data came in much stronger than expected, with unemployment falling to 6.4% versus 6.9% in 2Q (consensus was looking for 6.7%). Additionally, Finance Minister English recently stated that interest rates are still at historically low levels and expects higher rates in the next year to 18 months. English went on to say that +3.0% GDP growth over the next year is achievable – current expectations are for 2.6% in 2011. With this in mind, we believe the current RBNZ cash rate of 3.0% may be raised significantly by the end of 1H 2011, perhaps to as high as 3.75%. Overall, we believe this warrants a “buy on dips” strategy for both the AUD and NZD vs. the USD, as well as the JPY – In AUD/USD 0.9850/950 and NZD/USD 0.7700/7800 zones may be attractive.
Key data and events to watch next week
Monday – Fed’s Bullard to speak to New York Analyst’s Society
Tuesday – October NFIB Small Business Optimism, November IBD/TIPP Economic Optimism, September Wholesale Inventories, November ABC Consumer Confidence
Wednesday – September Trade Balance, October Import Price Index, Initial Jobless Claims (Nov. 6), Continuing Claims (Oct. 30), DOE U.S. Oil Inventories (Nov. 5), October Monthly Budget Statement
Thursday – Fed’s Lockhart speaks on U.S. economic outlook in Atlanta
Friday – November U. of Michigan Consumer Confidence
Monday – November Sentix Consumer Confidence, Juncker speaks to European Parliament Committee, September German Current Account, September German Trade Balance, September German Industrial Production
Tuesday – October German Consumer Price Index
Wednesday – ECB’s Trichet speaks in Lyon, October German Wholesale Price Index, Germany’s Wiseman Release Annual Economic Review
Thursday – ECB’s Stark speaks in Berlin
Friday – 3Q Advance GDP, September Industrial Production, German 3Q Preliminary GDP
Tuesday – November BRC October Retail Sales Monitor, October RICS House Price Balance, September Trade Balance, September Industrial Production, September Manufacturing Production, October NIESR GDP Estimate
Wednesday – Bank of England Quarterly Inflation Report
Friday – October Nationwide Consumer Confidence
Sunday – October Official Reserve Assets
Monday – September Coincident Index & Leading Index, October Bank Lending Banks, September Current Account Total, September Trade Balance
Tuesday – October Bankruptcies, October Machine Tool Orders
Wednesday – October Consumer Confidence, September Machine Orders, October CGPI
Monday – October Housing Starts
Tuesday – September New Housing Price Index, Bank of Canada Governor Carney speaks in Geneva
Australia & New Zealand:
Monday – New Zealand October QV House Prices & October Credit Card Spending
Tuesday – Australian NAB Business Conditions & Confidence Surveys, Australian Westpac Consumer Confidence, New Zealand Reserve Bank Financial Stability Report, Bollard speaks at Select Committee on Financial Stability
Wednesday – Australian September Home Loans, New Zealand October Business PMI & October Food Prices
Thursday – Australian November Consumer Inflation Expectations, Australian October Unemployment Rate & Employment Change, New Zealand October REINZ Housing Price Index
Wednesday – October Trade Balance
Thursday – October Producer Price Index, October Consumer Price Index, October Retail Sales, October Industrial Production, October Urban Fixed Assets Investments
Friday – October Property Prices
Friday – G20 Summit in Seoul, Korea commences
Disclosure: No Positions