By Dean Popplewell
The forex market requires a diverging interest rate policy amongst G7 economies for "sustainable" volatility. In 2014, geopolitical risk has been regionally contained and risk-on or -off trading strategies have been orderly executed, no matter if it has been Russia/Ukraine, Gaza, Syria or Iraq influenced. Various individuals will argue that the Fed's zero-interest rate policy (ZIRP) model (followed by Japan and most likely soon to be Europe) is creating a "moral hazard" environment, encouraging the formation of asset bubbles that will eventually burst and lead to a deeper economic mess. These symptoms are reason enough to want to fully comprehend central banks' rate thinking.
This week, investors will hopefully gain further insight to understanding the current mindset of policy makers from various inflation reports, central bank minutes and from Ms. Yellen's attendance at Jackson Hole Economic Symposium. To date, the BoE has been hotly tipped to be the first of the developed central banks to hike rates. Up until last week the market had been pricing in a UK November hike. However, the BoE's Governor Carney has been able to throw cold water on that idea, citing excess capacity in the labor and wage department. Tomorrow's UK MPC minutes should be able to shed some light whether any BoE "hawks" have split from the consensus and voted for monetary tightening. Nevertheless, it's today's surprising UK inflation data that is pressurizing the pound's current advances.
Carney can afford to wait
It was not a surprise; UK inflation was expected to fall in July, but not by this much. It cooled more than expected (-0.3% vs. a -0.2% drop) and has now eased pressure on the BoE for an early rise in interest rates. The annual rate of inflation fell to +1.6% in July from +1.9% a month earlier, and takes the annual rate of inflation well below Governor Carney's +2% target. Subdued inflation has been a global central bank phenomenon, and despite strong UK economic growth, the BoE will not feel pressured to act. Dealers and investors should now feel more comfortable pricing in a UK hike for Q1, finally eliminating anything happening this year.
GBP/USD (£1.6650) has managed to fall to a fresh four-month low, basically giving back all of the Carney hawkish comments over last weekend. Sterling's fall from grace this morning is also managing to support the EUR indirectly on the cross (€0.8023). Technically, this morning's sharp drop highlights the underlying bearish structure of the market, through £1.6640 with conviction gives way to another big "fig" below. A plethora of resistance levels now come into play topside - the sterling bear should be expecting more GBP offers to appear around the psychological £1.6700 handle.
The market will now shift its focus to tomorrow's MPC minutes for the BoE's August 6th meeting. Will any of the nine members have jumped ship and called for a rate hike? Before last week's Quarterly Inflation Report (QIR), the market was probably looking for one dissenting member. The dovish report - highlighting the lack of wage growth and slashing of 2014 growth forecasts - has probably changed investors' mindsets. The QIR has lessened the chance of a split, and the consensus is for a 9-0 reading.
EUR bear seeks support
Euro equity markets have so far extended the gains seen in yesterday's Wall Street session (again led by the DAX, which is highly sensitive to Ukraine affairs) amid lack of significant news flow out of Russia/Ukraine. Despite the situation remaining highly delicate, easing of tension is allowing for some risk trading. Nevertheless, the single unit's opening maneuver this morning is a fresh test of its current €1.3330-40 range.
There has been no new "real" news to drive the EUR lower, nor a material shift in risk appetite or a change in the bund/Treasury spreads. All of these reasons should clearly support the EUR bears' position. If the EUR/USD is unable to rally on risk then the "long" positions have a problem. Currently, the outright EUR positions are being indirectly supported by weaker cross currencies - EUR/GBP (€0.8019). EUR stop losses are beginning to pile south of the recent 2014 low (€1.3333). The EUR's inability to climb does make these positions more vulnerable. The technicals require a sub €1.3333 close to support the EUR bears' current endeavor and opens up a new handle below. Nevertheless, with option barriers dotted about, there will be a reluctance from investors to trade ahead of Jackson Hole or today's US inflation report with conviction.
Aussie "carry" trade has support
Investors involved in the AUD "carry' trade, particularly those financed in EURs, found some support from the RBA last night. Governor Stevens indicated no change to their view that interest rates were likely to remain "on hold" for some time. The RBA minutes indicated that despite the uncertainty in economic outlook, "steady rates remained the most prudent course." Dealers have been pricing in a +50% chance that the next move in interest rates will be down in H1 2015. Similar to other central bankers, "greater labor market slack and the reassessment to balance of risks to the wage/inflation outlook" will underpin the RBA's rate policy normalization policy. Higher unemployment and weak commodity prices may indicate that the Aussie economy has been contracting, hence the potential need for a pricing ease.