Range Conditions Persist, But a Break May Be Building
Another week sees another round trip between recent range highs and lows for the USD against many other major currencies. Since the beginning of December, EUR/USD has been effectively contained in a 1.30-1.35 range, with this week’s test below the range bottom having proved unsustainable. The euro’s subsequent rebound to above 1.3400 looks similarly unsustainable in the short-term, but a further upside test of recent range highs and above 1.3500 seems likely as long as European credit markets continue to mend.
We would note the regular monthly meeting of EU finance ministers next week has the potential to generate more positive news flow over the prospects for a permanent debt crisis resolution mechanism, potentially offering a fundamental catalyst to send the EUR higher (see more below). However, there is also potential for disappointment on this front and we would note comments from German Fin. Min. Schaeuble on Friday where he repeated Germany’s opposition to so-called euro-bonds, the most viable long-term resolution to the debt crisis.
For this reason, we would prefer to use EUR strength on a test and potential break of recent range highs as an opportunity to establish short EUR/USD positions in the 1.3450-1.3650 area for an expected medium-term decline. We still think additional bailouts will be required down the road and that sovereign debt restructuring (i.e. defaults) will ultimately come to pass for several of the peripheral countries.
Has Europe Turned a Corner?
The euro dominated action in the forex markets this week. But it was a week of two halves for the single currency: it started the week in sub-1.3000 region versus the dollar and ended up heading toward 1.3400, now the single currency is on course to have its best weekly performance in 2 years. The turning point was the success of Portugal’s long-term debt auction. The auction was oversubscribed and the Iberian nation paid yield of 6.7 per cent, crucially this was below the 7 per cent threshold that is considered the rate at which Portugal would need to apply for funds from the EU/ECB/IMF rescue fund.
Even though Portugal could borrow at a cheaper rate from the lending facility, for now it can still borrow in the market, which is helping to restore reputational risk. Indeed, 10-year yields on Portuguese government debt has fallen 35 basis points since reaching a peak last week, and for now a bailout is off the table.
While this softened investors’ attitudes in the credit market, the rally in the euro was sparked by two factors: firstly, news that the EU authorities are discussing credible long-term solutions to the sovereign debt crisis, and secondly the perceived hawkish tone to ECB President Trichet’s press conference on Thursday.
After failing to agree on a long-term resolution to the debt crisis that has gripped peripheral Europe since the end of 2009, reports that the EU would look at possibly extending the size of the European Financial Stability Fund (EFSF) and extend its scope so that it could directly buy foreign bonds along with reducing the interest rate for rescue funds cheered the market. This fuelled the rally in the euro.
It was given more gusto after ECB President Trichet was perceived as being hawkish during his monthly press conference. He noted that inflation had risen on the back of higher commodity prices and hinted that if it persisted it may warrant a rate rise. The market has rushed to re-evaluate its interest rate expectations for the ECB, and although a rate rise may not be imminent, it is too early to rule one out for the second half of 2011.
The widening differential in interest rate expectations between Europe and the US has fuelled EURUSD gains. As long as sovereign risk fears remain on the backburner and the ECB remains more likely to raise rates before the US, then EURUSD should be supported. If it can break above 1.3410, then we could see 1.3500, before the 1.42 November 2010 high comes back into view.
But there are some serious hurdles the market would have to clear first before we would be comfortable with EURUSD breaking back in the 1.40 territory. Firstly, EU officials need to come up with the goods and find a credible solution to the sovereign debt crisis. This will most likely require greater fiscal union between euro-area members, with a larger transfer of funds from the rich countries to the peripheral ones. This would hurt Germany as it is the largest economy in the eurozone.
Credit-default swaps on German bunds have been rising steadily higher in recent weeks as investors worry that Germany could get the rough end of the stick in any permanent resolution mechanism. This may make German officials reluctant to agree to expand the EFSF rescue fund, which would dent investor sentiment toward European assets in our view, as it would make a bailout of Portugal and Spain more likely.
Added to this, some large bond funds are still staying away from peripheral debt, and the ECB remains a large purchaser of this asset class. The markets are by no means robust, and a cocktail of German reluctance to extend funds for a rescue mechanism, weak economic data in the currency bloc and a less hawkish ECB/ less dovish Fed could spark a reversal in the single currency’s rally. So we are keeping in mind significant support levels for EURUSD including 1.2910 – recent lows, then 1.2650 – the low reached in August.
China’s Continued Tightening Is a Temporary Setback in Risk
The PBoC announced another hike to the reserve requirement ratio (RRR) today with the intent of managing liquidity and controlling the pace of bank lending. This is the fourth 50bps hike to the RRR in just over two months and will bring the rate for major banks to a record high of 19% when it takes effect next week on Jan. 20. Monthly new yuan loans data released on Tuesday came in at 480.7 billion yuan for December compared to expectations of 360 billion yuan which shows that lending remains at elevated levels.
With inflation above 5% and rising from the prior reading, the central bank is also faced with the task of cooling upwards price pressures. The PBoC last raised benchmark rates by 25bps in late December and is now likely to shift towards using reserve requirements as a primary tool to rein in liquidity with several more RRR hikes expected throughout 2011.
The continued tightening in China – the world’s second largest economy – has added to the “risk off” sentiment and resulted in a knee-jerk reaction of firmer greenback and softer AUD and NZD. Commodities were also hit following the announcement of further tightening measures. China has allowed its currency to strengthen slightly as President Hu Jintao prepares to meet with President Barack Obama in Washington next week.
Treasury Secretary Timothy Geithner was on the wires on Wednesday with his usual stance that China needs to strengthen the “substantially undervalued” yuan. We would expect the current decline in risk appetite to be a periodic setback and not to have a substantial impact on Chinese growth which was last reported at 9.6%. We would anticipate a rebound in sentiment coming from the tightening by the PBoC, although external factors (i.e. Europe) will remain a key driver of risk sentiment.
A Long and Winding Road to BoC Tightening
The Bank of Canada is set to release its interest rate decision on Tuesday, Jan. 18. With the target rate likely to remain unchanged at 1%, the market will home in on Wednesday’s release of the January Monetary Policy Report. In the October report, the BoC revised its 2012 year-end inflation outlook lower to 2% but highlighted upside risks from three principal factors: higher commodity prices, ‘a stronger-than-anticipated US recovery’, and the potential for ‘greater-than-expected momentum in the Canadian household sector’.
The first upside risk to the BoC’s revised inflation outlook has been fully realized as commodity prices have moved broadly higher since November (CRB Index is up about +10% since 11/1/10). The second risk, a ‘stronger-than-anticipated US recovery’, has also been set in motion and the BoC will likely note positive Canadian export growth on the back of improving US economic conditions.
However, the third upside inflation risk (‘greater-than-expected momentum in the Canadian household sector’) has not yet developed and will likely keep the BoC’s upcoming inflation outlook balanced. Household spending growth has been decelerating and signs of a rebound may be fleeting as household debt has been on the rise - household debt to disposable income was a record 148% in Q3 2010.
The discouraging uptrend in households’ debt to income ratios dampens upside inflation risks as well as the possibility for a rate hike any time soon. A premature hike would weigh especially heavy on debt saddled households and subsequently Canada’s growth prospects - household spending accounts for about 60% of aggregate demand.
We believe that price gains in commodities alongside a quickening pace of recovery in the US may see the BoC acknowledge upside inflation pressures in the upcoming January Monetary Policy Report. However, we think that BoC tightening is still much further down the road. Although domestic conditions are showing signs of improvement, worse than expected housing data (Dec. Housing Starts 171.5k versus expected 180k, Nov. Building Permits -11.2% versus expected +1.5%) and high debt to income ratios suggest a Canadian economy unable to absorb rate hikes in the near future, not to mention the risk for the US recovery to stall. BoC policy direction, however, is moving down the road to tightening - albeit a long and winding one.
Key Data and Events to Watch Next Week
- Monday: Fed's Plosser Speaks
- Tuesday: Jan. Empire Manufacturing, Nov. Total Net TIC Flows, Jan. NAHB Housing Market Index, Weekly ABC Consumer Confidence
- Wednesday: Dec. Housing Starts & Building Permits
- Thursday: Weekly Initial Jobless & Continuing Claims, Dec. Existing Home Sales, Dec. Leading Indicators, Jan. Philadelphia Fed, Weekly DOE U.S. Crude Oil Inventories
- Monday: EU Finance Ministers Meet in Brussels
- Tuesday: EU-27 Finance Ministers Meet in Brussels, German Jan. ZEW Survey, EU Jan. ZEW Survey
- Wednesday: Nov. Eurozone Current Account, EU Nov. Construction Output, ECB's Stark Speaks
- Thursday: German Producer Prices, Jan. Eurozone Consumer Confidence
- Friday: French Jan. Own-Company Production Outlook, French Jan. Business Confidence Indicator, German Jan. IFO
- Monday: Jan. Rightmove House Prices
- Tuesday: Dec. Nationwide Consumer Confidence, Dec. RICS House Price Balance, Nov. DCLG UK House Prices, Dec. CPI, Dec. Retail Price Index
- Wednesday: Dec. Claimant Count Rate & Jobless Claims Change
- Thursday: Jan. CBI Business Optimism, Jan. CBI Trends Total Orders
- Friday: Dec. Retail Sales
- Monday: Dec. Consumer Confidence
- Tuesday: Nov. Industrial Production, Nov. Capacity Utilization, Dec. Nationwide Dept. Sales, Dec. Tokyo Dept. Store Sales, Dec. Machine Tool Orders
- Wednesday: Nov. Tertiary Industry Index
- Thursday: Nov. Coincident & Leading Index
- Friday: Nov. All Industry Activity Index, Cabinet Office Monthly Economic Report
- Monday: Nov. Int'l Securities Transactions
- Tuesday: BoC Interest Rate Announcement
- Wednesday: Nov. Manufacturing Sales, BoC Publishes Monetary Policy Report
- Thursday: Dec. Leading Indicators, Nov. Wholesale Sales
- Friday: Nov. Retail Sales
Australia and New Zealand
- Monday: NZ Dec. REINZ Housing Price Index & Sales, NZ Dec. Food Prices, AU Dec. TD Securities Inflation
- Wednesday: AU Jan. Westpac Consumer Confidence, AU Jan. DEWR Skilled Vacancies
- Thursday: NZ Dec. Business PMI, NZ 4Q Consumer Prices, AU Jan. Consumer Inflation Expectation, NZ Jan. ANZ Consumer Confidence Index
- Friday: NZ Nov. Retail Sales, AU 4Q Import/Export price index
- Tuesday: Dec. Actual FDI
- Thursday: 4Q Real GDP, Dec. CPI, PPI, Industrial Production & Retail Sales, Dec. Fixed Assets Inv. Urban
- Friday: President Hu Jintao's State Visit to United States