US dollar rally fizzles; ranges hold for now, but a break may be building
The past week began with the greenback testing higher, only to fail and reverse course by the end of the week. The proximate cause for the reversal came following news that a pair of Iranian warships would transit the Suez Canal en route to Syria, a move which Israel labeled a ‘provocation,’ suggesting it might respond in some fashion. Geopolitical tensions ratcheted higher, and the JPY, CHF, gold and oil all registered sharp gains as investors sought havens.
The USD failed to attract any safe have demand, presumably on fears that any confrontation between Israel and Iran would then draw the US into the conflict. However, we think those concerns are overblown and will eventually recede. Still, the USD reversal has done some technical damage, and with a potential US government shutdown looming when the temporary budget expires on March 3, there are plenty of reasons to shun the USD.
Another way of looking at it, and one that ignores the geo-political themes we find suspect, is that the USD simply tested key technical resistance levels at recent range highs and failed. In EUR/USD, the key 1.3450/3500 support zone we highlighted last week was tested, but ultimately held on a daily closing basis. Reports of reserve managers buying in that area also surfaced. In USD/JPY, the 84.00/50 recent high was also approached and has capped gains for the time being. Similarly, GBP/USD, USD/CHF, AUD/USD all tested range boundaries and have all reverted back into the ranges.
On the USD index, though, we see signs of a potentially more ominous USD development. The US dollar index closed last week inside the Ichimoku cloud, but ultimately was rejected from the Kijun line and has fallen back out of the cloud to finish this past week. Also, since the beginning of February, the US dollar index formed a likely bear flag consolidation. dollar weakness at the end of this past week broke below the base of the flag, suggesting a new leg lower in the buck may be unfolding. A daily close below 77.50 February 9 lows would suggest further weakness.
A similar pattern appears in EUR/USD, with the flag top at about 1.3720/25, just below recent 1.3745/50 highs. A break above that 1.3725/50 level would signal to us a potentially much larger USD decline and EUR/USD gains well beyond the 1.3860/70 highs for the year. There are certainly enough eurozone issues to restrain further gains in the single currency, but we would conclude they are being ignored or papered over on a daily close above 1.3750. Finally, we would highlight the US holiday on Monday (President’s Day) and the tendency for breakouts to occur around US-only holidays.
Mixed messages from the Bank of England
Last week's Inflation Report was expected to give the markets a steer on how close the Bank of England is to raising interest rates. However, although inflation expectations for the next two years were revised up, the Bank revised down its growth profile. This reinforces the difficult path for monetary policy over the coming months: inflation could rise to 5 per cent this year, while the most likely outcome for growth is a fairly tepid 1.5-2 per cent, and the Bank hasn't ruled out a return to recession. Bank governor Mervyn King dampened expectations for a rate hike when he said that some people were running ahead of themselves and the Bank wasn't "pre-announcing or laying the ground for a rate rise." This caused a sell-off in sterling and UK Gilts. However, once the dust had settled, sterling closed around the 1.6050 mark versus the dollar and gilt yields had only come off moderately by the end of Wednesday.
While King, who has voted to keep rates on hold, sounded dovish when he presented the Inflation Report, it is worth remembering that he is only one member and if the majority of the MPC want to hike then rates will rise. King did highlight the wide range of views on the Committee and this was in force the day after the Inflation Report when arch-hawk Andrew Sentance said that rates need to rise to stop inflation from taking hold. This sent GBPUSD soaring 100 points. But it is worth remembering that Sentance will be leaving the MPC in May. We don't know who his replacement will be yet, but if they don't share his views then the Bank will lose its most hawkish element. We will get an update on the range of views at the MPC in the minutes from the February meeting on Wednesday.
As we close the week the market is still looking for more than 50 basis points of rate hikes by the Bank by year-end. So, although the prospect of a rate hike in the next couple of months is looking less likely post the Report, the rate curve (based on short-sterling interest rate futures) is still steep for the second half of the year. Above 1.6000 the pound is still in a technical uptrend, but the outlook for sterling is extremely volatile. Austerity cuts don't start with gusto until April this year, so we won't know until late summer what the initial impact on growth will be.
But, worryingly, there are signs that the labor market is already deteriorating and the number of people claiming jobless benefit rose unexpectedly in January. This highlights the deeply uncertain outlook for UK growth as the UK embarks on a massive fiscal retrenchment, and in the coming months there is a risk that the market will reassess its expectations of any rate hikes at all for this year.
Emerging market outflows here to stay?
Capital outflows from emerging market to developed economies continued this week driven by inflationary concerns, fears of growth impacts from EM policy tightening, and improving growth outlooks in developed economies. However, of more significance than the why is the when - are these flow shifts the underpinnings of a larger scale rotation or merely a temporary correction? Improving activity in the U.S. (February Philli Fed registered 35.9 vs. expected 21.0) and eurozone (January F PMI Manufacturing printed 57.3 vs. expected 56.9) seem to support the prior but uncertainty concerning the U.S. labor market outlook (Initial Jobless Claims 2.12 was 410k vs. expected 400k) and eurozone periphery are supportive of the latter. Further supporting the latter has been the commodity market reaction to EM outflows.
Commodities have traded broadly higher - silver hit record nominal highs around 32.88 on Friday - which contrasts from the expected reaction for lower commodities as result of weakening EM demand. We think that the recent correction in EM-DM flows is just that – a correction and that resilient growth despite capital controls may see EM equities and inflows return to trend. Ultimately, this would be a positive for commodities and related currencies (AUD, CAD, and NZD).
Scandies surge, Norges Bank indicates higher rates
The Scandinavian currencies have been exceptional performers of late with the Swedish krona as the top performer of the G10 currencies. It has experienced a year-to-date gain of 4.24% against the U.S. dollar. The Norwegian krone, or “Nocky” as it is sometimes referred to, has also seen strong gains reaching highs against the greenback which have not been seen since January of 2010. This is largely due to higher rate expectations and relatively strong GDP growth. Additionally, Norway boasts Europe’s lowest unemployment.
The Norges Bank was the first in Europe to raise rates following the financial crisis and noted that it will increase rates again in mid-2011. Rates have been on hold at 2% since May as inflation has stayed below the 2.5% target. The pause in rates has also been attributed European austerity concerns and the potential negative impact on Norway’s exports. Exports fell 1.3% last year while the krone gained.
Newly appointed Governor Oeystein Olsen, who took office last month after the departure of Svein Gjedrem, delivered his first annual address yesterday and said that “we don’t want to take responsibility for the currency level nor the overall competitiveness of the manufacturing industry”. He went on to say, “at Norges Bank we have no specific view on any equilibrium target or views on a specific level for the exchange rate.” The central bank provided guidance through the end of 2014 and expects its benchmark rate to average 2.25% this year and 3.25% next year. This indicates an expected 25bps hike each quarter from June 2011 until the end of 2014. The policy board will meet on March 16 to discuss interest rates publish its monetary policy report which will contain an updated interest rate path.
Technically, USD/NOK has broken below key support just below the 5.7000 level and sees the 2010 lows of around 5.56000 ahead of the 2009 lows of about 5.5100 as the next significant levels of support. Key resistance may be found around 5.7800 where the daily Tenkan and Kijun lines converge. The 21-week sma, currently around 5.8730, looks to have capped the upside over the past several weeks.
Key data and events to watch next week
- Tuesday – December S&P/CaseShiller Home Price Index, February Consumer Confidence, February Richmond Fed Manufacturing Index, Fed's Kocherlakota Speaks
- Wednesday – January Existing Home Sales, Fed's Hoenig & Plosser Speak
- Thursday – Fed's Bullard Speaks, January Chicago Fed Nat Activity Index, Weekly Initial Jobless & Continuing Claims, January Durable Goods Orders, January New Home Sales, Weekly DOE U.S. Crude Oil Inventories
- Friday – 4Q second GDP & PCE, February Univ. of Michigan Confidence, Fed's Yellen Speaks
- Monday – EZ February preliminary PMI Composite, Manufacturing & Services
- Tuesday – German Mar. Consumer Confidence
- Wednesday – French January CPI, EZ December Industrial New Orders, German Committee Discusses Euro Crisis, ECB's Trichet & Quaden Speak
- Thursday – German final 4Q GDP, EZ February Confidence Indicators, German Finance Minister Schaeuble Speaks
- Friday – German February preliminary CPI, ECB's Constancio Speaks
- Monday – February Rightmove House Prices
- Tuesday – January Public Finances
- Wednesday – BoE February Meeting Minutes, January BBA Loans for House Purchase
- Thursday – February CBI Reported Sales
- Friday – February GfK Consumer Confidence, 4Q GDP, BOE's Bean Speaks
- Monday – Monthly Economic Report, December All Industry Activity Index
- Wednesday – January Corporate Service Price Index, January Merchandise Trade Balance, February Small Business Confidence
- Friday – February Tokyo CPI, January National CPI
- Tuesday – December Retail Sales
Australia & New Zealand:
- Monday – NZ January Performance Services Index, NZ January Credit Card Spending
- Tuesday – NZ Q1 RBNZ 2yr Inflation Expectation,
- Wednesday – RBA's Stevens Speaks, NZ Finance Minister English Speaks, AU 4Q Construction Work Done & Wage Cost Index
- Thursday – AU December Conference Board Leading Index, AU 4Q Private Capital Expenditure, AU Nov. Average Weekly Wages
- Friday – February MNI Business Condition Survey