Dollar stays weak, but holds key levels
The financial media was all atwitter over USD weakness this past week, but the buck managed to hang on despite reports of its imminent demise. The greenback got off to a weak start after a less than supportive G7 statement retained the same language on FX as the April communiqué, rather than a more strongly worded vote of confidence. The dollar then took a beating on the back of a report by a prominent UK journalist that secret meetings between mid-East oil producers and Russia, Japan, and France, among others, were held to discuss pricing oil in a basket of currencies, including gold, and not in US dollars. Those reports were later denied by most of the countries mentioned, but the dollar continued to slide, while gold prices surged higher to new all time highs of around 1061/62. USD sentiment remains undeniably bearish, excessively so in our view, but it's important to note that the USD tested key support levels (EUR/USD key highs at 1.4850/70; USD/JPY 88.00; and US dollar index at 75.80/90) and ultimately held.
In USD/JPY, failure to press below 88.00 triggered a sharp rebound on Friday. But a sharp back-up of nearly 25 bps in US 10-year Treasury yields from 3.15% to 3.38% on Friday is the most proximate cause. US rates are higher on the back of a relatively weak 30-year bond auction on Thursday (weak demand leads to selling of Treasuries, sending yields higher) and hawkish comments from Fed Chair Bernanke on eventual US tightening. With those moves, US overnight rates are now back above Japanese rates, making the JPY the cheapest funding currency as of Friday. USD/JPY is now above its daily Tenkan line at 89.21, and just below key daily channel resistance at 90.00/10, with the Kijun line as the next major hurdle at 90.66. Around mid-week, there were rumors that Japanese officials had cautioned Japanese banks not to be short USD/JPY going into the weekend, so there may still be more fireworks to come there.
Overall, risk assets remains well supported, though we continue to favor a correction in coming weeks on rising concerns over the fragility of the recovery. At the moment, though, we have no concrete indications that such a reversal is imminent, and so we must reckon with the potential for further risk asset strength/USD weakness. We would also note the market's tendency to stage significant breakouts/reversals around US holidays, and we have the Columbus Day holiday coming up on Monday, so we will be on high alert for sharp moves to start next week. There's a lot of important data out next week (see below), but we would call your attention in particular to Wednesday's FOMC minutes release. There may have been a greater discussion of the need to eventually tighten before a recovery becomes fully entrenched, and if that materializes, US rates may be headed higher still. While our view remains that the Fed won't tighten until late 2010, markets are ripe for such chatter and could decide to pare back risk/cover USD shorts. Another scenario to watch is that JPY-crosses, now that the JPY is back as the cheapest funding vehicle, could resume their positive correlations to risk assets. If so, USD/JPY could move higher, while the USD remains weak against others, sending JPY-crosses higher too.
The answer to last week's riddle: When is a hat not a hat? When it becomes a woman.
The data in the US have been mixed of late and next week brings two vital reports that should elicit some volatility in both risk assets and the USD pairs. US retail sales are up on Wednesday and the market is looking for the headline to drop a steep -2.1% in September after a robust 2.7% jump the prior month.
Most of the decline is expected to come from a massive drop in auto sales as the hangover from the government cash for clunkers program hits. US unit auto sales dropped a massive -41% on the month and will weigh heavily on the headline retail print. Excluding the auto component, the market anticipates a modest 0.2% increase and when you strip out gasoline sales, consensus sits at 0.0%.
We see considerable downside risk to the headline number and are looking for a more aggressive -2.7% decline. For retail control - which excludes auto dealers, building materials and gasoline - we think the drop will be somewhere in the -0.2% ballpark. If the number prints more in line with our view, we would expect risk assets to trade lower and the USD to strengthen.
Consumer prices are also a major focus for traders next week and they are due on Thursday. September price increases are expected to remain rather benign and consensus expects a 0.2% monthly increase on the headline and an even more modest 0.1% add to the core number (excludes food and energy). Given that energy price increases at the consumer level were minimal, we expect a similar outcome on the headline.
The risk is that we get a more aggressive rebound in the annual inflation run-rate. The market forecast is -1.4% and we are looking for -1.3% (up from -1.5% the prior month). In terms of the core number, we are a touch above the market at 0.2% MoM and this takes our core annual rate to 1.5% from 1.4% - consensus looking for a steady annual rate. A higher than anticipated annual inflation rate could fuel speculation that the Fed will need to fend off inflation sooner rather than later and we could have the USD supported by higher bond yields which would likely follow.
That said, inflation is expected to remain rather modest in the months ahead and we are currently forecasting a steady climb to a 2.4% headline rate by the middle of next year. The core number is likely to see even more muted acceleration and we look for this metric to touch 2.1% by the end of 2Q 2010. In terms of how this impacts gold, our modest outlook on inflation short-term coupled with a significantly one-sided market to the long side - 15 long gold contracts for every short - support our short-term view for lower XAU/USD as well.
The market is expecting UK CPI to fall to 1.3% y/y in September. In the minutes of the September MPC meeting the committee described the CPI index as having remained 'stubbornly high over a number of months'. Not only this but the MPC also admitted that the probability of inflation falling below 1% in the coming months had declined since the August inflation Report and while it would probably fall again in September that thereafter it would rise sharply. This point was driven home by the release of stronger than expected Sept. UK PPI data. PPI output rose +0.5% m/m on the back of a rise in petroleum product prices. Unless the forthcoming CPI release surprises to the downside, it appears that there is a good chance of the BoE revising higher its estimates for inflation in next month's Inflation Report. That being so, the chances for a further increase in QE next month will be reduced suggesting that sterling may find some support going forward. That said, the outlook for the pound is still plagued by fiscal difficulties and the absence of economic growth. UK labor data is also due for release in the coming week, with the unemployment rate potentially set to hit 8%, the near-term outlook for sterling is likely to remain grim. Near-term, the uptrend in EUR/GBP remains in place. We remain buyers on dips for a possible move above 0.9300.
Germany's ZEW Oct investor confidence indicator is due for release in the coming week. Last month the index rose to a 3 year high but fell significantly short of consensus expectations possibility reflecting concern in the market that the rise in risk appetite may have become over-extended. The consensus expectation for the Oct survey stands at 58.8, a moderate improvement from 57.7 in Sept. In the wake of the weaker than expected German trade data for Aug and a host of recent remarks from Eurozone officials making clear their concern over the impact of EUR strength, the release of Aug Eurozone industrial production data will be of interest. The market is expecting a healthy 1.2% m/m rise in tune with a continued economic recovery in the region. Eurozone Sep CPI is expected to fall further to -0.3% y/y. These data will confirm expectations of no reverse in easy ECB policy for some time but are unlikely to impact the market. Following the Oct ECB policy meeting ECB President Trichet stressed the forecast that CPI will return to positive levels in the months ahead.