What to look for in the week ahead
The Week Ahead updated March 19, 2010
• Greek denouement looms
• RBI hikes, more coming from others
• SNB pulls the rug out from under EUR/CHF
• March 24 UK budget will be critical in pre-election positioning
• CAD--To parity and beyond
• Key data and events to watch next week
Greek denouement looms
FX markets continue to fluctuate broadly in recent ranges, turning with every twist in the ongoing Greek drama. Risk saw higher in the beginning of the past week as EU leaders appeared to be in agreement on a plan to provide an aid package to Greece. Then the German government indicated it could not legally support such a plan and that Greece should seek aid from the IMF, sending EUR/USD and most other risk assets lower into the end of the week. Then on Friday, EU Commission President Barroso confused matters further by advocating a standby financial aid mechanism of coordinated bilateral loans from Euro-area countries. The immediate Greek drama may be entering the final act, though, as next week's EU summit is likely to see a definitive resolution one way or the other. If European leaders fail to reach an agreement, it will look very bad for Euro-area cohesion, exposing the fiscal vulnerabilities of other members now seen to be on their own, and likely see the Euro suffer as a result.
In the end, Greece will be bailed out, whether by the EU, the IMF, or some combination of the two, and we think the risk of a Greek debt default remains remote. Even though its last bond auction was well oversubscribed, Greece is facing unsustainably high borrowing rates and a package is needed to lower Greece's borrowing costs and give the austerity plan time to work, otherwise a high cost debt-spiral would ensue. Once an aid package is resolved, we would expect some of the tempest to subside and for the EUR to stabilize and potentially recover. Given that EUR/USD has moved back to the lower end of the recent range, we would prefer to be buyers of EUR/USD while its holds above the key 1.3430/50 level. A daily close below that level, however, would suggest that the market was not in agreement with us and we would have to reckon with weakness down to 1.3200/50 initially.
From the charts, this past week's price action mostly highlights downside potential ahead. Attempts to rally in EUR/USD, GBP/USD, XAU/USD and AUD/USD, all look to have been rejected, and the US dollar index has posted a weekly bullish engulfing line. But until the ranges break, fading the ranges (buying dips/selling rallies) still seems the most viable trading strategy.
RBI hikes, more coming from others
The Reserve Bank of India caught markets flat-footed on Friday with an inter-meeting rate hike of 1/4%, its first rate hike since July 2008, and the RBI indicated it would need to do more. The move itself was not unexpected, just the timing. But it should serve as a reminder that central banks globally are in the process of monetary tightening for those doing well (emerging markets mostly, maybe Canada--see below) or removal of extraordinary liquidity measures for those limping along (the G7). The PBOC, China's central bank is widely expected to raise again its required reserve ratio, further restricting credit in China and potentially undercutting the global recovery. The Fed is also expected to further normalize (raise) the discount rate again before its next meeting. In most cases, such moves should only lead to short-term setbacks for risk appetites, and these may be sharp at times. However, we generally prefer to use such dips as a buying opportunity on risk assets.
SNB pulls the rug out from under EUR/CHF
SNB board member Jean-Pierre Danthine shocked markets by suggesting that the Swiss need to be prepared for higher rates and an eventual exit from accommodative policies. The CHF strengthened sharply on indications that the SNB was stepping back from its efforts to rein in CHF strength, and EUR/CHF plunged to essentially the all time low around 1.4315/20. Danthine later tried to put the cork back in the bottle, saying that the SNB will continue to counter excessive FX gains, but the markets were too busy unloading EUR/CHF to hear. We think the risk of intervention remains and we would not be surprised to see the SNB in the market sometime early next week. The fundamental flows, however, favor the CHF, especially if there is an EU impasse on Greek aid, so we would prefer to be sellers on the approach to 1.4500 should the SNB step in. SNB Chairman Hildebrand will be speaking on Tuesday morning in St. Gallen and he may stir things up. For those who anticipate a positive resolution to the Greek situation or believe the SNB is not done yet, it may be worth trying small longs in EUR/CHF, but with a highly disciplined stop loss below at around 1.4270.
March 24 UK budget will be critical in pre-election positioning
The March 24 budget will provide the incumbent UK government with a make or break opportunity to lay out its stall ahead of the general election. The release of better than expected public finances data for February will have put a small spring back in the step of Chancellor Darling. With just one month to go until fiscal year end the February data suggest that Darling will be able to announce that public sector borrowing this year is likely to be between GBP5 bln and GBP 10 bln less than forecast.
In essence this appears to be good news, but it requires qualification. Firstly, the February numbers may be better than expected but they are a far cry from good data. In the fiscal year to February net borrowing stands at GBP 131.9 bln. At this stage last year the borrowing requirement was around half the size at GBP66.5 bln; meaning that public finances are very much still in a shockingly poor condition. Not only that but there is risk that Chancellor Darling will use the news that the borrowing requirement is set to come in under his (very high) GBP 177.6 bln target to announce some pre-election sweeteners on March 24. The huge UK budget deficit (around 12.9% of GDP) is already a nasty thorn in the side of sterling, additional spending would not be welcomed by investors.
The recent falls in the value of the pound vs the US dollar are correlated with the fear that the general election (expected on May 6) will provide a hung parliament. The optimal outcome from the election as far as the markets are concerned would be a clear majority for the Conservative party insofar as this is more likely to bring a quicker resolution to the worries surrounding the huge UK budget deficit. Recently, there were signs that the Conservative party's lead in the poll could again be increasing (albeit by probably not enough to win a clear majority) and this brought some support for the pound. Sterling also posted gains on the news that the February borrowing requirement data were better than expected. However, these gains proved to be short-lived. Further losses for the pound would be likely if the Labour party picks up more votes as the result of a pre-election giveaway at the March 24 budget. In the absence of clear evidence on March 24 that the incumbent government is committed to tackling the budget deficit cable could also see lower. The risks surrounding the pound suggest potential for a deeper decline. Below the GBP/USD1.4960/00 level may see towards USD1.4870.
CAD--To parity and beyond
Despite what has been a massive run-up of late, we maintain that the Canadian dollar still has considerable upside in the short/medium term. Rate hike expectations for the Bank of Canada (BOC) continue to increase, economic data in Canada remains robust and market positioning has yet to reach an extreme. These factors should help drive USD/CAD though parity and beyond.
Bank of Canada rate hike expectations continue to be nudged higher and the latest inflation report north of the border only increases the probability of a rate hike occurring sooner rather than later. Core consumer prices (excludes food and energy) jumped to an annual rate of 2.1% in February and this was well above the 1.7% run-rate expected. Remember that in their March statement, the Bank of Canada noted that core inflation had been slightly firmer than projected and the fact that it is now above their 2.0% target puts some pressure on the bank to potentially raise interest rates before their end of 2Q 2010 line in the sand. We will have to see just how much of this pricing power at the retail level was due to the winter Olympics, but regardless, the trend in inflation remains decidedly higher and could force the bank's hand. We may get an update from BOC Gov. Mark Carney next Wednesday (Mar. 24) when he delivers a speech and holds a press conference.
Canada also continues to outperform compared to the majority of the G-10 when it comes to economic growth. Not only have gross domestic product, international capital flows and housing starts come in better than expectations, but the all-important retail sales report (released just this week) blew away the consensus. Retail sales jumped 1.8% month/month in January and this was significantly better than the 0.5% market projection. The number in February is likely to be even stronger given the aforementioned impact from the winter games. This will continue to put Canada on better relative footing than most of the developed world and should continue to help attract capital to its shores.
Finally, while there has been much talk about the so-called overextended long position in the Canadian dollar, we must keep in mind that it is still well below the recent record. The non-commercial net position currently sits long 62,123 contracts and while this is quite elevated by historical standards, it remains nearly 30% below the 2007 highs when USD/CAD was making its 0.9058 low. In other words, there is plenty of room left to run here. Traders are now watching the 1.0050 level, where ostensibly a major option barrier lurks. Below there should see parity in no time.
While the Canadian dollar has the ability to rally on its own due to exceptional fundamentals, moves in other markets could help drive the move through the 1.00 level and beyond. In terms of what the CAD has been best correlated with since the beginning of the year, oil and stocks jump out. Loonie has moved in tandem with US equities 92% of the time in 2010 thus far and 85% of the time with oil. The relationships suggest that 1180 on the S&P 500 and/or $86 oil would translate to USD/CAD at parity.
Positive top-line 4Q earnings in the US coupled with massive amounts of flows out of money market funds suggests the upside in stocks remains in place. In terms of oil, the commodity is in what we would call a seasonal sweet spot. Looking back at the last 20 years, oil prices have rallied more than 10% on average from March through June - just in time for a Bank of Canada rate hike!
Key data and events to watch next week
The calendar lightens up in the United States in the week ahead. The under-the-radar Chicago Fed National Activity index kicks off the action on Monday. Existing home sales are due Tuesday while durable goods and new home sales are up on Wednesday. Initial jobless claims highlight Thursday while the final cut of 4Q gross domestic product and the University of Michigan sentiment index round out the week on Friday. Look out for a Bernanke testimony on Wednesday as well - these always have the potential to move markets.
It is also not very busy in the Eurozone. Consumer confidence starts off the week on Monday while French business confidence is due Tuesday. PMI indices, industrial new orders and the German IFO surveys are due Wednesday. French consumer spending is up Thursday while Friday has German consumer confidence due up. It will be a busy week in Brussels ahead of the EU summit on Thursday and Friday; expect a lot of headlines.
It is extremely light in the UK. Consumer prices are up on Tuesday, UK budget release on Wednesday, retail sales are due Thursday and business investment is scheduled for Friday.
Ditto for Japan. The BOJ meeting minutes kick things off on Monday, international trade is up on Tuesday while consumer prices are expected Thursday.
Canada is ultra-light, with leading indicators on Tuesday the only noteworthy release.
Don't look down under for much excitement either. Australia has leading indicators on Thursday while New Zealand sees gross domestic product on Wednesday and trade numbers on Thursday.