Highlights

  • Risk rally looks set to stall
  • Central banks likely to wait and see
  • How low can the yen go?

Risk rally looks set to stall

The rally in risky assets over the past several weeks has been well supported by better macro data along with an ample supply of liquidity and easy monetary policy from central banks (i.e. BoE QE, ECB 3-year LTRO's, BoJ inflation target and asset purchases, Fed low rate pledge and QE3 speculation, and PBoC RRR cuts). As a result, equities have advanced, the dollar has weakened, and high beta currencies have outperformed (NZD is up nearly +7.01% against the USD year-to-date). This past week risk was further supported heading into the ECB's second 3-yr LTRO operation in which the bank allotted €529.5B to 800 financial institutions. This was slightly higher than consensus and more than the December 3-yr LTRO which allotted €489B to 523 banks. With the operation complete the ECB is likely to keep policy on hold and take time to assess the impact of recent measures. Furthermore, German opposition to the recent liquidity measures are likely to be heeded - for now at least - as Chancellor Merkel and Bundesbank Chair Weidmann said that recent measures from the ECB must not be repeated.

Economic data continued to come in positive with an upwards revision to U.S. 4Q GDP which showed 3.0% growth, 4-year lows in U.S. weekly jobless claims and a February manufacturing PMI of 51.0 in China that indicates continued expansion. Fed Chairman Ben Bernanke acknowledged the improvement in recent data noting positive developments in the labor market and dampeni expectations of another round of quantitative easing. The response from the market on the reduced likelihood of QE3 resulted in profit taking in risky assets and a strengthening of the dollar. Taking into consideration the recent comments from Bernanke, next week's February employment report will be crucial to see if the pickup in the labor market can be sustained. With inflation relatively contained, QE3 prospects appear to hinge on the Fed's employment mandate.

As central banks are likely to keep monetary policy on hold and refrain from additional easing in the week ahead, we believe a short term correction in risk may be coming as traders book profits which could see further dollar strength and euro downside. We favor euro weakness over commodity currencies due to an inflated ECB balance sheet and as focus shifts back towards structural weakness in Eurozone economies. Furthermore, uncertainty with regards to Greek debt restructuring and mechanics of its bailout may elevate the market's aversion to risk. In this scenario safe havens would benefit, namely the US dollar as the Japanese yen has been weakened by the Bank of Japan's commitment to keep policy easy to combat deflation. Significant technical developments also favor the USD over the JPY with a move above the weekly ichimoku cloud in USD/JPY.

Central banks likely to wait and see

Major central banks are set to meet next week to announce monetary policy. The Reserve Bank of Australia (RBA) will be the first of the week on March 6 followed by the Reserve Bank of New Zealand (RBNZ) the next day. The Bank of England (BoE), European Central Bank (ECB) and Bank of Canada all meet on Thursday, March 8 to announce interest rates.

We expect the RBA to keep rates steady at 4.25% as conditions improve domestically and abroad. Australia's unemployment rate fell to 5.1% in Jan., retail sales climbed, and the trade surplus has expanded. In addition, Chinese data has been relatively positive which is supportive of both the Australian economy and the AUD. The RBNZ is also likely to remain on hold at 2.50% as it has over the past year. Inflation remains within the bank's 1-3% target band and the degree of uncertainty with regards to global conditions is likely to warrant further monitoring by the RBNZ. The Bank of Canada meeting on Thursday is likely to be a nonevent and we are looking for the policy rate to remain at 1.00%. Economic releases out of Canada have been on the positive side overall with today's GDP figures showing a monthly gain of +0.4% in December vs. expected +0.3%. Elevated oil prices and strength in U.S. economic activity has also helped to support Canada and the Loonie. As such we anticipate no change in policy from the BoC.

In Europe, the ECB and BoE will announce policy on Thursday. The extraordinary liquidity measures from the ECB will most likely result in the bank to pause and take time to assess the implications (see above). We will also monitor the ECB's weekly purchases to see if the bank returned from its hiatus to buy government bonds after having made no purchases in the prior two report weeks. It was said that the ECB was in the markets this week buying Portuguese bonds however Portuguese yields have risen sharply.

We anticipate no change in policy from the Bank of England as the debate within the BoE on the need for further QE appears to suggest that most members have adopted a neutral stance. Economic data out of the U.K. will be closely watched as this will dictate whether or not new purchases will be needed after the end of the current round. Industrial production has advanced and the recent manufacturing PMI showed continued expansion in February. If the data continues to surprise to the upside then we expect the BoE to downplay the need for further QE which is supportive of the GBP. On the other hand should economic conditions deteriorate, the perceived likelihood of QE increases which may weigh on the pound.

How low can the yen go?

Recent BoJ/MOF actions - implementation of a 1% inflation target, enlarged JGB purchase program & aggressive verbal intervention - have succeeded in broad-based yen weakness. Prospects of extended and easier monetary policy measures sent USD/JPY skyrocketing above the 81.00 figure. Yen losses against the US Dollar were further boosted this week by declining QE3 expectations stemming from the absence of any QE3 hint by Chairman Bernanke during his semi-annual testimony to the House Financial Services Panel. As a result, the UST yield curve sharply steepened with the 2s and 10s widening close to 6bp while the 30s jumped about 10bp higher. Historically, price direction in USD/JPY has been driven by interest rate differentials between the US & Japan. As things stand, JGB yields look to be going nowhere as Japan's economy remains mired in deflationary conditions - Japan Jan. core CPI fell -0.1% y/y & Tokyo Feb. core CPI fell -1.1% y/y - while UST yields have been bolstered by a 'pricing out' of QE suggesting USD/JPY may continue to advance in the week ahead.

On a more technical perspective, USD/JPY looks set to post its 1st close above the weekly Ichimoku cloud. A rather significant development considering it would constitute the first such close since 2005 which saw subsequent price gains of almost +12%. However, we would be remiss to ignore potential risks to further USD/JPY gains. The first being simply a matter of overextended positioning as both retail, real money, and macro names have loaded on short yen positions on the back of expected BoJ policy direction. This is similar to price action seen in EUR/USD as of late which saw the single currency collapse this after heavily skewed shorts were rebalanced via the squeeze higher in prior weeks. Another potential risk to further yen weakness may come from a narrowing current account (CA) surplus. Earlier this month, Japan reported its largest decline to its balance of payments in decades - CA surplus fell -43.9% on the year. USD/JPY immediately shed one big figure. Considering the vulnerable state of the global economy, further declines in Japanese exports cannot be dismissed as external demand is certainly feeling the impact of deteriorating growth conditions.

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Eric Viloria, CMT | Senior Currency Strategist | FOREX.com

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The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warranty that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.

Foreign Exchange and other leveraged products involves significant risk of loss and is not suitable for all investors. Increasing leverage increases risk. Spot Gold and Silver contracts are not subject to regulation under the U.S. Commodity Exchange Act. Contracts for Difference (CFDs) are not available for US residents. Before deciding to trade forex, you should carefully consider your financial objectives, level of experience and risk appetite. Any opinions, news, research, analyses, prices or other information contained herein is intended as general information about the subject matter covered and is provided with the understanding that FOREX.com is not rendering investment, legal, or tax advice. You should consult with appropriate counsel or other advisors on all investment, legal, or tax matters. FOREX.com is regulated by the Commodity Futures Trading Commission (CFTC) in the US, by the Financial Services Authority (FSA) in the UK, the Australian Securities and Investment Commission (ASIC) in Australia, and the Financial Services Agency (FSA) in Japan.