- After the G7, where for the EUR and USD?
- A Different path for Asian currencies (JPY)
- Risk aversion returns, but not yet extreme
Please note: This report has been prepared before the G7 communiqu is released on Friday evening. I will provide an update on Saturday that will be available via our website and trading platform.
After the G7, where for the EUR and USD?
The G7 meeting appears increasingly likely to retain prior language on currencies: We reaffirm that exchange rates should reflect economic fundamentals. Excess volatility and disorderly movements in exchange rates are undesirable for economic growth. We continue to monitor exchange markets closely, and cooperate as appropriate.
Should the FX language stay the same it suggests that the US remains opposed to any coordinated official action to stem the USDs slide. Other G7 members, most notably European officials, have made a full court press for the G7 to speak up on what they view as excessive Euro strength, with EU Fin. Min. chief Juncker having had a private 80-minute chat with US Pres. Bush on the matter, but seemingly to no avail. The typical market reaction to no change in the G7 statement would normally be for a return to pre-existing trends and themes, which effectively means a return to USD-selling. There is even likely to be a speculative backlash, as short-term funds smell blood and decide to go after the greenback with a vengeance. Certainly, the fundamental trends favor additional USD selling, with consumer sentiment hitting 25-year lows according to the preliminary April Univ. of Michigan sentiment, the latest in long string of weak US data. And the US outlook shows little sign of improving in the foreseeable future.
But there are likely to be important shifts in the USD path lower. To begin with, EU officials have effectively thrown down a gauntlet to the market with their most vocal criticism of EUR strength to date. European officials have variously called the Euro overvalued, its gains excessive and brutal, and noted its negative impact on Eurozone exports. At the same time, US fundamentals have deteriorated rapidly, and look set to weaken further in the near-term, necessitating aggressive Fed interest rate cuts with more still to come. Eurozone data, both growth and inflation, continue to point to steady interest rates from the ECB. The gist here is that the Euro has a formidable tailwind that will not soon be altered by economic fundamentals, leaving only official action as the only viable option. The escalated European criticism of Euro strength amounts to an implicit threat of intervention by EU central banks. Looking at the post-G7 reaction, its easy to imagine that FX traders will first try the Euros upside, and this sets up a showdown between the market and Eurozone rhetoric.
Looking at concrete levels in EUR/USD, the series of tops at 1.5900/20 area represent a tempting trend continuation pattern/breakout level from which to attack 1.6000 and higher. Above 1.6000, though, and the prospect of Eurozone intervention increases substantially. If the G7 statement on FX is unchanged, I would reckon with a successful test of recent highs, ultimately leading to a break above 1.6000, with follow-through potential to the 1.6200/50 area initially. From there, however, I would not recommend staying long EUR/USD due to the risks of intervention. At the same time, I would not go the other way (short) in anticipation of intervention, but instead look to get short if/when intervention does occur. Traders run tremendous risks if they hold positions based on intervention materializing.
A Different path for Asian currencies (JPY)
For the JPY, the outlook is slightly different and this stems from the G7/IMF concern over global imbalances and the need for countries with large current account/trade surpluses, mostly Asian nations, to allow their currencies to appreciate more rapidly. China is the most obvious target in this regard, but other Asian economies are under similar pressure. Asian regional growth remains the strongest in the world, adding fundamental support to currency appreciation. The JPY would normally be under competitive pressure to appreciate as a result, but Japan is currently experiencing no/slow growth, and Japanese officials are concerned by the speed of the JPYs rise. Stepping back and looking at the currency adjustments that have occurred over the last few years, the USD has clearly weakened, but largely at the expense of European/Western currencies. The Chinese Yuan has actually strengthened against the Euro, and EUR/JPY is only about 5% below its peak last year.
As such, Asian currencies are likely to come under even greater pressure to realign (appreciate), and despite MOF (Japans Ministry of Finance) misgivings, the JPY will be part of that process. This view argues for a lower USD/JPY and additional downside potential in JPY-crosses (EUR/JPY, AUD/JPY, GBP/JPY, CAD/JPY and NZD/JPY). I look for USD/JPY to remain heavy while below 102.50/103.00 and for an eventual drop below the 98.50 level, which will set up a test of the key 95.00 level. The theme of JPY strength is also supported by what I perceive as yet another wave of risk aversion currently washing over financial markets.
Risk aversion returns, but not yet extreme
Over the past few weeks, investor sentiment recovered and stocks and carry trades (risky assets) rebounded as well. In last weeks report, I suggested that risk appetites were about to falter as economic reality set in and stocks and carry trades have moved lower since. Still, risky assets are nowhere near recent lows, suggesting more than ample room for additional weakness in the near future. On top of the G7/global imbalance themes, economic fundamentals and financial market trajectories are also pointing to accelerated Asian currency appreciation. If there was any doubt that the sub-prime fallout would not remain confined to Wall Street, it was eliminated on Friday by weaker earnings reports from GE and the plunge in US consumer sentiment. Main Street (the US consumer) is now experiencing the spillover from the housing meltdown and credit crunch, but while Wall Street is likely more than half way through its ordeal, Main Street is only beginning to feel the pain now. I think we are looking at an ugly spiral lower where US consumers increasingly withdraw, hurting corporate earnings in a broader swath of the economy, leading to increasing unemployment, further limiting private consumption, and so on. As long as we are faced with high and rising energy prices, falling home values, increasing unemployment and reduced credit, this cycle looks set to continue.
The coming week will see 1Q earning reports begin in earnest and while there will undoubtedly be some positive surprisesexpectations have been cut sharply, after allthe bulk of earnings are likely to be on the weaker side. Of particular interest will be earning reports from leading US banks over the next two weeks. I continue to expect additional write downs and losses from the banking sector and this will shake the confidence of even the most ardent bargain hunters. Incoming weak US data (retail sales and housing reports are key next week) will additionally cause optimists to abandon the worst is over thinking and come to the belated realization that we are looking at a deeper and more protracted US contraction.
In currencies, a return to risk aversion suggests additional downside for JPY-crosses (carry trades) and I remain a seller of them on strength. If the news is as bad as I fear, the USD may actually fare reasonably well, gaining sporadically against non-JPY currencies as JPY-cross selling overwhelms poor US datas effects on the USD. EUR/JPY below 158.00 is likely to be the harbinger of a sharper unwinding of JPY-crosses.
Disclaimer: 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. 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. 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.