Key currencies largely consolidated this past week, with the commodity currencies (AUD & CAD) generally outperforming, the EUR trading heavy across the board, and the USD index mostly unchanged on the week. Stock markets similarly held to rather narrow ranges, while commodities saw some upside gains, but remained within the prior week's range. Most JPY-crosses recouped some of the prior week's sharp losses but generally remain lower.
While most of the financial media was focused on the Greece/EU drama (more below), we think the real story remains one of faltering global recovery prospects. On Friday, just before the start of the weeklong Lunar New Year holidays, China raised its bank reserve requirement ratio (RRR) another 1/2% as it seeks to limit red hot bank lending. (China's banks lent nearly 20% of the total annual lending target in January alone.) Further RRR increases are expected in the months ahead, but the aim is clear--to let the air out of a potentially massive real estate/ production capacity bubble before it bursts on its own. The implication for the global recovery outlook is clearly for lower commodity demand and another reduction in growth expectations. Along these lines, Eurozone 4Q GDP was extremely disappointing (+0.1% vs. exp. +0.3% and prior 0.4%; German 4Q GDP flat after prior +0.7%), while Bundesbank Pres. Weber held out the prospect of negative 1Q German GDP. In the US, next week will see key housing data, potentially providing another source of concern to recovery efforts. In short, just as central banks are laying the groundwork for withdrawing monetary accommodation, key economies are showing signs of slipping back. With stimulus efforts globally winding down (the exception being the US until mid-2010), we think the risks remain biased toward a further pullback in risk appetites, likely leading to lower stocks, commodity prices and another bout of weakness in carry trades (lower JPY-crosses). In FX, we are watching the recent range lows as the trigger to further declines after the past week of mostly consolidative price action.
EUR remains under extreme pressure
EU leaders attempted to put a safety net under the EUR with a pledge to support Greek efforts to reduce its budget deficit, but they stopped short of committing real money to the solution, leaving the EUR twisting in the wind. EU Finance ministers will meet on Monday and Tuesday next week and are expected to unveil a more concrete proposal to restore confidence to Greek budget consolidation. However, unless a real money commitment is made, which we think is politically implausible at the moment, we think markets will be disappointed yet again and the EUR will pay the price. Our preferred scenario is that the ministers announce a program of intense monitoring and benchmarking of Greek reform efforts, likely under the technical auspices of the IMF, with a pledge to review the subject in late March, just before Greece needs to access the bond market to replace government debt maturing in April.
In EUR/USD, we and the rest of the market are focused on the pivotal psychological level of 1.3500 down through 1.3450 as the next trigger to further declines. The 1.3750/3850 remains a sell zone, barring any concrete cash pledges from Eurozone finance ministers. The past week's price action broke down out of a bear flag consolidation targeting minimum weakness down to the 1.3250/1.3300 area.
Greece in the headlines
An Emnid poll conducted for a German TV station has suggested that 71% of German tax payers are against providing additional financial help for Greece. Insofar as taxes are habitually not collected in Greece, the perception that Greece could be free-riding by drawing increased subsidies from the EU rather than embarking on a difficult process of budgetary reform has toughened the attitude of the electorate in other parts of Europe. This has complicated the task of EU officials in trying to find a solution for the Greek crisis. What is agreed is that structural reform will have to take place in Greece. This will be hard and will probably entail a reduction in the wages and numbers of public sector workers. In order to increase the incentive for Greece to follow through with its commitment to reform, the EU is likely to follow the form of the IMF and lay down a process in which progress in achieving reform will be rewarded. The reward may be a commitment to support Greek sovereign debt though this will have to be within the current EU laws.
The cracks in EMU which have been uncovered by Greece's fiscal crisis harp back to the issue as to whether a monetary union is sustainable in the long-run without stronger harmonization over fiscal policies or failing that an undying will to maintain transfer payments to countries in need. EU financial ministers should take steps to impose controls over fiscal policies to avoid another 'Greek' issue after the next recession. However, insofar as bringing fiscal policies more closely in line begins to questions the sovereignty of member nations, this has been an issue which EU countries have been sidestepping for decades. Until EMU finance ministers can prove that deficit issues are under control, the EUR is likely to maintain its downward adjustment vs. the USD.
The pulse of US housing and the buck
The US housing market will continue to be scrutinized in the upcoming week with the release of some critical data. The National Association of Home Builders (NAHB) will release their industry survey on Tuesday and the details of the report will be important in terms of assessing the prospects of this space. The January report showed a surprising dip in homebuyer traffic to 12 from 13 prior, and the weakest since the 9 print back in March of 2009 (when the US equity markets were plumbing the depths). This is the critical component to watch and another dip down should be cause for concern.
The January drop was somewhat attributed to the effect of the late November expiration of the initial first-time homebuyer tax credit (the hangover if you will). Next week's survey, however, should not have any of those statistical quirks and thus will provide a clearer picture. The government has since extended the homebuyer tax credit through the middle of 2010 and this should theoretically elicit somewhat of a drift higher in the housing data - making a decline ever the more worrisome. Housing starts and building permits are also due up and the latter is the more pertinent data point. Permits activity tends to lead actual building by about six months and thus any increase here will be construed as a net positive for the industry outlook, even if the starts number slips.
The housing data will be extremely important over the next few weeks because of its potential impact on Fed policy. The Fed has clearly begun to withdraw some of the stimulus by canceling many of the ad-hoc liquidity programs this month and is expected to complete its $1.25 trillion MBS (mortgage-backed securities) purchases by the end of March. How the data come in will dictate whether they do indeed exit the program on time. The withdrawal of liquidity is de-facto tightening of policy and thus should elicit a steady increase in US rates. Given the problems across the pond, higher US rates should work in the favor of the US dollar by attracting more capital from abroad. So while better housing data would be directly dollar positive from a growth standpoint, it would also have serious implications for Fed policy going forward which will in turn have a discernable effect on the buck. In other words, watch this space!
Sterling should be prepared for strong CPI
The market is expecting UK January CPI to surge to 3.5% y/y. This is way above the BoE's 2% target and will require Governor King to write a letter of explanation to the government. However, this data should not impact interest rate expectations. In presenting this month's Quarterly Inflation Report, King reiterated that this rise will be short-lived and is a function of last year's temporary VAT reduction and the autumn surge in oil prices. The BoE maintains that inflation will have fallen below its 2% target within its forecast period. This suggests that if anything there will be no rate hike until at least Q3 and possibility later. Given the dovish Inflation Report, the minutes of the forthcoming Feb MPC meeting will be examined for any sign that the BoE may be prepared to re-open the door to QE. While inflation data should not have much market follow through, PSNCR and labour data may. Labour data have recently been better than expected. Any further positive surprises will lift sentiment in the pound. That said there is little scope for good news from the PSNCR data. While some commentators have been playing down the negative implications of a hung parliament in the UK, any further opinion polls suggesting that the opposition Tory party is losing its majority is unlikely to be welcomed by sterling. The GBP/USD1.5540 channel base remains a key technical level for cable and break below could see a fall to USD1.5270 initially. Given the EUR's woes, sterling is likely to fare better vs. the EUR. Last week's failure by EUR/GBP to move above the 200 day sma at 0.8830 points to further weakness, suggesting corrective bounces could provide good EUR selling opportunities.
Key data and events to watch next week
The US calendar remains busy in the week ahead with some top-tier data on tap. Tuesday kicks off the holiday-shortened week with international capital flows, NY Empire manufacturing and the NAHB (homebuilder) index. Import prices, housing starts/permits, industrial production and the minutes of the recent FOMC meeting are due Wednesday. The usual initial jobless claims, Philly Fed, leading indicators and the weekly oil inventory data are all up Thursday while Friday rounds out the week with consumer prices.
The Eurozone has some important events scheduled as well. The EU Finance Ministers meeting will be closely watched on Monday while Tuesday brings the ZEW surveys. The trade balance is up on Wednesday while consumer confidence is due Thursday. The week closes in busy fashion with the current account, PMI surveys, French business indicators and German producer prices on Friday.
It is relatively light in the UK. Home prices are up on Monday while consumer prices are the highlight on Tuesday. The Bank of England minutes are on deck Wednesday along with the employment report. Friday closes out the week with retail sales.
Japan looks a touch busier than usual. GDP is scheduled on Sunday while industrial production is due on Monday. Tuesday brings the Tertiary industry index and Wednesday sees machine tool orders. The BOJ rate decision is on Thursday along with the leading index and department store sales. Finally, look for the all industry activity index on Friday.
Canada has a typical and light week ahead. Manufacturing sales are due on Wednesday. Thursday brings consumer prices and international capital flows. While Friday closes out the week with the all-important retail sales data.
The calendar down under is characteristically light. New Zealand has producer prices on Monday and credit card spending on Friday. Australia, meanwhile, sees the RBA minutes and leading indicators on Tuesday and business confidence on Thursday.