- Back to the brink—again
- The Fed disappoints, but signals only one direction
- Month/quarter-end promise volatility; ECB and NFP to boot
- Key data and events to watch next week
Back to the brink—again
The world as we know it would seem to be coming to an end. Oil prices have risen through the $140/bbl level, stock indexes globally are trading at or below their lows for the year (no small feat), and the USD is on the verge of collapsing. And yet, the feeling of panic that accompanied the last visit to the edge of the abyss does not seem as much in evidence. Instead, this time around the aura seems to be one of resignation and helplessness. Of the two episodes, the current one seems more ominous in the sense that solutions seem less available. Key central banks have already largely exhausted their ability to provide monetary stimulus and are now constrained by runaway inflationary pressures. The financial sector, having assured markets a few months ago that the worst was behind them (I cautioned readers on April 18 Don’t buy it), are back under the gun and financial system stability is being threatened anew. Central bankers have cautioned that additional bailouts are less likely and this raises the prospect of more severe financial sector stresses than before. Consumers globally are being pummeled by rising food and energy prices against a backdrop of slowing economic growth and restricted credit. If there is any light at the end of this tunnel, it seems very far off and likely a mirage.
Now that I’ve probably depressed most of you to the point of not wanting to read any further, let’s take a step back for a reality check. The key to the doom and gloom of the preceding paragraph is that it’s highly emotional and therefore very subjective. A few concrete touchstones: Gold prices, while higher, are still well below the crisis highs seen back in Feb/Mar; the USD, while clearly under pressure, is still above its lows seen in the same period and still within the ranges of the last two months; US 10-year Treasury yields are about 70 bps above the crisis lows; stocks are plumbing their lows, but given the outlook, shouldn’t they be? Oil and other raw commodities are the one asset class that is appreciably higher, but that is a supply/demand inflationary phenomenon and not an indication of investor sentiment. In other words, from a trading perspective the current situation is best characterized as desperate, but not serious. All things considered, one could argue the USD is actually holding up reasonably well.
That is not to say that circumstances cannot deteriorate further from here. On the contrary, there is every likelihood that we could experience another severe setback in stocks, the US dollar, and associated asset classes. The key point to take away from all this is that while we’re on the brink, we have not yet fallen over it. Oil will continue to be the driver of most other asset classes and the USD in the short-term and we need some pullback to prevent the USD re-testing all-time lows. The key levels to watch in major currency pairs are: 1.5800/50 in EUR/USD and 105.50/70 in USD/JPY. Should those levels break, batten down the hatches and prepare for more downside for the USD. EUR/USD 1.6000 no longer seems the impenetrable line it once was, as ECB policymakers have indicated intentions to raise rates and that the strength of the EUR helps offset inflation. While those levels hold on a daily closing basis, I would favor buying USD on this weakness. Remember, range limits are made to be tested, as we are currently doing, but beware a break should it occur.
The Fed disappoints, but signals only one direction
The FOMC this week shifted its policy bias virtually imperceptibly to a tightening bias, but the language they chose failed to satisfy markets who had bet on a more hawkish signal, as we correctly suggested in our FOMC preview. The result in FX has been a weaker USD, but note that the buck is only about 1.3-1.5% lower from pre-Fed announcement levels, hardly a material decline. The ultimate message from the Fed to note is that US rates are not going to go lower in the near future and that the path of least resistance is now clearly higher. Unfortunately, the Fed is playing a waiting game, so the timing of any rate hikes could still be months off. In the past, I have suggested that the Fed would likely remain on hold for the rest of this year, but I am coming around to the conclusion that they are now more likely to tighten in the fall, as soon as consumption and financial markets show greater signs of stabilizing.
In the 325 bps of easing provided during the course of the sub-prime/credit crisis, the Fed has implicitly indicated that some of that easing was extra-insurance to promote stability and get the message across that the Fed was on the ball. They have also subsequently indicated that once conditions stabilized sufficiently, it would be imprudent to leave that extra-insurance out there. I can readily envision the Fed withdrawing 25-50 bps of the crisis-easing without materially depressing the economic outlook further (oil is doing that for them), but then returning to the sidelines until the broader economy exhibited signs of recovery. So once markets get over this week’s disappointment, I would look for the USD and US Treasury yields to begin to reflect renewed ‘pricing-in of rate hike expectations. As it stands now, Fed Fund futures indicate a slightly better than 50% likelihood of a 25 bp rate hike at the Sept.16 meeting. Should US data (outside sentiment gauges that reflect high and rising gasoline price) stabilize further in coming weeks, those probabilities should increase further.
Month/quarter-end promise heightened volatility; ECB and NFP to boot
Next week sees the month end and the end of the 2Q. Liquidity conditions will be reduced as is typical, and that holds out the prospect that excessive volatility will distort price action, a particularly challenging trading environment. After the close of 2Q, real money asset managers will need to rebalance their currency exposures to reflect changes to underlying stock and bond portfolios. Given the sharp declines in stock indexes this month, it’s safe to say that asset managers will be reducing rather than increasing hedges, but we don’t have any indications yet which way the net currency flows will move. Stay tuned to the ForexInsider for more current updates on these one-time flows.
The ECB in all likelihood will raise rates by 25 bps when they announce their decision on Thursday July 3. Markets have largely priced in such a move since ECB Pres. Trichet signaled the intention at his last press conference on June 6. The key to future FX moves will be what guidance he suggests on the potential for additional rate hikes beyond that. Trichet has given every indication that a July 3 rate hike will be a one-time policy adjustment. I will be looking for language along the lines of ‘with today’s policy adjustment, we believe benchmark interest rates are appropriate to ensure that price stability is maintained in the medium term.’ If Trichet does signal that this is only a one-time adjustment, EUR strength should be limited and likely reverse.
Key data and events to watch next week
The US calendar is bustling with top-tier data in the holiday shortened week with the June ISM manufacturing index leading the way on Tuesday. On Thursday all eyes will be on the June employment report, where the market expects yet another decline in nonfarm payrolls and for the unemployment rate to correct slightly to the downside. In terms of the speaking circuit, the main event is Atlanta Fed President Lockhart speaking on the economy and financial turmoil on Tuesday. Treasury Sec. Paulson will be speaking on capital markets and the global economy from London on Wednesday afternoon.
In the Eurozone all of the focus will be on the European Central Bank’s rate decision on Thursday where the ECB is expected to hike 25 basis points. The press conference following the rate announcement will also be critical in assessing the ECB’s rate direction going forward. Before that however we’ll see German May retail sales and the German June unemployment rate on Tuesday. German May factory orders on Friday closes out the week.
The economic calendar in Japan looks relatively light with the main event being the 2Q Tankan sentiment indices due out on Monday. The only other noteworthy release is the May leading index out on Friday.
It is a moderately busy week in the United Kingdom, kicking off with the June Gfk consumer confidence survey on Sunday evening. The June Nationwide Building Society’s house prices report is due up on Tuesday and the market looks for further depreciation in that space. UK PMI’s for June will also be released, with manufacturing out on Tuesday and the services counterpart closing out UK data for the week on Thursday.
Canada’s economic calendar is extremely light but we will see a couple of meaty releases. Canadian April GDP is due up on Monday and the consensus is for a rebound from the prior month’s disappointing result. No other data until Friday with the all important Ivey Purchasing Managers Index for June on deck.
Australia gets an important round of economic events next week, with the RBA rate decision the highlight; rates are expected to be held steady at 7.25%. May retail sales and the AiG performance of service index are up on Wednesday, while the May trade balance ends the week of data on Thursday.
New Zealand has a light week in store with May building permits out on Sunday evening and the June NBNZ business confidence measure due up on Monday.
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.