Highlights

  • Shift in FX drivers may provide support for the USD
  • Budget D-day for Osborne
  • The ECB's tough talk

Shift in FX drivers may provide support for the USD

This week U.S. Treasury yields broke out of their ranges and rocketed higher. 10-year yields rose nearly 28bps since Monday and advanced above the 200-day sma for the first time since July to reach current levels of around 2.31%. U.S. equity markets rallied significantly as well this week with the S&P 500 closing above 1400 for the first time since 2008 while the Dow Jones Industrial Average traded at levels that have not been seen since 2007. At the same time, the USD gained against its major counterparts most notably against the Japanese yen. This may be the start of a significant shift in FX drivers as a risk rally has typically coincided with USD weakness and a sell-off in US Treasuries (yields higher). What we are seeing now is that the USD and its relationship to the risk-on/risk-off environment is deteriorating as markets revert back to fundamental drivers and interest rate differentials. The correlation between the Dollar Index and the S&P 500 has diminished with the 30-day rolling correlation (based on % change) now at -0.42 from -0.59 late last week. This underscores the breakdown in the inverse relationship between risk and the greenback. On a shorter term basis (5-day), the correlation has actually turned positive for the first time since July of last year which indicates a positive relationship between the USD and risk (i.e. risk-on, dollar strength).

U.S. economic data and what it implies for Fed policy moving forward is increasingly impacting exchange rate fluctuations while risk sentiment has taken a backseat. Positive data surprises have been constructive for the greenback as traders price out the likelihood of QE3 as the economy improves. Likewise, softer data weighs on the buck as seen with Friday's weak Feb. industrial production, softer core CPI, and unexpected decline in consumer confidence. While the Fed has not completely taken the option of more asset purchases off the table, it has backed off from the prospect of additional stimulus for now and acknowledged positive developments in labor markets and expects moderate (upgraded from modest) economic growth. The pledge to keep rates low until late 2014 remains unchanged, however if more members join Lacker in his dissent with regards to the time commitment, yields could move higher and the dollar may follow suit. The week ahead sees a number of Fed speakers scheduled which include FOMC voting members Dudley, Lockhart, and Chairman Bernanke. There is relatively light data flow in the U.S. with key February housing reports (new and existing home sales, housing starts) and leading indicators of note. We will also be monitoring weekly jobless claims which hit multi-year lows of 351k.

We expect that the USD will continue to be the beneficiary of safe haven flows as the CHF and JPY are expected to remain weak as a result of SNB and BOJ policy stance. This past week, the Swiss National Bank reiterated its commitment to maintain a ceiling on the franc while the Bank of Japan seeks to achieve its 1% inflation target which may require further easing of monetary policy as Japan currently faces deflation. The removal of a significant tail risk in Europe and easing of financial conditions after extraordinary liquidity operations provided by the ECB have resulted in a rise in European bourses and reduction in sovereign yield spreads. We would not downplay the severity of the Euro zone crisis however as the situation remains fragile. Political disruptions may intensify heading into key elections and structural imbalances as well as a pending recession continue to be a major concern. Euro zone PMI's are scheduled for release in the week ahead and this will provide insight into the economic growth of key nations in the region.

Budget D-day for Osborne

The highlight event in the UK next week is the Chancellor presenting his Budget to Parliament on Wednesday 21 March at 1230GMT.  This comes at a difficult time for the exchequer, growth faltered in the fourth quarter of this year, and although it is expected to recover later this year it is likely to remain fairly lackluster this year and next.

However, as much as the Chancellor may want to try and boost growth he needs to balance this with preserving the UK's prized triple A credit rating. Thus, don't expect a deviation from the government's austerity program, as it has become even more pressing since rating agency Fitch joined Moody's and put the UK on ratings watch negative last week.

Osborne could have some good news on this front. There are signs the UK's finances are better than expected. The Office for Budget Responsibility's borrowing estimate for 2011-2012 was GBP127 billion, however the actual figure is likely to come in below this at the GBP122 billion mark after tax receipts were extremely strong in January and public spending has been slower than anticipated.

The UK still has a mountain to climb when it comes to fiscal consolidation, so don't expect any un-funded giveaways from Osborne this year. Instead we expect a few changes that may cause some volatility in sterling-based markets in the middle of next week.

The markets are likely to react positively to anything that is pro-business, for obvious reasons. But this budget could be more muted than usual since a corporation tax cut is due to come into effect in April 2012 as part of the Finance Bill.  We don't believe the Chancellor will cut the new 25% rate any further this year, although a small cut like 1% could surprise the market and might be considered affordable by the Chancellor especially if it could help boost jobs in the UK economy.

Any reduction in red tape for business is also likely to be warmly welcomed by the markets including the outcome of the Office for Tax Simplification's review of the taxation program for small businesses and a reduction in the compliance burden for firms with foreign subsidiaries.

Added to that any cut to the top 50% rate of tax, which could be reduced to 45% and maybe even back to its original 40%, may not be popular with the overall electorate but could help boost consumption among high earners. The Chancellor may admit that the tax increase for those earning GBP150K or more failed to bring in the GBP 2 billion revenue expected, so is not worth keeping in place.

We believe a pro-business budget could have a temporary upward impact on the pound only. However, a budget that either 1, constrains growth or 2, threatens the UK credit rating could have a longer-term negative impact on sterling. The pound had a storming end to last week's trading session as the dollar gave back recent gains. It closed the week on Friday approaching its 200-day sma resistance at 1.5870. This could thwart further gains as we start the week as markets get nervous about the prospect of Osborne's Budget and take profits.

We also get MPC minutes and inflation out next week. Any sign that inflation is not falling as fast as the MPC predicts could see expectations of QE get taken off the table. This could limit future declines in the pound especially versus the euro, the CHF, the yen and the dollar. These currency crosses are all being driven by relative monetary policy. The US-UK interest rate differential has been widening since October 2011 helping to keep GBPUSD fairly weak, thus if movement in this spread slows then further losses in GBPUSD could be muted going forward.

The ECB's tough talk

There were two developments in the Eurozone last week that could impact the value of the euro. The first was the Bundesbank's annual meeting last week where President Jens Weidmann said that the ECB needs to start thinking about how to unwind its crisis measures like LTRO loans to Europe's banking sector.

Added to this the head of the Austrian Central Bank Nowotny said that further rate cuts from the ECB are not on the table right now. Weidmann was careful not to say that all emergency measures to help support the banks should be removed, however, he did say that the consequence of the LTRO auctions clearly raised the risks that the ECB now has to burden in the form of low quality collateral that banks from the currency bloc can use to get hold of ECB cash.

So the ECB isn't exactly hawkish, but it is unlikely to add any new stimulative measures to its policy mix any time soon.  But what does this mean for the euro? We have noted in previous reports that the interest rate differential between the US and Germany (as benchmark for the currency bloc) has widened for the last five months. This has contributed to the bout of euro weakness we have seen since the late summer and the failure of EURUSD to crack 1.35 in recent weeks. Thus, now that the ECB is talking tougher than it has in the past about inflation risks the spread may not widen at such a fast clip.

This doesn't mean that we will see a rebound in EURUSD any time soon, even though the single currency had a storming finish to the European session on Friday. Instead it suggests that further declines could be muted and we are back to range trading. As we start a new week the range to note in EURUSD is 1.3050 - 1.3250.

 

 

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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.