Monthly FX: From a Bang to a Whimper
What began the month with an unexpected bang in currency markets ended with a not so unexpected whimper. Fed Chairman Bernanke's eventful speech of June 3rd to the International Monetary Conference supporting the dollar was seen as the possible end of Washington's policy of benign neglect towards its currency. But the economic fundamentals wouldn't play along.
US Treasury Secretary urged the Gulf States not to end their pegs to the dollar or not to even revalue their currencies against the greenback. Saudi Arabia conformed to Paulson's requests urging the rest of GCC states to do the same. And in order to make that possible, i.e. to combat the inflationary pressures of pegging their currencies to a falling dollar, Saudi Arabia increased oil supply by 200K barrels per day and even hosted an extraordinary summit in Jeddah where oil producers and consumers could work out their differences. Meanwhile, French and German politicians, warned of the inflationary dangers of excessive dollar declines from oil and recessionary implications of rapid euro strength. All seemed to be working in the direction of a steadying dollar and stabilizing oil prices. Bond yields jumped to 6-month highs, gold dropped to 1-month lows and the dollar index hit 3-month highs.
Many have blamed the ineffectiveness of Bernanke's dollar-supporting speech on the comments from his ECB counterpart JC Trichet one day later, clarifying to the world his intention to raise interest rates. But little was said about what had ensued in the next day. On June 6th, US unemployment soared to 5.5% and payrolls delivered their 5th straight monthly decline. The dollar-supporting remarks appeared artificial at best as rising bond yields proved untenable considering weakening fundamentals. Rising jobless claims, falling housing sales/prices/starts/permits, falling industrial production and deteriorating consumer confidence could not be ignored by currency or bond traders. And as the ECB clarified its intention to raise interest rates, the spread between 10 and 2-year yield moved against the USD and in favor of the EUR, GBP and even JPY. The dollar damage intensified not only because oil prices hit new highs on a daily basis, but also because of the escalating announcements of US bank writedowns, negative earnings from Fedex--a major economic bellwether and preliminary signs of a capitulating US consumer.
Further dragging the dollar was the FOMC statement, which quelled speculation of any near-term rate hike despite its upgrade of inflation risks. We continue to expect that the next move in US interest rates is down, (1.50% by year-end) not only due to the aforementioned erosion in economic fundamentals, but also the negative repercussions to the already shaky financial system. History has shown the Fed rate hikes do not take place without an extended decline in the unemployment rate of 0.5-1.0%. This requirement is far from present as the unemployment stands at 4-year highs of 5.5%, weekly jobless claims at 3-year highs and continued claims at 4-year highs.
Euro May See Rapid Advance But Not A Lasting One
Euro regains the $1.58 mark on a manifestation of USD weakness, anticipated ECB rate hikes and prolonged oil strength. All of these factors dominated any negative impact from the manufacturing PMI index, which fell to 49.2 in June, its first contraction (below 50) in 3 years. The worsening fundamentals in the Eurozone have been broadening into France and Germany, but have largely been shrugged by currency markets due to rising oil and resurfacing erosion in US markets and economic data. This suggests that the any moves above $1.60 are likely to be short-lived. Thursday's twin release of the ECB rate decision, press conference and US jobs figures could well be one of those instants. Accordingly, we anticipate renewed jawboning from US and European officials (non-ECB) in talking up the dollar. But the more effective Forex signal will have to come from the ECB, seeking to warn about excessive moves in the euro. Merely saying the ECB agrees with the importance of the strong dollar has proven to be futile. Instead, Mr. Trichet will have to spell out the euro in warning about excessive currency moves as was the case in 2004 and 2006. Trichet's reluctance to directly talk down the euro stems from the increasing inflation repercussions of higher oil via a weakening currency. Interestingly, Mr. Trichet has denied that speculation is the cause of rising oil prices, stating that supply and demand are the culprits. EURUSD may extend gains as high as $1.6070 before settling at $1.5750. Renewed gains will not be seen until the fundamentals augment market expectations of a Fed cut.
Yen to Gain on Risk Appetite at Weaker Pace
The yen strengthened after the Bank of Japan's Tankan survey on Q2 business sentiment revealed a better than expected showing for manufacturers, large and small. The forecast for all-industry capex rose 2.4% versus expectations of 2.0% and -1.6% in Q1. But improved business outlook does not necessarily reflect improved profit expectations, which grew weaker than in Q1. Looking ahead, the yen is to gradually gain across the board on a deepening decline in US and world equities, with the drop in USDJPY specifically dragged by falling US-Japan 10-year yield spread reaching its lowest since June 6th at 3.2%. Since peaking at a 6-month high of 4.63%, the spread has been on a continued decline. We have long warned about the changing fortunes of the medium and longer term trends of US equities until the 50-week MA has finally broken below the 100-week MA last week for the first time since April 2001, a time coinciding with the first 1/3 of the 2000-2002 bear market. Today, we left off a month of June that was the worst monthly stocks performance since September 2001. The April-June quarter returned its worst decline since 1978. And the January-June period showed the worst performance since 1970. These historic underperformances aren't expected to ease any time soon if the Fed keeps rates unchanged. 2.00% fed funds rate remains well above as the 45-year low levels of 1.00% in June 2003. And despite higher inflation rates, the domestic situation is decidedly more ominous as faltering market liquidity is accompanied by rising solvency and weak macro dynamics.
These risk appetite repercussions for the Japanese yen may not be as significant as they were last summer due to the fact that a considerable amount of carry trades have been unwound. Rising commodity prices are also presenting a yield alternative to high yielding currencies and equities that may help offset any yen gains.
Accordingly, USDJPY is seen charting a gradual retreat towards below 103 until attaining 102.30-50 by month end. A breach of 101 is expected to take part in August, with projections seen extending towards 98 in September. With the pair having failed to show any definitive breach above the 200-MA, any recovery is seen capped at 107 and 107.50.
Sterling Upside Increases with Vulnerability
The 2-month highs in GBPUSD occurred despite the UK manufacturing PMI's fell to 45.8 in May from 49.5, its sharpest decline since December 2001. Markets were expecting a slight rise to 50. The new orders index tumbled to 43.5 from 47.5, its worst level since Dec 1998, while the employment index fell to 46.5, the lowest since Aug 2005. Inflation remained a problem as the input prices index jumped to 82.1 from 76.9, showing its highest reading in the 16-year history of the series. Sterling's gains versus the dollar remain largely a result of negative US fundamentals, which raises the alert for another sharp GBP decline, which is typical of the pair. And with UK stocks tumbling today by as much as 2.5% to reach their March lows, UK markets will find eroding growth (2.2% 2008 GDP forecast) and high interest rates (5.0%) an unsustainable combination.
Sterling's current rebound vs EUR and AUD has also been a reflection of markets' paring down of expectations of lower BoE rates. But we expect this to, anticipating the BoE cuts to as low as 4.25% by Q4. Cable faces key pressure at the 50-week MA of $2.0020, which is also the 61.8% retracement of the $2.040-$1.9360 move. A breach above it seen capped at 2.0060. Support climb to 1.9850 and 1.9930.
Aussie Uptrend Shaken but Not Broken
The Australian dollar falls across the board after the Reserve Bank of Australia issued a dovish policy statement by adding its concerns with the slowing labor market to the existing dynamics of tightening liquidity and slowing household demand. Leaving rates unchanged at 7.25%, the RBA added the phrase "tentative signs of an easing in labour market conditions", which was not present in any of the previous statements. Nonetheless, the central bank also added that "CPI will be further boosted in coming quarters", which is a more specific inclusion of inflationary risks. Although the next quarter CPI figures are due in July 22, markets will get an indication from the preliminary inflation figures from private sector indices. Separately, the AiG Manufacturing Index contracted to 47 in June 2, while HIA new home sales fell 5% in the month ending in June following a 0.1% increase.
Aussie weakness began during the Monday US session on technical dollar rebound, before the pace accelerated in the aftermath of the RBA decision. Downside stabilized at our stated support level of 0.9540, but we do not rule out protracted declines towards 0.9500 and 0.9470. In the long-term, the technical up-trend remains intact as long as no breach of 0.9350 takes place. Interim gains seen capped at 0.9570 and 0.9600 considering the adverse environment on risk appetite.
Loonie's Oil Drive Dampened by US Slowdown
We mentioned last week the Canadian dollar remarkably fared as worst performing currency in G10 due to aggressive rate cuts from 4.25% in December to 3.00%, the downdraft from the US Canadian officials' persistent talking down of their currency. All of that has managed to offset the usual positive impact from oil prices. The impact of US weakness on Canada's economy can be compared to that on the Japanese yen, which is another currency showing more modest performance than last year. While Canada's economy has by no means stalled, the role of "currency management" by the central bank and Treasury remains considerable.
USDCAD is seen prolonging its 1.03-1.00 consolidation, underpinned by interim support at 1.0050 and 0.9870. Upside to remain capped at 1.03380. CAD plays remain favoring EURCAD, GBPCAD, AUDCAD, and negative CADJPY and NZDCAD.