Sterling to extend downside despite BoE hold
The Bank of England left interest rates unchanged at 5.00% as expected, giving GBP a short-term bounce before renewed pullback. The Bank is widely expected to stick to its pattern of cutting rates in alternating months, thus reducing rates in June to 4.75%. We continue to expect 4.00% by year-end. Sterling is expected to maintain its predominantly weak tone against USD, JPY, AUD and EUR. Interim rebounds in cable are seen largely capped at 1.9620 and 1.9660. On the longer-term horizon, we expect the downtrend to prevail, unless a breach of $2.0100 is attained.
Euro breaks under key support
All eyes turn to the 8:30 a.m. EST press conference from the European Central Bank (ECB) for whether President J.C. Trichet will accentuate the downside risks of the Euro zone economy besides its anti-inflation vigilance. We certainly do not expect Trichet to temper the Bank’s persistent hawkish stance as oil prices surge to new highs. Instead, he may shed a little more attention on the emerging signs of weakness, such as Euro zone retail sales. But even without Trichet’s shift to a less hawkish stance, the euro is expected to revisit today’s $1.5280s as markets start to assess ECB policy to fall behind the growth curve. Our month-end target of $1.53 has already been breached earlier today, but we expect a combination of mixed U.S. data and surging inflationary dangers in the Euro zone to trigger periodic rebounds in the single currency.
After having resisted a breach below the $1.5345 support in three different occasions over the past two months, the euro finally breaks to hit $1.5282 before bouncing towards the $1.5330s. Downside in the euro is more durable as a result of weak European data rather than strong U.S. figures. Yesterday’s Euro zone retail sales report is expected to increase the shift into net euro shorts against the dollar, which started last week for the first time since December 2005. Surging oil prices and mixed U.S. data will slow the pace of the euro’s decline. Upside remains capped at $1.5480, followed by 1.5550
USD/JPY in midst of downturn
Both the weekly and daily charts suggest a continuation in the USD/JPY, which is in line with the VIX analysis above. Wednesday’s U.S. trade action saw a rapid decline to 104.15 on the heels of broad selling in U.S. equities. The divergence between the dollar’s strength against European currencies and weakness versus the yen is not an anomaly as reduced risk appetite boosts the low yielding yen. We expect broad yen gains to emerge in the next sessions, with USD/JPY nearing 104.00, followed by 103.60, with resistance slipping towards 105. NZD/JPY is seen extending losses towards 80.00 and 79.20, while CAD/JPY is seen targeting 102.70.
VIX seen extending upside
The recent price action unfolding in the Volatility Index (VIX) may be sending an early signal that Wednesday’s declines in U.S. equity indices may have followed an intermediate top, after which a prolonged period of negative consolidation could be in the offing. We increasingly refer to the essential signals emitted by major U.S. equity indices to help shape our view on overall risk appetite and the implications for a rebound in the Japanese yen and a retreat in the high yielding currencies. The Chicago Board of Trade’s VIX is viewed as a barometer of the market's attitude towards risk. A high number reflects creeping fear, with a figure above 30 possibly suggesting excessive pessimism and selling. Conversely a low VIX suggests optimism or confidence in the market, with a figure nearing 10 suggesting possible complacency.
So what can we infer from the latest price action in the VIX about the overall market, risk appetite and major currencies:
Each time the VIX has closed three or four times below 20.0, complacency may have become overstretched and a break out was imminent. Wednesday’s close of 19.73 was the fifth consecutive daily close below 20.0, but the jump from the 18.43 open suggests rising momentum for a recovery ahead.
The last time the VIX closed below 20.0 for three consecutive days was on Dec. 21, 24 and 26 of last year, after which the index soared by more than 6 points to 26.0 in the following two weeks, accompanied by sharp selling in equities.
The last occasion prior to the aforementioned one the VIX closed below 20.0 for four consecutive days was on October 5, 8, 9 and 10. Notably, Oct. 11 marked the all time high in the S&P500 and the Dow Jones Industrials Index, after which the bear market in equities unfolded.
Thus, even though the VIX closed below 20.0 during the last five days (May 1, 2, 5, 6 and 7), the fifth day involved a rally of more than 7%, reflecting an attempt for an impending upward break out, which is bearish for equities and risk appetite.
Each of the S&P500, Dow and Nasdaq fell short of breaching their 200-day moving average, suggesting a clear failure to undo the prevailing downtrend.
The timing of this suggested top in equities also coincides with the near end of U.S. corporate season, a phase which started with mostly negative news on the banking front, followed by better performance in the technology, consumer staples and materials and energy sectors, each of which were propped by the common denominator of a weak dollar and superior demand from abroad. Once the earnings season is concluded, stocks may find difficulty maintaining their upward tone at a time when the Fed is “attempting” to signal a pause in interest rate relief, while economic data remain mostly downbeat.
The price action in high-yielding currencies is also in synch with falling risk appetite. Last night’s job figures from New Zealand showed the fastest decrease in employment in nearly 20 years when Q1 employment fell by 29,000, or 1.3%, reversing the 0.9% gain in Q4. On Tuesday, Alan Bollard, head of the Reserve Bank of New Zealand said the Kiwi was “broadly overvalued”. Although such comments sound too explicit for a central banker, Bollard has shown similar extreme candor vis-à-vis the currency over the past three years as the high yielding Kiwi soared to multi-decade highs. The jobs data and the negative comments from Bollard do herald further declines in the Kiwi which are “classic carry trade unwinding”.
In addition to the 8:30 a.m. EST press conference, markets will await the release of the U.S. weekly jobless claims, which could potentially accelerate the dollar’s existing gains in the event claims fall below 380,000. Recall last week’s release showed a jump from 345,000 to 380,000, while continuing claims soared to 3.019 million from 2.945 million.
Ashraf Laidi
Chief FX Strategist
CMC Markets US
a.laidi@cmcmarkets.com
