What began the month with an unexpected bang in currency markets ended with a not so unexpected whimper. Federal Reserve Bank Chairman Ben Bernanke’s eventful speech of June 3 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.
U.S. 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 200,000 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 six-month highs, gold dropped to one-month lows and the dollar index hit three-month highs.
Many have blamed the ineffectiveness of Bernanke’s dollar-supporting speech on the comments from his European Central Bank (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 6, U.S. unemployment soared to 5.5% and payrolls delivered their fifth 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 the 10- and two-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 U.S. bank write downs, negative earnings from Fedex, a major economic bellwether, and preliminary signs of a capitulating U.S. 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 U.S. 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% to 1.0%. This requirement is far from present as the unemployment stands at four-year highs of 5.5%, weekly jobless claims at three-year highs and continued claims at four-year highs.
Euro may advance but not last
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 three years. The worsening fundamentals in the Euro zone have been broadening into France and Germany, but have largely been shrugged by currency markets due to rising oil and resurfacing erosion in U.S. 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 U.S. jobs figures could well be one of those instants. Accordingly, we anticipate renewed jawboning from U.S. 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, 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, Trichet has denied that speculation is the cause of rising oil prices, stating that supply and demand are the culprits. EUR/USD 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 appetiteThe 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 U.S. and world equities, with the drop in USD/JPY specifically dragged by falling US-Japan 10-year yield spread reaching its lowest since June 6 at 3.2%. Since peaking at a sixth-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 U.S. equities until the 50-week moving average (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 to 2002 bear market. Today we leave June, which was the worst monthly performance for stocks 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. A 2.00% Fed funds rate remains well above 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, USD/JPY 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
The two-month highs in GBP/USD 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 August 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 U.S. 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 too, 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 to $1.9360 move. A breach above it would be capped at 2.0060. Support climb to 1.9850 and 1.9930.
Aussie uptrend shakenThe 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 labor 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 U.S. 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 U.S. slowdown
We mentioned last week the Canadian dollar was the worst performing currency in G10 due to aggressive rate cuts from 4.25% in December to 3.00%, the downdraft from the U.S. 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 U.S. 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.
USD/CAD 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 EUR/CAD, GBP/CAD, AUD/CAD, and negative CAD/JPY and NZD/CAD.
Ashraf Laidi
Chief FX Strategist
CMC Markets US
a.laidi@cmcmarkets.com
