A confluence of factors has emerged that has negatively impacted the so-called 'risk' trade (long stocks, commodities, gold, and JPY-crosses), which ultimately is a bet on the speed and strength of the global recovery. The starting point would seem to be last Friday's disappointing US employment report, which was the first reminder of the long and bumpy road ahead for the world's largest economy. This past week began with a spurt of euphoria as China reported strong export and import growth. But the party was short-lived as the very next day saw China's central bank (PBOC) take additional steps to rein in bank lending, tweaking rates higher and raising reserve requirements, triggering fears that Chinese growth may begin to slow. All along, deficit concerns weighed on most major developed economies, most acutely in the case of Greece and the Eurozone (see more below). Fears came to a head on Thursday as ECB president Trichet made it 'crystal clear' that Greece would get no special treatment and had to resolve its budget shortfalls on its own. German Chancellor Merkel gravely noted that "the Greek example can put us (i.e. the EUR) under great, great pressure." Weaker than expected US Dec. retail sales and Univ. of Michigan consumer sentiment added to the growing sense of resignation. Interestingly enough, some better than expected 4Q corporate earnings reports failed to stem the tide of pessimism (more on earnings below). And the cold snap in the northern hemisphere finally broke (at least over North America), pulling the rug out from under oil and other commodities that had benefitted from the weather.
Markets had gotten off to an exuberant start at the beginning of this year on the expectation that the global rebound would continue and possibly even accelerate. We're now going through a re-think of that optimistic scenario, and just as the data has been uneven, so too is the likely risk retrenchment. Many of the fundamental developments cited above have another side to the coin. In the case of China aiming to reduce bank lending, they're doing it because the economy is viewed as potentially overheating. In the case of Greek deficits leading to a break-up of the EUR, Trichet appropriately labeled the notion an 'absurd hypothesis.' In other words, these are likely short-term negatives that will eventually fade, but they probably still have a little room left to run. On the technical side, this past week initially saw risk assets attempt to extend gains to new highs, but the end of the week saw those moves reversed, suggesting rejection.
For the week ahead, then, we prefer to be sellers of risk assets on any bounces. In EUR/USD, the failure above 1.4450/4500 suggests an eventual test of recent range lows in the 1.4250/4300 area. If the recent price pattern has been a bear flag consolidation channel, the move above the 1.4500 channel top was false, and suggests an eventual break below the flag bottom, which now coincides with the 200-day sma. A break below the flag base suggests the overall down move in EUR/USD is resuming, and we would look for the 1.35/37 area over time. GBP/USD also looks to have failed below 1.6350/6400 and seems ripe for a return to recent range lows in the 1.58/59 area. USD/JPY also had a rejection from the key 93.30/80 level recently and may see down to the 89.20/50 area. US Treasury yields will need to stabilize to prevent further losses in USD/JPY. Taken together, those dollar views suggest selling JPY-crosses on any corrective rebounds, with AUD/JPY, GBP/JPY, and NZD/JPY still at attractive levels offering the greatest downside potential. EUR/JPY has outpaced to the downside (also across the board against other currencies), but is also clearly below the daily Ichimoku cloud bottom (131.42) and the Kijun line at 130.95, suggesting a trend shift back to weakness.
Oil prices (WTI/USD) tried to break up above the weekly cloud top at 81.20, but have clearly failed, suggesting rejection potential lower. WTI crude also dropped below the daily Tenkan line at 80.82, which is itself showing signs of topping. Warmer weather and large inventory builds, coupled with potential for a stronger USD, all argue for further weakness in oil. Gold prices are currently inside the cloud, and recent daily close highs were contained by the cloud top, suggesting another rejection/failure and highlighting downside potential. Below the daily Kijun line at 1118.33 exposes the cloud bottom at 1106.70, while the Tenkan line is the immediate resistance at 1138.65. As much as we are anticipating heightened risk aversion in the weeks ahead, we're also mindful that data and events can continue to vacillate, so we will not chase lower and prefer to sell on likely bounces. Should key price support levels outlined above break on a sustained basis, however, we'll be forced to step up the selling, as the failures and rejections of the past two weeks are compelling trading signals.
Earnings season disappointments could bring JPY opportunities
The earnings calendar really heats up over the next three weeks, when more than 300 of the S&P 500 companies are slated to report. Total earnings for 4Q are expected to post a massive 67% improvement over the prior year. This, however, is drastically skewed by the financials space. Excluding this sector, the consensus is looking for relatively flat results over the 2008 comparables. We think the composition of earnings will matter greatly once again in terms of guiding risk appetites. The prime example was just this week when a major US financial institution beat bottom line expectations but missed on their revenues by about -4%. The market took no solace in the better bottom line and declined broadly ahead of the weekend. This suggests it will be critical to digest both what top line and bottom line earnings are doing. If companies are merely beating because of cost cutting measures and not due to organic growth, we do not think risk will have the impetus to head higher. Should earnings disappoint, this would dovetail nicely with Japanese investor repatriation and should elicit a short-term decline (buying opportunity) in the yen crosses.
The recent change in the corporate dividend repatriation tax, which now allows Japanese investors to bring profits from abroad free of charge, should cause some divergence amongst the JPY crosses. The previously levied tax took the difference between Japan’s corporate tax rate and that of the dividend’s country of origin. For those invested in the US, the tax was essentially zero as both corporate tax rates are around 40%. However, those bringing revenues back from other areas were subject to about a 10% tax as most countries tended to operate with a corporate tax in the realm of 30%. This would have been a major disincentive to repatriate funds from countries other than the US. With that now gone, repatriation ahead of the March fiscal year-end could have a more material negative impact on EUR/JPY, GBP/JPY, CAD/JPY (among others) and less of an impact on USD/JPY. Seasonal trends observed over the last decade suggest the period of mid-February could open up a very good buying opportunity in these crosses. For the balance of 2010, economic fundamentals and interest rate differentials do not augur for a strong yen.
Greece outweighs economic news in the Eurozone
Next week’s scheduled releases of Eurozone PMI and the German ZEW survey would ordinarily be sufficient to dominate the attention of the EUR. In the current environment, however, economic data are likely to be overshadowed by ongoing market concerns over Greece’s budget position and the fears over what this means for the coherence of EMU. Economic arguments have been made suggesting that Greece may be forced out of the system. These arguments have academic validity. However, EMU was always more a political arrangement than an economic one. The huge amount of political credibility invested in EMU will mean that it is too early to speculate that Greece will be ejected from the system insofar as this could trigger a broader collapse. That said, the EUR will remain vulnerable particularly given skepticism on Greece’s accounting principles and on its ability to stamp out tax evasion. As a result, the country’s efforts in putting together its stability pact are unlikely to bring calm.
Sterling bolstered by rate speculation, CPI and labor data may support
Sterling has performed well, partly on the back of its position outside the EMU and partly on speculation that the BoE may be poised to raise rates sooner than had been projected. The release of headline CPI and RPI inflation for December may show a strong rise. However, this is likely to be on the back of energy prices and should not overly worry the BoE, though a sharp rise in underlying inflation would be more problematic. The minutes of the Dec MPC will be dissected for signs of hawkishness. There may be a hint that the MPC is ready to pause QE in February though this has been creeping into the price since the end of last year. On the economy, the BoE is likely to retain a cautious outlook. In recent months UK unemployment data has surprised on the upside. Another round of less bad data would justifiably bolster the outlook for sterling. That said, PSNCR figures are set to remind the market about the awful state of public finances and this could dampen the mood. The break below the 200 day sma at 0.8850 is a bearish signal for EUR/GBP and suggests scope for further losses towards EUR/GBP 0.8700.
Key data and events to watch next week
The calendar in the US is just modestly busy in the week ahead. Most US markets are closed on Monday for the Martin Luther King Jr. holiday and Tuesday kicks off the action in earnest with international capital flows (TIC) and the NAHB (homebuilder) sentiment index. Wednesday has producer prices and housing starts/permits on tap while Thursday rounds out the week with jobless claims, Philly Fed and leading indicators.
It is not that busy in the Eurozone either. There is an important meeting of EZ Finance Ministers on Monday. Construction output and the ZEW survey of economic sentiment are up on Tuesday. German producer prices are scheduled for Wednesday while the PMI surveys (manufacturing and services) are on deck Thursday. Friday closes things out with the French business confidence indicator.
The UK starts off the action on Monday with home prices and this is followed by consumer prices on Tuesday. Wednesday is important with the Bank of England minutes and the employment report due out. Retail sales is the other noteworthy release, up on Friday. There are also plenty of BOE officials speaking next week, with BOE Gov. King the highlight on Tuesday.
Japan looks characteristically light. Industrial production starts off the week on Monday. Tuesday is key with the tertiary industry index and consumer confidence lined up. Machine tool orders are due on Wednesday. The leading index is scheduled for Thursday while nationwide department store sales close out the action on Friday.
Canada has a very important week ahead. International capital flows start things off on Monday while Tuesday has the all-important Bank of Canada rate decision (expected unchanged; watch for BOC Gov. Carney comments opposed to CAD strength) along with leading indicators. Consumer prices are up on Wednesday while retail sales round out the week on Friday.
The calendar down under is not terribly busy. Australia has consumer confidence on Tuesday and terms of trade (import and export prices) on Friday. New Zealand sees home prices on Sunday, consumer prices on Tuesday and business PMI and retail sales on Wednesday.
Be on the lookout for important China data as well. The releases are all slated for Thursday when we will see GDP, producer prices, consumer prices, retail sales and industrial production.
Brian Dolan is chief currency strategist at FOREX.com.
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.