Dollar sags as key E.U. decision looms

What to look for in the week ahead

  • The Dollar sags as key EU decisions loom
  • The ECB takes its anti-inflation medicine
  • Commodities continue to stay aloft amid tensions in MENA
  • The BOE gets pipped at the post
  • Kiwi under pressure ahead of RBNZ

The Dollar sags as key EU decisions loom
The greenback slumped further as violence in Libya escalated and fears continue to mount of unrest spreading to other, more economically significant countries in the region. Despite the largest gain in jobs since census-induced hiring in mid-2010, and other signs of improvement in US labor markets e.g. further declines in initial claims, the buck limped out at its lowest level for the year according to the USD Index. But the USD’s performance was mixed against most currencies other than the EUR, which rallied across the board on ECB rate hike expectations (see below). All in all, it could have been much worse for the USD and this suggests a safe-haven bid may be returning to the greenback. US stocks declined and Treasury yields fell on safe-haven buying of US Treasuries in spite of the ostensibly upbeat Feb. jobs report. Precious metals and commodities also continued to gain ground on the Mid-East upheaval. The focus there is firmly on efforts to oust Libyan leader Gaddafi and we would suggest it is a question of when, not if, he disappears into exile, potentially setting up a rapid reversal in safe haven assets. In the meantime, civil conflict in Libya is likely to drag on and the dollar’s descent seems likely to continue, though probably less of a rapid collapse and more of a slow grind.

Over the next several weeks, EU leaders will be meeting to tackle their debt/financial crisis, culminating in the March 25 summit that aims to produce the comprehensive crisis resolution mechanism. The end of next week will see the ‘European Competitiveness Pact’ unveiled, which aims to strengthen economic and fiscal coordination among member states. Indications are that deep divisions remain on many of the key issues, such as establishing concrete debt reduction goals, increasing the size of the bailout fund, and whether to allow it to buy peripheral government debt. The risk to recent EUR gains is that EU leaders fail to produce a credible mechanism and markets conclude sovereign defaults remain a serious threat, which may see EUR come under pressure despite rate hike expectations. Lastly, we would note the relatively minimal gains in EUR/USD since the relatively surprising ECB announcement (only about 120 pips), which we interpret as a sign most of the move was already priced in.

We see immediate upside potential for EUR/USD while the 1.3800/50 area holds. Initial resistance is at 1.4020/50, above which gains to the 1.4180/1.4200 are our expectation. Overall, a Fibonacci wave extension suggests 1.4420/25 as a potential target for the current advance, once above 1.4050.

The ECB takes its anti-inflation medicine
ECB Governor Trichet surprised the markets last week with an explicitness he has saved until the last 6 months of his term in office. He reverted to the verbal code words he used during the Bank’s previous tightening cycle when he said that “strong vigilance” is warranted with a view to continuing upside risks to price stability. In the past this signaled that a rate hike was imminent. Now the market expects Trichet to announce a rate hike at April’s meeting. But it wasn’t this stock phrase that surprised market watchers, it was Trichet’s candidness.

Although he said the ECB never pre-commits to a rate decision he added that he expects rates to rise by 25 basis points and that a rate hike next month would not signal the start of a tightening cycle. This was central bank communication at its most clear. Immediately investors scrambled to re-adjust interest rates armed with this new information. 3-month euro Eonia swap rates surged 10 basis points to their highest level in 2 years, while Euribor – the inter-bank lending rate – also surged on the news. The extra yield boosted EURUSD, and it is now on the brink of 1.4000.

Up until last week the markets had been expecting the Bank of England to hike first. After the ECB press conference the yield differential between German and UK yields widened considerably which boosted EURGBP to 0.8600.

So why did the ECB bite the bullet? The most likely reason is that rapidly rising oil prices don’t warrant extraordinarily accommodative interest rates. Indeed, Trichet omitted to mention that the interest rate was appropriate; instead he said the current stance of monetary policy was “very accommodative.”

But will one hike be enough? We would say probably not. Inflation in the Eurozone is running at a 2.3 per cent annualized rate. Even with a 25 bp increase real interest rates will still be negative, so the ECB aren’t going to stamp out inflationary pressure with a small, one-off rate hike. So if the Bank is serious about inflation a series of hikes seems more likely. The market has rushed to price in a more than 50 per cent chance that rates will rise to 2 per cent (they are currently 1 per cent) in 12-months’ time.

The ECB and the Federal Reserve are now at either end of the policy spectrum, with the latter seemingly committed to providing the full $600bn allotment of QE2 to the US economy until June. The diverging paths of the two largest global central banks should benefit EURUSD. So far it has failed to break above 1.40, but in the coming weeks, based in its yield advantage, we see EURUSD back at the 1.4250 highs last reached in November 2010.

Commodities continue to stay aloft amid tensions in MENA
This week crude oil prices rose to fresh 29-month highs ($104.30/35) amid the rapid deterioration of stability in Libya and the threat of it spreading to other MENA (Middle East/North African) nations. The persistent violence has caused supply disruptions in Libya of approximately 1 million barrels a day, which is over half of their daily output. While news that Saudi Arabia guaranteed to use spare oil capacity if needed – Saudi’s spare oil capacity is estimated to be 5 million barrels a day, temporarily calmed the markets, it’s not an exact match since Arabian oil is much heavier than Libya ’s light sweet crude and is thus problematic since it needs additional refining. With the current geopolitical environment riding high emotionally, fundamentals are likely to remain in the rear-view mirror. Furthermore, even prior to the political unrest in the Middle East we saw signs of demand growth picking up in China and India, and with today’s U.S. unemployment rate falling to 8.9% it signals demand in the west may begin to pick up as well. Lastly, market participants are beginning to envision a weaker USD moving forward, based on diverging interest rate expectations between the Fed and the ECB and BoE, which has caused greater demand for commodities and ultimately adds more “fuel to the fire”.

The “flight-to-safety” trade has not just been all about oil, but was also present in precious metals as well. As noted in this week’s Commodities Corner, “with tensions in the Middle East unlikely to subside anytime soon, this flight-to-safety trade could be stronger and last longer than the market currently anticipates, subsequently traders are beginning to take action.” Over the past week gold broke to new nominal all-time highs near $1440/oz. and silver just made fresh 30-year highs of $35.35/40 at the time of this writing. Going forward, price action should remain volatile, however pullbacks could be shallower than one would anticipate as investors who have missed the current move higher in commodities may look to jump on board in the not too distant future. A resolution to the Libyan turmoil, on the other hand, could see a more serious set-back.

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