Eurozone steps closer to the edge

Will Greece capitulate?

Can the USD extend its rally?
Since the beginning of May the dollar index has seen a sharp rise from the May 1 lows of around 78.60 to test near multi-year highs which were last seen on January 13 around 81.75. The buck has gained amid demand for safety as concerns surrounding Greece’s future in the euro and contagion fears have escalated. The rally may be running out of steam for now as negative external factors stemming from the Euro zone haven been largely priced in and as domestic concerns keep the prospect of additional Fed stimulus in sight.

While safe haven flows resulting from external uncertainties have benefitted the dollar, domestic concerns cannot be ignored as the FOMC minutes released earlier this week reminded markets that the Fed remains open to the idea of further monetary easing. The minutes noted that the recovery would have to falter in order for more stimulus to be warranted. Though our base scenario is for no additional QE, this past week’s data showed a slight deterioration in economic activity. Inflation slowed with the yearly change in headline CPI falling to +2.3% in April, retail sales softened, weekly jobless claims showed no sign of improvement, and the Philadelphia Fed index showed contraction for the first time since Sept. 2011. In the week ahead, new and existing home sales, regional Fed manufacturing reports, and durable goods orders are scheduled for release and any significant disappointments may cause markets to increase speculation on additional Fed measures.

Technically, the dollar is approaching significant levels against many of the majors which suggest that it may find resistance as dollar longs look to book profits. EUR/USD has slowed its decline ahead of the 2012 lows which may act as support in the near term and USD/JPY continues to face resistance around the top of its weekly ichimoku cloud. The ascent in the dollar index has decelerated and looks to be stalling around the 81.75 level. Daily candle sticks are showing long top wicks indicating the markets reluctance to push the buck higher at this time.

Bank of Japan may extend maturity of its bond buys
The Bank of Japan (BoJ) will meet next week on May 23 to announce policy and we expect the bank to keep policy on hold with a small tweak to the maturity of its purchases. With a net ¥5T increase in total purchases at last month’s meeting, we think that it is too soon before the bank expands the amount of bond buys.

The BoJ has been buying Japanese government bonds (JGBs) as part of its asset purchase program – a monetary policy tool designed to fight deflation. The program began in October 2010 and earlier this week the bank saw its first shortfall in its bond buys since the start of the program as it was unable to reach its target of ¥600B in JGB purchases. The bank received only ¥480.5B offers in short term JGB’s as there was an insufficient supply. With the bank facing difficulties in implementing its operations, we think that the bank may need to adjust its approach by increasing the maturity of its purchases.

Currently, the bank is only purchasing short term debt with a maximum maturity of up to 3 years. The bank announced the extension from a maximum of 2 to 3 years at the last policy meeting and in our view, the bank is likely to extend the maturity at next week’s meeting. The impact will likely be muted however as the Japanese government yield curve is already very flat. Two-year yields are currently at about 10 bps and 10-year yields are around 83 bps.

With expectations of strong action from the BoJ low, the yen is likely to remain firm as traders avoid risky assets. This past week, the JPY outperformed the G10 currencies as risk aversion saw flows into safe havens. We expect the yen to remain rangebound against the dollar as it consolidates within the weekly ichimoku cloud that sees the top and base around 80.45 and 78.00 respectively. The risk is for potential intervention, which finance minister Azumi has been hinting at for some time. As we have previously noted, actions taken by Japanese officials have not had a lasting impact and have been relatively ineffective in sustained yen weakness.

Pricing in more QE from the Bank of England
The pound was one of the worst performers out of the G10 last week after the Inflation Report from the Bank of England was perceived as being dovish. Although the Bank revised up its forecast for inflation this year, it also revised its growth forecast lower after the contraction in the economy in the first quarter. But since the Bank sets policy with a two-year time frame, its longer term inflation forecast was more important. It expects inflation to under-shoot its 2% target in the next two years, which suggests the Bank will keep the door open to more QE.

So why didn’t the BOE do more QE at its meeting earlier this month, when the last round of asset purchases was completed? Outgoing MPC member Adam Posen (he leaves in August) explained that his decision to stop voting for more QE last month was down to the stickiness of inflation, however although he said there was a chance that growth data could be revised higher, he said that he would be reviewing his vote for QE going forward.

This highlights some of the difficulties faced by the BOE. The economy could do with more stimulus, yet household incomes are constrained by rising prices especially food and energy prices. Thus, the recent decline in the oil price (Brent crude has fallen nearly $18 since March) could give the MPC much-needed room to add more stimulus later this year.

It’s a big week for economic data in the UK. Inflation and retail sales are the highlight, the BOE minutes are unlikely to deviate too much from the Inflation Report. CPI data is expected to decline to 3.1% from 3.5% in March. This is a sharp fall, but remains above the Bank’s 2% target. If inflation is stronger than expected then the prospect of more QE is likely to get pushed back. However, if it is lower this could boost the chances of more QE, especially if the growth outlook remains weak and if the Eurozone debt crisis (which the Bank said was the biggest threat to the UK economy) takes another turn for the worst. Retail sales are expected to fall by 0.7% in April, although some of this decline could be due to the early timing of Easter.

Last week the pound broke its inverse relationship with Gilt yields. In the past few months it has strengthened as Gilt yields have fallen, leading the pound to be called a “safe haven”. However, earlier this week the pound fell alongside bond yields, and also couldn’t manage to keep EURGBP below 0.8000.

Since monetary policy has been a key driver of the forex markets in recent months, a more dovish MPC is likely to weigh on the pound. We think the pound is vulnerable especially against the yen and the Aussie dollar. Weak inflation data could push GBPUSD below 1.60, after it found support at this level last week. EURGBP also managed to recover, however although we think the euro may consolidate here we believe it could grind lower in the longer-term and re-test the air below 0.8000.

GBPUSD is harder to predict. Because the dollar is a safe haven, this cross is vulnerable to selling pressure when the markets are in risk-off mode. As we mention above, the markets may be ripe for a pullback, and any dollar weakness could help GBPUSD to recover. However, we tend to think that 1.60 is likely to cap any gains in the current environment of heightened tension in the currency bloc. 1.5700 may act as good support.

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