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Sunrise Market Commentary: Currencies

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Chinese report on reserve diversification puts dollar under (very) mild pressure

Mon, Oct 26 2009, 08:22 GMT
by KBC Market Research Desk

KBC Bank

On Friday, EUR/USD hovered sideways around the 1.5030 Thursday’s closing level for most of the session, closing with marginal losses at 1.5009. The greenback once more had difficulties to gain on the equity correction that hit Wall Street. The stronger EMU PMI data triggered a small spike lower in EUR/USD, apparently on the expectation that it would support equities, but as equities barely reacted, EUR/USD reverted higher, helped later on by the weak UK GDP report. However, it is fair to say that these small intra-day gyrations never could generate momentum. During the US session, equity weakness pushed the dollar up, but also these gains were marginal.

Overnight, EUR/USD tested last week’s highs on a China report, but currently changes again hands at 1.5040, slightly below the highs (1.5163). In an article published in a People’s Bank of China paper, Zhou Hai, an BoC official wrote that while the dollar would remain the principal currency in China’s huge Fx reserves, the share of the euro and the yen should increase. Later on, Zhou said it was purely a personal view. He also said that China should improve the yuan exchange rate mechanism to reduce pressure on the central bank to buy inflows of foreign exchange. The comments of Zhou are of course pertinent and nothing earth-shocking, but add to the negative sentiment on the dollar, even if it remains difficult to judge whether it contains much news or signal a concrete change in the management of reserves or of the currency is imminent. In any case, it seems the central bank will act very gradual on the subject of the reserves and on the way it manages the currency. We think that a renewed appreciation of the yuan versus the dollar is very likely, following a pause in the appreciation since mid 2008, but the timing of it is difficult to guess.

Today, the market calendar is not quite interesting, as is usual the case on Monday. The Chicago National Activity Index is no market mover and neither is the Dallas Fed manufacturing Index. Later this week, there are some interesting eco releases in the US, especially Q3 GDP that should show good growth. In EMU, the dataflow includes M3 money supply growth (tomorrow) and CPI on Friday. However, the FX market might be more interested in the fate of the fresh US supply that will hit the bond markets. It starts with a $7B 5-year TIPS re-opening today, followed by auctions of 2-, 5- and 7-year papers in the next days, the size of which is always new record highs. In recent months, the auctions attracted strong and aggressive demand, but that cannot prevent nervousness ahead of the auctions, especially if articles about a diversification of Chinese future reserves away from dollar are published and the Fed will conclude its Treasury purchase program this week. If the auctions would be failures, not our favourite scenario, it might hit the dollar. Central Bankers should be less vocal this week, as the FOMC and ECB meet next week. Equities will be another key ingredient for FX trading. Equity weakness should be dollar positive, but recent weakness helped the dollar only marginally.

Global context: recently, the swings in risk appetite/risk aversion were the drivers on the currency markets. Improving investor sentiment towards risk is still considered a good reason to sell the US dollar. On top of that, in this low yield environment, the dollar has become (or is at least perceived to have become) the preferred currency to fund carry-trade deals. Lingering uncertainty on the huge US financing needs, some international debate on the status of the dollar and the Fed’s intention to run an expansionary monetary policy for a prolonged period of time offer additional ammunition for carry traders to use the dollar rather than other currencies. This has put the dollar in a vulnerable position. We stay dollar skeptical as long as we don’t get a clear signal that the Fed is coming closer to scale down its stimulating monetary policy (see higher). Nevertheless, the ongoing building up of USD short positions at some point will trigger a ST correction. Such a correction most probably will occur in step with the stock markets. In this respect, the inability to clear the 1100 level (S&P) recently may be a signal that such a correction is approaching.

Looking at the (technical) charts, the break of EUR/USD above the range top at 1.4438/48 and above the 1.4719 (Dec high) improved the picture, but the move continued to develop in a rather gradual way. Nevertheless, the corrections are very limited, too. However, as we have reached our long-standing technical target of 1.5021 (2nd target double bottom of 1.3739), we are more cautious on the ST upside potential in the pair and advice partial profit taking on standing EUR/USD long positions. We wait for a correction to (re)establish EUR/USD long exposure.

On Friday, USD/JPY continued to grind higher in a session devoid of important data, comments or other news items. The USD/JPY pair simply corrected higher in a move that started on October 8 when the pair tested the USD/JPY 88 level. The feeling started to grow that the steep yen gains were overdone, as the yen strength was out of line with the economic weakness that would be exacerbated by more yen strength. USD/JPY is now closing in at the 92.53/93.10 level (September 21 high/downtrendline), the first key resistance level. This is a first test whether the upmove in USD/JPY is simply technical in nature of has some stronger fundamentals behind.

Overnight, the yen trades little changed to marginal stronger against the dollar. The market shrugs largely off a Chinese report stating that China would keep a greater proportion of its huge reserves in yen (and euro). The Nikkei is trading higher, maybe following last week’s weakening of the yen, in which case it of course is no factor that should support the yen. Indeed, exporters are doing well on the bourse today. South Korea reported much stronger-than-expected GDP figures, up 2.9% Q/Q and 0.6% Y/Y, the fastest pace in more 7 years. However, it caused no euphoria in Asia as large part of the increase was inventory rebuilding, more than final demand. Indeed, consumption and construction were weak. This means that the Korean authorities might keep stimulus measures and low rates in place for longer than expected. Therefore, the report didn’t give Asian currencies a boost. The trade weighted dollar is nearly unchanged. Most likely, the market is simply hovering sideways at the onset of a new trading week, waiting for new eco data and the US fresh supply that will come onto the market later this week. Indeed, the 5-year US TIPS (today) and the end-of-month 2-, 5- and 7-year T-Note auctions are a hurdle for the dollar this week and the results will be closely watched by the forex markets.

Global context: USD/JPY reached a reaction high in the 97.80 area early August. Despite positive global investor sentiment, the dollar could not hold on to its gains against the yen. The link between USD/JPY and global investor risk aversion/risk appetite became less tight and sometimes it even reversed. The dollar (and not the yen) was said to have become the preferred funding currency for carry trades. So, the price action in USD/JPY more or less joined the global dollar trend (decline). The long-term trend obviously remains USD/JPY negative. However, recently, we turned more cautious on USD/JPY shorts on technical considerations. On top of that, the change in talk from the Japanese authorities also slowed the ascent of the yen. So, the situation in USD/JPY has become a bit paralysed. Recently, we indicated that we were looking to sell into a more pronounced up-tick, hopefully in the 92/93 area. We keep a wait-and-see approach and still hope to get the opportunity to resell higher, something that has become more likely.

On Friday, sterling was heavily sold off, as the Q3 GDP totally unexpected showed a steep drop (-0.4% Q/Q) whereas modest growth was expected. So, the UK recession still didn’t end in Q3, prolonging it to a post-war unprecedented six quarters. It also re-opened the debate on a potential extension of the QE policy above the £175 B Gilt purchase program that is almost finished. Earlier last week, the market had sharply lowered its expectations on the extension of QE, which at that point led to a sharp short covering rebound of sterling. The November MPC meeting might be tense with proponents and opponents of a QE extension inside the MPC probably still near balance. It will be a finely balanced decision because some members of the MPC, like outsider observers, will question the reliability of the GDP figures and may wait for confirmation of the content, but after all we favour an extension decision or at least an postponement of the decision. Whereas sterling was still slightly strengthening ahead of the release and the EUR/GBP 80.8984 support loomed, the pair shot higher on the publication and saw more follow through buying throughout the remainder of the session, reaching the 0.9188 level in early afternoon and later on closing at 0.92021, near session highs. Overnight, Asian investors got the opportunity to react, keeping sterling under some downside pressure and EUR/GBP changes hands at 0.92257 currently.

Global context: Since early August, sterling sentiment deteriorated again. The BoE decision in August to raise the asset purchase program to £175B and Governor King’s call for an even greater effort indicated that the Bank intended to maintain a loose policy for a prolonged period of time. This triggered a new sterling selling wave. At the September meeting, the BoE took no additional policy steps and this applies also to the October meeting. However, the Minutes of that meeting nevertheless attracted the attention. Some observers correctly noted that in contrast to September meeting, the more dovish MPC members didn’t re-state there preference for more QE, making such an expansion of the QE unlikely, especially as some MPC members including governor King in a newspaper had become slightly more optimistic on the economy. We were not sure whether such an interpretation of the Minutes was correct and we probably only know at the next MPC meeting in early November. However, the weak Q3 GDP figures show the debate on QE is entirely open. This question will dominate markets in the next ten days. We have a long-standing sterling negative view and don’t feel any need to change it. We were looking to add/reinstall EUR/GBP long positions around first important support area at 0.9080, but given the violent correction refrained from doing it and adopted a wait-and-see attitude. Friday’s post MPC rally make us again more comfortable with sterling shorts, but we want some confirmation of the sterling weakness before adding to the position.

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Published on  Mon, Oct 26 2009, 12:06 GMT