Market Outlook

Tue, Jan 19 2010, 06:46 GMT
by Kenneth Broux

Perceptions of a regime shift in the USD and bearish price action in GBP/G10 have stalled as the currency market ponders its first moves of the new year. A fall in the VIX below 18 and rally in the FTSE-100 through 5,500 have boosted demand for high yielding and commodity currencies, with Asian currencies also attracting support on speculation of policy tightening in Asia ex-Japan and China. As we enter the second half of January, the return to better liquidity levels may give a better sense of direction. Bearish GBP dynamics were temporarily suspended this week as MPC policymakers communicated their views on QE. UK December CPI and the January MPC minutes will be released next week and should favour wider UK/G10 yield differentials and basis spreads, underpinning GBP crosses. Following disappointing December payrolls data, the flatter Fed fund futures strip and comments by NY Fed member Dudley that rates will stay exceptionally low for ‘at least 6months’ have tempered enthusiasm for a second leg to the USD rally, though a negative equity market response to the first Q4 US corporate results could temper USD aversion.

USD

Follow-through buying around 78.0 in early January failed to materialise and puts our 79.0 target out of reach for now. IMM positioning has favoured adding USD longs since mid-December, but disappointing non-farm payrolls data has caused pro-USD enthusiasm to peter out in early 2010, pushing the USD index below 77.0 to a 4-wk low (76.601) .
The next major US event is not until January 26/27 when the FOMC meets. Mixed comments from FOMC officials (Plosser, Bullard, Fisher, Kohn) indicate that discussions are likely to turn more animated in coming months as the Fed approaches the end of the road in terms of MBS purchases on March 31 and the labour market turns.
We remain positive for the USD outlook in 2010 but have to be respectful of price action and of the fact that risk appetite alone and US portfolio inflows are insufficient to steer the currency out of the trasing range. On a risk/reward balance, the re-flattening of the Fed fund futures strip (see chart) and widening US/G10 rate differentials favour near-term downside for the USD index. Bullish USD flows will struggle to gain traction until non-farm payrolls expand by 150-200k on a monthly basis.

Releases next week include November TIC data, December PPI and housing stats. Asian purchases of Treasuries fell in October to only $6.4bn, a 5-mth low. A further decline could increase pressure on USD/Asia. A blackout period ahead of the January 26/27 FOMC meeting means there will be no official commentary on policy or the economy.

EUR

Default concerns in Greece have continued to cloud performance of EUR/USD, though occasional signs of a decoupling of 10y Greece/ bunds and EUR/USD this week makes us wonder if currency markets are prepared to move on. The strong start to 2010 for equities and the widening in EU/US 2y spreads favour near term upside for EUR/USD if EU deficit concerns are contained.
EUR/USD has rallied gradually from the December 24 low of 1.4324 to a 1.4579 high on January 13. A test of 1.4631, the 61.8% Fibo retracement, would open the door for a move back up to 1.50. We are wary of profit taking above 1.45 and reiterate our longer term call for a move to 1.40 on global reserve diversification (PBoC tightening) and a tightening in EU/US spreads later this year. The EUR is 19.5% overvalued vs the USD on a PPP basis (OECD).
A 1.5pt drop in one-year EUR/USD vol below 11.5 following disappointing US non-farm payrolls has pushed the 1mth/1y spread to 1.55, the lowest since last October. We look for IMM positioning to reduce net short EUR positions over the coming week.
A quiet week ahead features the advance EU-16 flash PMIs for January on Friday the 22nd. Sovereign bond supply has been well absorbed this week despite deficit concerns and wider spreads (Spain, Portugal). Next week, Germany will sell 7bn in 2012 paper and Spain will tap the market for 2014 and 2029 funds.

GBP

A turnaround in GBP/USD has gathered steam as we approach the halfway mark in January, with a bounce from the December 30 low of 1.5833 through the 200d MA (1.6142) attracting buyer interest. We look for strong CPI data to support bullish momentum next week and target a move up to 1.65 on a break of 1.6340, the 50d MA. Support rests at 1.6142.
GBP found a solid bid this week after MPC member Sentance (hawk) was quoted saying that the time has come for the MPC to adopt a waitand see approach and that interest rates may have to rise this year if the recovery poses a threat to inflation. His view are not representative of the nine-man strong committee but are potentially a sign of things to come and a possible split between hawks and doves at the February MPC meeting on whether to extend or pause QE (the Bank sold corporate bonds last week, hinting at a freeze in asset purchases). Sentance’s comments may be a launchpad for GBP into next week, though conviction to push GBP higher will depend on CPI and January MPC minutes.
For EUR/GBP, a break of 0.8849 trendline support forced sterling bears to cover and squeezed the pair to 0.8810, a 4-mth low. Strong UK CPI data and hawkish MPC minutes would up the ante for a test of 0.88 support, potentially followed by a more portracted decline towards the September 09 low of 0.8704.
UK data next week is forecast to show a rise in annual CPI to 2.5% in December vs 2.1% in November. RPI is expected to jump to 2.1% from 0.3%. The claimant count total is forecast to have stayed flat in December following a surprise 6.3k drop in November. Indications of a looming MPC split in the January minutes would be GBP bullish. The DMO will auction 3.3bn 2019, 3.75% gilts.

CAD

USD/CAD shows good traction for a move back towards the October 09 low situated at 1.0207, supported by a bounce in oil prices to $80 and pro-risk appetite for commodity currencies. This inevitably brings back speculation of USD/CAD parity, supported by positive CA/US rate differentials and the risk of verbal intervention by the Bank of Canada to slow the appreciation of the CAD.
CA/US 2y spreads have widened to 42bps from 33bps in late December, supported by disappointing US non-farm payrolls and a flattening of the Fed fund futures strip. A widening in the 2y spread up to 54bps is likely to support near term CAD strength, though the TSX Composite underperforms the FTSE-100 and S&P since early December (+1.2% vs +3.5% and 3.8%) and continues to lag over the early part of January.
IMM positioning showed a near 50% surge in CAD net long positioning during the change-over from 2009 to 2010 to the highest level since October 20 when USD/CAD traded at 1.0207. For GBP/CAD, we target a move back to 1.65. The cross stopped short of 1.67 trend line resistance and we expect selling pressure to push the cross lower within the downward channel.
The Bank of Canada meets next week and is not expected to change the outlook on interest rates or inflation. We do expect the Bank to comment on the strength of the CAD and are alert to short covering efforts in USD/ CAD and a relief bounce up to 1.04. The outlook is for the overnight lending rate to stay at 0.25% until Q2-10

JPY

A turn in Japanese investment flows for the first time in three weeks helps to explain the reversal in USD/JPY from the January 8 high of 93.77, though a compression in 3mth Japan/US libor differentials to +1bps and currency markets fret over a shaky start by new Japanese Finance Minister Kan.
The largest investment inflows from overseas residents into Japanese equities since July 2007 was observed during the first week of January (overseas bond redemptions flows and a rally in global equities has prompted Japanese investors to buy more stocks), boosting net inflows including money market securities to Y0.9 trln. Over the first two weeks of January, this puts the Nikkei-225 ahead of the FTSE-100 and S&P with a gain of 3.4%.
A cluster of support levels for USD/JPY is situated in the 90.50 area, with participants eying targets around 90.0. The 100d MA runs along 90.44 and a penetration of the 90.35-44 support zone would give way for a move to 90.05. IMM positioning shows an overwhelmingly bearish JPY skew since December 15. Some unwinding is likely to take place following a duo of weak US labour market and retail sales stats in early January. USD/JPY 1mth risk reversals favour JPY calls (-0.8075) but sentiment on the whole remains balanced compared to early December.
For EUR/JPY, a rapid descent below the 50d, 100d, and 200d MA since January 12 favours near-term weakness and a decline below 130.0 where buyers are likely to emerge. Key support runs in the 128.0 area. Japanese data next week includes consumer confidence and the tertiary industry index. The Cabinet Office will issue its monthly report on the economy.

AUD

AUD/USD has fully recovered from a late December dip, supported by the rally in pro-risk assets, strong Australian macro data and wider AU/US rate spreads. The question from here is whether to fade the bounce or add AUD/USD longs and raise targets to the early November high at 0.9406. Good support runs at 0.9125, the 50d MA.
Australian Q4-09 inflation data along with US Q4 corporate earnings and the performance of global stock and commodity markets are set to drive AUD flows over the coming week. IMM positioning shows AUD longs are the highest since December 1, pointing to broad based sponsorship for the bounce into January, though AUD/JPY has lagged. For GBP/AUD, key resistance is pinned around 1.7713.
With a 25bps rate hike by the RBA priced in next month, we look forward to the quarterly CPI data on January 27th and wonder if stronger data could tempt the RBA catch the market off guard with a 50bps hike in the cash target to 4.25%.
AU/US 2y spreads have widened nearly 25bps to 361bps over the last week, driven by weak US economic data and dovish comments from the NY Fed’s Dudley. We look for the spread to widen to 370bps.
The decision by China to tighten commercial banks reserve requirement ratios this week proved only a minor setback for AUD/ USD, but could neutralise bullish momentum beyond the RBA meeting in February as markets speculate over a PBoC hike in the lending and deposit rates. A decoupling of AUD/USD with the Shanghai composite suggests other factors may play a more powerful role over the coming week, with the failure of gold to follow-trough above $1,150 providing bearish distraction.

NOK & SEK

NOK and SEK strength has resumed over the course of the past month after both currencies retraced somewhat against the US dollar towards the end of last year. We expect further appreciation over the year and in the near-term. Our short EUR/NOK position has begun to gather momentum after breaking lower through support at 8.25 to 8.16. We think this has further to run given the uncertainty surrounding Greece’s fiscal position and possible associated problems in the rest of the eurozone. Economic fundamentals continue to remain positive in Norway with the PMI survey for December moving above 50 to 50.4 to the highest since May 2008 which continues to imply that the Norges Bank will be towards the front of the line when it comes to rate hikes later this year. We look for EUR/NOK to target 8.03 and USD/NOK to re-test the recent lows of 5.512.
EUR/SEK tested the neckline of the head and shoulders formation but failed to break above. Although the head and shoulders pattern implies a move down to around the 9.50 level, the currency pair has been range bound over the past four months between 10.03 and 10.5. A break below the 10 handle should confirm the H&S reversal and we would expect to see a sustained move lower towards 9.50 This is supported by our view that SNB may well bring forward rate hikes currently pencilled in towards the end of the year given the shift in tone we are beginning to see in some of the monetary policy council members comments. NOK/SEK continues on a short-term upward trend but upside looks to be capped at 1.2571. A break above here would target 1.2804 but we are likely to see some downside first with support at 1.230 and then 1.2161.