Market Outlook

Mon, Mar 15 2010, 11:13 GMT
by Kenneth Broux

Rising inflation expectations in the UK and confirmation that the Budget will be held on March 24 means GBP shorts may be forced to cover positions as government leaks emerge over the next two weeks of UK deficit reduction plans. Ultra-loose monetary policy in the G7 and positive economic data surprises in the G10 are lubricating pro-risk strategies, with higher oil and equity prices supporting rallies, notably for the CAD where strong employment data may force the Bank of Canada to raise rates before the Fed. A shift in the FOMC’s stance on low interest rates and ‘extended period’ rhetoric appears unlikely at the one-day meeting next week, and may put the trading emphasis on the BoJ meeting instead where new measures to counter persistent deflationary pressures may be discussed. For the BoE MPC minutes (Wednesday), we doubt much will come out in terms of major new points of contention on the committee, though the surprise surge in the February services PMI (data trio of dismal retail sales, IP and foreign trade unknown to the MPC at the time) and the strongest Inflation Attitudes survey in two years may reveal a less conciliatory stance with regard to the possible extension of QE, lifting GBP to better levels to sell.

USD

• Fed fund futures have reined in tightening prospects since the start of the year, but this has not held back the USD from strengthening against the G10 bloc except for the JPY. Though speculation has intensified that the Fed may soon agree to make subtle changes in the FOMC statement to give itself leeway to exit from the ‘extended period’, the resilience of risk assets may keep the USD rangebound for now. Broad investor sentiment towards the greenback remains neutral in the absence of a clear Fed tilt or flight-toquality, keeping the DXY in a tight 79.50- 81.0 range. The FF future strip is only pricing in one rate hike by December.

• The one-day Fed meeting on Tuesday obviously takes centre stage. We look for Hoenig to have repeated his opposition against the view that interest rates can stay low for an extended period. The key question for the USD is twofold: (i) did another committee member enter a reservation, and (ii) does the statement make a first overture towards removing the pledge to keep rates low. The deadline of March 31 for agency and MBS purchases will put the spotlight on long-end Treasuries and mortgage rates for signs that the Fed’s exit as a principal buyers is pushing up longterm yields.

• TIC capital flows data set of a small storm last month about China trimming Treasury holdings to an 11-month low. China’s head of SAFE repeated during a visit to Washington last week that China is fully committed to its Treasuries holdings, so evidence of rebound in Chinese purchases in January (data due Monday) may put to rest diversification concerns. February CPI data are due on Thursday.

EUR

• Sovereign funding concerns in the euro area have drifted into the background as EU ministers mull a bond sales plan, giving the euro a degree of breathing space since the start of the month. The resulting fall in euro volatility is translated into handsome gains vs the JPY, USD and GBP. Disagreement at the ECB over proposals to set up a European Monetary Fund may keep the euro hostage as doubts linger over the sizeable Q2 funding requirement. We reiterate our defensive position on EUR/USD, targeting 1.3250 in the medium term. We fade a relief rally in the 1.3839 area, the February 9 high.

• EUR/USD is trapped in a 1.3436-1.3839 trading range since early February. Though event risk from the euro zone has dissipated near-term, appetite to reduce EUR shorts by the speculative community is low. (69,000 contracts last vs 78,200 previously). The correlation of the EUR with risk assets is nonexistent and leaves EUR/USD exposed to downside pressure on profit taking in stocks. One-month risk reversals have edged up to -1.04, a 4- week high. 1-month vol has collapsed below 10.0.

• EU-16 February CPI and January foreign trade data, and the German ZEW survey will offer some clues about the state of the economy next week, but are unlikely to cause too much of a distraction in a market still very much conditioned by trends in peripheral bond spreads and G10 interest rate differentials. Greece is reportedly planning to issue two more bonds this month and is also looking to issue in Asia or the US.

GBP

• Rising inflation expectations threaten to complicate the outlook for the BoE but may have temporarily averted a further breakdown in GBP crosses. Inflation expectations rose to 2.5% from 2.4% according to the latest BoE Inflation Attitudes survey, the highest since 2008.

• Confirmation that March 24 is Budget day may force sterling shorts to trim overweight positions, with tactical leaks in the next two weeks pledging a deficit reduction potentially relieving GBP from ‘ratings downgrade fever’. This should set GBP up for better levels to sell going into the General Election. Our medium-term target is for a decline in GBP/USD to 1.44.

• Declines for GBP/USD below 1.50 are a magnet for relief bounces, but heavy resistance in the 1.5150-96 region stands in the way of a more convincing rally. Following a short squeeze late on Friday above 1.52, we are keeping a close eye on 1.5279, the 50% Fibo retracement. IMM positioning shows still shows overwhelmingly bearish GBP/USD positioning. Support runs at 1.4830.

• A worsening of the UK macro backdrop is evident from a trio of dismal January reports of retail sales, foreign trade and industrial output data. This reminds us of the historical tendency of the economy to slow in the run-up to the general election. With higher oil prices/weak GBP eroding purchasing power and fiscal tightening forthcoming, we doubt whether exports and business investment can kick start stronger growth.

• For EUR/GBP, heavy resistance in the 0.91 area is keeping the cross from making a move to 0.9141 where trendline resistance is situated. We target a return to the 100d MA at 0.8916. Guidance from UK/EU 2y rate differentials is insignificant, but may need revisiting next week if UK yields gain traction from less dovish March MPC minutes.

• A big week for data and events features February data releases of unemployment, public finances and preliminary M4 data. The minutes of the March MPC meeting are due on Wednesday. We doubt much will come out of this in terms of fundamental policy changes, though the surprise surge in the February services PMI and rising inflation expectations may reveal less dovish tendencies (GBP positive) and greater determination to keep the APF at £200bn. The report on Thursday of a rise in M4 money supply growth may buoy optimism that QE is working.

JPY

• The bi-weekly BoJ meetings have been a rather dull affair since the Bank decided last December to ‘further enhance easy monetary conditions’ by introducing a new funds supplying operation. Speculation has been rife since the Nikkei reported a week ago that the BoJ will mull new measures in March before taking a decision to implement a new liquidity initiative in April to combat deflationary pressures.

• Next week’s meeting (March 16) comes before the March 31 end of an unlimited collateralised loan facility. The Nikkei reports that the BoJ may expand the 3-month lending programme from 10tln to 20tln yen, though broader measures will reportedly be saved until April (new fiscal year) allowing the BoJ to bide its time until after Q1 Tankan survey on April 4.

• It must be said that the JPY has been holding up rather well especially vs the USD despite the rally in risk assets, the negative JAP/US 3-month libor spread, and seasonal factors that typically weigh on JPY this time of year. USD/JPY 1-month risk reversals have ticked up to 2 1/2 month highs (-0.33). 1-month vol dropped to a near 4-month low below 11.0.

• For USD/JPY, upside is capped in the 91.80-91.35 area, with the 50d MA (90.46) acting as major pivot. Speculation about new measures in China to tighten credit and monetary policy following a round of strong February economic data (CPI at 2.7%) effectively means the PBoC is dictating the next move in JPY crosses. See our weekly special on CNY revaluation for more analysis of the impact on G10 fx.

• For EUR/JPY, follow through buying has emerged on EUR/USD outperformance vs USD/JPY, with the cross making steady progress towards 125.28 resistance as EU sovereign funding concerns drift into the background. For GBP/JPY, we look for the uptrend to reverse before the cross hits 138.50.

AUD

• Correlation with risk assets remains overall positive but is off the highs and losing traction as we move into the second part of March. Instead, a widening in AU/US 2y rate differentials to 394bp is supplying bullish momentum, guiding the cross to near two-month highs at 0.9190.

• AUD/USD has done well to overcome resistance in the 0.9085 area and now finds itself in the middle of an ascending channel with momentum building for a rally up to 92.50 trendline resistance. What the FOMC says or doesn’t say next week may be pivotal for near-term direction, with a bounce in US 2y rates potentially knocking AUD/USD back for a retracement towards 0.9058, the 100d MA. We fade GBP/AUD rallies in the 1.6750 area and target a test of 84.0 in AUD/JPY for a move up to the January high (86.20).

• A quiet week ahead features a speech by RBA deputy governor Edey on Monday, the RBA minutes on Tuesday, and a panel discussion with RBA governor Debelle on Wednesday. The next RBA meeting is not scheduled until April 6. At 64,000 contracts, long AUD IMM positions are the highest since January 19th.

CAD

• We are CAD bulls vs most G10 currencies, taking direction from IMM positioning (CAD longs still rising) and our positive bias on CAN/G10 rate differentials. We are also coming around the view that the Bank of Canada may start raising the overnight lending rate sooner rather than later. The case for the BoC to move ahead of the Fed received a major boost from the latest labour markets statistics. Full time employment surged by 60,000 in February, and the unemployment rate fell to 8.2%, marking a second successive drop.

• Supported by the recent shift in Bank of Canada inflation rhetoric and a bounce in Nymex crude through $82.50, we like buying dips in CAD/G10. Conditions on the Fed keeping extended period in the FOMC statement on Tuesday, we target a short-term move to parity for USD/CAD. The cross took out key support levels at 1.0225 and 1.02 last week, with offers emerging in the 1.0160 area. US/CAN 2y rate differentials continue to hit resistance in the 64bp area ahead of Tuesday’s FOMC. For CAD/JPY, we target a test of the January 8 high (90.63).

• Download Full FX Technical Strategy