Turning point for the USD?

Tue, Jul 13 2010, 05:23 GMT
by Kenneth Broux

Market Outlook

Tactical view:

= Turning point for the USD?

Stronger than forecast employment data from Australia and Canada along with short covering in risk assets boosted the AUD, CAD, NZD and NOK, but doubts over momentum have not disappeared as markets square up to the first reports of US Q2 company earnings. With market positioning still overwhelmingly short EUR, we look for bearish EUR trends eventually to be reasserted on profit taking ahead of July 23, release date of the bank stress tests. Correlation with risk assets remains elevated for higher yield and commodities currencies, but with the balance tipping in favour of a second rate hike by the Bank of Canada later this month, the CAD looks well placed to resume its upward move vs the AUD. The prospect of a 7th drop in the UK claimant count rate in June may neutralise this month’s rally in EUR/GBP. Greece will tap the capital markets on Tuesday.

Recap

A rally in global equities propelled the AUD to the top of the G10 ranking, helping the currency to log a 4.7% gain vs the JPY, a 4.4% gain vs GBP and a 4% profit vs the USD. GBP fell against all G10 peers, but losses were limited to 1.3% vs the EUR and 0.7% vs the USD. The weakness in sterling was partially attributed to the compression in UK/G10 yields. UK/EU 2y benchmark yields fell into negative territory for the first time since February. The unwinding of safe haven flows put the JPY at the bottom of the G10 table, with losses ranging between 5% vs the AUD to 0.4% vs GBP, despite the report of record JGB buying by China in May and a 0.5% upward revision by the IMF to Japan’s 2010 growth outlook.
UK economic data came up short of expectations this week for most of the releases, except for the bullish report by the NIESR on Q2 GDP. The NIESR estimates that the economy expanded by 0.7% q/q in Q2, down from an upward revised 0.9% in Q1. The BoE left Bank rate and the APF unchanged at 0.50% and £200bln, respectively. The services PMI slipped to 54.4 in June from 55.4 in May, marking a 3rd drop in 4 months. The global trade deficit widened to £8.0bln in May, a 3-month high as imports rose 2.4% to £29.5bln, the highest since Jul-08. Industrial output rose a stronger than forecast 0.7% m/m in May, and PPI output price inflation slowed to 5.1% in June vs 5.7% in May (core up to 4.8%).
A mixed week for UK rates but overall yields stayed within the tight recent ranges and close to the cycle lows observed since mid-May. 5y swaps finished the week at 2.44% and 10y yields dropped back to 3.32% following a very solid session on Friday post weaker PPI and trade data. The prospect of lower June CPI data next week could bring the prospect of new lows and a bull flattening of the 2y/10y curve. The 3mth Libor/Ois spread narrowed a fraction to 22.5bp. EUR libor/Ois also tightened to 27bp (-5bp). The 2020 gilt sale drew very solid demand and was covered 2.45 times (0.2bp tail).

G10 FX - EUR/USD update: no ‘stress’?

The rally in EUR/USD from a 1.1877 low in June to a 1.2722 high on July 9 begs the question whether the negative trend has reversed and whether additional upside should be targeted. Though additional gains towards the 1.2800-50 area cannot be ruled out in the short-term, we think bullish EUR momentum is set to fade over the coming weeks and drag the cross back below 1.25.

Rationale for the EUR/USD bounce since June:

1/ record short EUR positioning and consequent short covering

2/ a deterioration in the US economic backdrop vs Germany and a tightening in actual and implied EU/US rate differentials

3/ fading of the USD as safe haven refuge since SNB policy tweak on Franc (June 17)

4/ cautious optimism surrounding recent EUR government bond auctions, a successful transition from ECB one-year LTRO to a 3- month tender

Key factors to watch

1/ A rise in the Eonia swap curve is not a sign that the monetary policy bias at the ECB is normalising. A change in ECB money market operations since the expiry of unlimited one-year liquidity last week and the drain of excess liquidity explain the rise in the 3-mth Eonia swap rate above 0.70%, but this does not imply that the chance of an ECB rate hike has now increased. President Trichet confirmed this in the July 8th press conference and council member Stark has also warned not to read too much in higher money market rates. Uncertainty in the months ahead, bank stress tests and nervousness in funding markets will keep the ECB sidelined into 2011, but may result in EUR libor rates staying above US and UK libor equivalents.

2/ The stalling of US economic growth in Q2 is in contrast to Germany where activity has accelerated. Early indications show that the euro zone economy probably expanded in Q2 at the fastest rate since Q1-08 (+0.7% q/q) whereas in the US, dreadful housing and weak confidence and labour market data suggest the opposite, causing speculation of the Fed resuming asset purchases. This has helped EUR/USD to rally from the 1.1877 low but in our view only partially explains the break above 1.25.

3/ As we have stated before, the aversion for the USD follows the decision of the SNB on June 17 to drop its ultra-dovish stance and halt its policy of Franc intervention as deflationary pressures in Switzerland recede. This has promoted the swissy as the new refuge of choice. The starting point of the USD reversal in June also incidentally coincided with the appointment of Japanese PM Kan on June 4, though Mr Kan's explicit desire for a weaker yen means one should not overstate Japanese politics for the retracement in USD/JPY below 88.0. The move does not reflect the heavy buying of foreign denominated government bonds (Treasuries) by Japanese investors over the last 8 weeks. Instead, record buying of short-term JGBs by China may have kept the JPY artificially strong, though the safe-haven status of the JPY cannot be underestimated if US Q2 company earnings disappoint.

4/ A widening of the EU/US 2y benchmark spread has been a powerful driver of EUR/USD as chart 2 demonstrates. In comparison to the 10y spread, the correlation of EUR/USD with 2y spread recently rose to 0.8. The 2y spread now stands at 15bp, the highest since March. The deterioration in US macro data bears some explanation for the move in spreads, though the reversal from overbought conditions in short-dated bunds also has to be cited as bank shares bounce back ahead of the release of the EU stress tests on July 23. An unsatisfactory response to the latter would inevitably cause EUR sentiment to wobble and the compression in EU/US spreads to resume, even though EU governments have committed to backstop facilities to recapitalise individual institutions. This would possibly include the 440bln eur stability mechanism agreed in May.

5/ Speculative IMM positioning has been overweight EUR short contracts for most of Q2 and has only recently started to reverse some of these positions. At -83,500 contracts, overall EUR shorts are still above recent norms (see chart 3), suggesting that the market retains a still ‘natural’ bearish view of where EUR/USD is headed. However, the counter-argument is also true and argues that the scope for short covering remains powerful if USD sentiment continues to sour.

6/ The correlation of EUR/USD with risk assets (S&P 500) flipped markedly in July, with the sharp fall pointing to complete opposite price behaviour between stocks and the currency pair. In other words, the sharp fall in equities has not translated into safe haven USD flows, as the dollar index testifies. The release of US Q2 earnings from next week onwards will in our view be key to sentiment in risk assets. Positive results may help negative US D sentiment to stabilise, with participants potentially also inclined to take profits in EUR/USD ahead of the release of the stress tests on July 23.