FYI | Mar 24 2012
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
• Searching for the next crisis
• What’s driving the dollar?
• Europe: what happened to the LTRO?
A couple of weeks ago the market was able to shrug off the prospect of a Greek default and a sharply rising oil price. Even weak Chinese economic data didn’t de-rail risky assets. However, that optimism didn’t last long and last week investors removed the rose-tinted spectacles and started to worry once more about the outlook for the global economy.
Last month China’s growth rate was downgraded to 7.5% per year from 8%. Since China has a history of out-performing expectations this downgrade had little market impact. However, a fifth straight decline for the HSBC/ Markit manufacturing PMI survey reading and the markets are concerned that China could have a harder landing than first expected.
This is fuelling worries especially for commodity demand. China imports half the world’s cement and bulk commodities, and a third of the world’s base metals and soft commodities including agricultural products, so the market is taking notice. The steep decline in US and European equities this week suggests that a slowdown in Chinese growth was not priced in by the market and until we see some signs that China’s growth has reached a bottom then it’s hard to see how commodities and stocks can sustain a rally when the world’s second largest economy remains in such a precarious position.
China is important to the financial markets not just as a major source of demand but also because of its huge FX reserves. If growth slows then its reserves will inevitably shrink. FX reserve diversification from China is considered one of the reasons why the euro has managed to hold up so well during the sovereign debt crisis. Now that China is slowing an important source of demand for the single currency may start to fade.
Rather than cause an outright collapse in the euro, it has caused choppiness as investors try to assess how severe a Chinese slowdown could be. In contrast, base metals and the Aussie dollar have been hit hard. AUDUSD fell nearly 2% last week. The market was behind the curve regarding China and now is rushing to price in weakness. The euro hasn’t been as affected by this. However, if Chinese data continues to under-shoot expectations then the euro may not be saved.
As we have pointed out in recent reports, the daily EURUSD chart may be starting to form a head and shoulders pattern. Thus, if we fail to break 1.33 (what could be the top of the right shoulder) in the coming days then we may head back towards 1.3150 – the neckline support – and then 1.30.
But are concerns about China overdone? The market will eventually price in a slower pace of growth for China and there are some signs that it could be lagging smaller Asian economies. For example, Last month Singapore’s PMI moved back into expansionary territory and Thailand has seen its economic data strengthen in recent weeks. Added to this, the US is still strengthening and the labour market is picking up, which could cushion the blow from a slowdown in Europe.
AUDUSD is still at risk from negative Chinese data surprises, but there are some tentative signs that the Aussie may be forming a base after a tough couple of months. The relative strength index in the daily chart has turned higher in recent days and the 100-day simple moving average held as good support. If China starts to show signs of life then the Aussie is poised to reverse recent losses.
What’s driving the dollar?
The dollar index has traded within a relatively tight range this past week and looks set to post a weekly decline as U.S. Treasury yields back off after their recent rally. 10-year yields were rejected after testing near the 50-week simple moving average which is just shy of the October highs around 2.41%. The yield on the 10-year note has fallen to around 2.24% at the time of writing and continues to be supported technically while above the 200-day SMA that currently comes in around 2.18%. As yields declined so did the dollar, but not to the same extent as the drop in yields is partly due to risk averse investors seeking safety in Treasuries and therefore buying dollars. There are two main forces driving U.S. rates and the dollar in the current environment – global risk sentiment and U.S. economic data surprises as they relate to Fed policy expectations.
Last week we noted a potential shift in drivers as the continued trend of positive U.S. fundamental data has reduced expectations of further monetary policy easing by the Fed thereby boosting yields and supporting the greenback. We also highlighted the return to a relatively calmer environment in sentiment with the removal of a tail risk after the completion of Greek debt restructuring. In recent days, risk aversion has resurfaced amid a deteriorating global growth outlook. PMI’s released in Europe and China disappointed markets and elevated worries about a hard-landing in China and a deeper recession in Europe. This prompted investors to flee risky assets in favour of safe havens. As a result of increased demand in U.S. Treasuries, yields declined. The buck gained significantly against the commodity currencies, AUD, NZD, CAD, and NOK as fears of a sharper than expected global slowdown put pressure on the growth sensitive currencies and weighed on commodity prices. While the dollar remained in ranges against the CHF, EUR, GBP, and SEK, it was significantly weaker against the other safe haven – the Japanese yen.
There are several Fed speakers scheduled next week including Bernanke, Dudley, Lacker, Lockhart, Yellen (all FOMC voters), Bullard, Plosser, and Fisher (non voters). Economic data due out includes the final revision to 4Q GDP (exp. 3.0%), consumer confidence indicators, durable goods orders as well as personal income and spending. We will be watching for data surprises as well as any shift in tone from Fed officials as USD drivers. Technically, the dollar index is likely to remain range-bound while support holds around 79.40 – where the 50% retracement of the rally from 2012 lows to March highs and the daily Kijun line converge – while resistance is seen at the convergence of the cloud top and Tenkan line (currently around 80.00). A sustained break of these noted levels would likely provide direction moving forward.
Yen strength may provide an opportunity
The yen outperformed in the G10 space last week amid increased risk aversion and positive Japanese data. The country posted a surprising trade surplus of +¥32.9B in Feb. while the consensus was for a deficit of -¥120.0B. The combination of positive Japanese data, lower UST yields, haven demand, and short covering from technically oversold levels was constructive for the yen. In our view, we think the yen may have more room to strengthen but that the trend of a weaker JPY (stronger JPY-crosses) remains intact. Specifically, against the dollar we would favour buying on dips towards the 82.00 level (where the 100-week SMA and 21-day SMA converge) and then the top of the weekly ichimoku cloud (currently around 80.75) next. A weekly close below the cloud top would negate our view.
In the week ahead, Japanese Feb. industrial production and CPI data will be of importance. The national CPI figures will be released for Feb. and Tokyo CPI figures for March. The more timely Tokyo CPI last showed deflation of -0.2% y/y on the headline and -1.1% y/y on the core reading while national data also indicated yearly deflation of -0.9% for core CPI. This will be important for monetary prospects moving forward as the Bank of Japan has taken a firm stance to fight deflation with an explicit 1% inflation target. If the data continues to show downwards pressure on prices, it is likely that the BoJ may need to engage in further easing which would weigh on the currency and support yen-crosses.
Europe: what happened to the LTRO?
We will be watching Europe’s peripheral bond markets closely next week after the positive effects of the ECB’s LTRO auctions are showing signs of wearing off. The long-term loans to Europe’s beleaguered banking sector was thought to have stabilised the crisis, however bond yields in Spain, Italy and Portugal are all starting to creep higher once more.
The Spanish yield is now back at the top of its two-month range. Not long ago Spain was considered out of the woods, and indeed Madrid is not facing the same problems as Athens since its debt burden is much more manageable. The problem for Spain is that its economic woes seem to be exacerbated by its membership of the Eurozone. It needs a much lower interest rate and a weaker exchange rate to boost its economy. This is in contrast to Italy, where the main problem is its excessive debt pile, which it would have to reduce either inside or outside the currency bloc.
Spain has already said it will miss its fiscal targets for this year and growth data last week was extremely weak. Its manufacturing and services sector PMI’s fell to 45 and 41.9 respectively, well below the average for the currency bloc. Weak growth makes Spain’s revised fiscal targets harder to achieve. Its long-term debt burden is front-loaded and this year it has to auction EUR129bn in 2012, in the next 6-weeks it has EUR35bn to try and sell.
While we don’t think Spain will have a failed auction, it puts pressure on the ECB to act further. The LTRO worked, but only temporarily, so the ECB may need to step up its help for sovereigns in Europe and not just banks to prevent another flare up of the crisis. This could cause the ECB’s balance sheet to expand going forward, which may weigh on the euro in the medium-term.
There were some rumours on Friday that the ECB may have stepped into the market to buy Spanish debt and yields retreated, we will find out on Monday when the ECB announces the size of its asset purchases for last week. But overall, we wouldn’t be surprised to see the ECB’s SMP programme pick up sharply in the coming weeks.
European data in focus:
The key data releases next week will be Germany’s IFO index, which measures business sentiment, and inflation for the Eurozone as a whole. The IFO has diverged from the PMI survey in recent months and the March reading is expected to show that Germany’s business prospects remain bright. But the sharp decline in March PMI readings suggests that even Germany – a competitive, well skilled economy with strong trade links – is suffering, which doesn’t bode well for the rest of the currency bloc. Since Germany is the largest contributor to the Eurozone’s rescue fund it can’t afford to have a deep recession.
The inflation data is likely to show a slight decline in the annual rate to 2.5% from 2.7% in February. However, oil prices remain elevated and the risks to price data for this month are balanced to the upside in our view. Rising inflation in the currency bloc is likely to be negative for the euro and euro-based assets as it makes more accommodative policy from the ECB less likely and it could also constrain the Eurozone consumer going forward.
In the UK, the Budget garnered a lot of negative media attention, but it delivered a rather sobering message – austerity is here to stay in the UK. February’s public borrowing figures were also much stronger than expected, which meant the Treasury could not revise down this year’s borrowing needs as much as expected. The final reading for GDP is released next week and it is expected to confirm that the economy contracted by 0.2% in the final quarter of last year.
The pound has been in the doldrums since the Budget and was weak versus the dollar and the euro last week. We believe GBPUSD will remain range bound for some time as the pound is already fairly weak against the dollar. The key levels we are looking for in GBPUSD is between 1.57 on the downside and 1.5950 on the upside.
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