Ashraf Laidi
Euro Momentum Remains IntactThe latest episode of Euro strength is underpinned by not only the breadth of the rally (gaining versus EUR, GBP and CAD) but is also founded on the unlikelihood that the European Central Bank will intervene to stem its strength. With inflation at a record high of 3.2%--well over the central bank’s preferred level of 2.0%--and oil prices surging above $103, markets are well aware of the anti-inflationary benefits of a strong euro during the soaring energy prices. And unlike in past episodes of Euro strengthening such as 2004 and early 2005, European politicians have shown remarkable coordination and cooperation with the ECB by tempering their complaints against the high currency, considering the ongoing slowdown in their economies. Such cooperation bolsters the credibility of the ECB and its president JC Trichet, in contrast to escalating criticism facing Fed Chairman Bernanke and BoE Governor Mervyn King.
But the Euro has more going in its favor than simply credibility and containing costs of rising oil. Two consecutive increases in Germany’s main business and investor sentiment surveys (IFO and ZEW) defying expectations of a decrease have played a major role in validating the monetary policy contrast to the Federal Reserve, Bank of England and Bank of Canada. The Euro is also boosted by the lowest net interest rate disadvantage since December 2002 against the top traded 7 currencies (USD, JPY, GBP, CHF, CAD, AUD and NZD), in contrast to the US dollar whose net interest rate disadvantage is at a record high, beating the levels of 2003-04 when US interest rates drifted at 45-year lows of 1.00%.
Another reason to expect further gains in EURUSD is the historical ways in which the pair has added to its gains each time it broke key figures; $1.20, $1.30, $1.40. This leads us to believe that $1.5400 maybe in the works as early as this month, especially in the event that the Fed opts for a 75-bp cut on March 18. A subsequent retracement later in the month is expected to stabilize at $1.5250 as jawboning from European politicians and policy makers is seen on the rise.
Yen Marshes Onward Seasonally in MarchShaky global investor confidence and deteriorating USD sentiment is expected to continue boosting the yen during the month before temporary stability in April and May. The yen’s historical strengthening during the month of March in light of pre-fiscal year-end repatriation by Japanese firms and institutions is likely to test the 102.30s. Markets will continue shrugging jawboning remarks from Japanese officials until policy makers are forced to threaten operational intervention, which has not been done since early 2004. One main reason Japanese officials have stayed away from intervention is the avoidance of accusations of a double standard, as the industrialized world has largely criticized China on its interventionist approach to keep the yuan from strengthening more rapidly. Another reason to the lack of interventions is the fundamental backdrop to the current gains, especially against the USD. Japanese officials have long stated that the impact of US sub-prime losses was limited in Japan and praised Tokyo’s ability to stave off the costs of yen strength. Therefore any remarks from Tokyo are unlikely to carry much weight without the threat to follow up with real intervention.
This week’s US labor report as well as the FOMC decision later this month will act as major possible determinants of the fate of the 102.00 figure. Unlike last year when aggressive Fed cuts weighed on the Japanese currency to the benefit of the USD on the argument of rising risk appetite, aggressive rate cuts today are largely seen to the detriment of the already floundering interest rate foundation of the greenback. Upside remains capped at 105.
Sterling Crosses Remain on the WaneThe fact that cable’s gains have largely emerged on USD weakness highlights sterling’s own weakness, especially as the currency has hit 11-year lows against the euro, 5-year lows against the Swiss franc and 7-year lows against the yen. The deteriorating landscape in UK housing as well as eroding public finances are seen spilling over to consumer demand, thereby, capping inflationary pressures and paving the way for further BoE easing. The proposed tax levy on non-domicile residents in the UK has already been received by threats from foreign workers to leave the UK. If the law is passed, it should accelerate home sales in up market real estate areas, thereby, exacerbating the decline in UK housing.
We expect three more rate cuts this year, bringing down base rates to 4.50% as the deteriorating picture in the housing market and public finances spills over to the private consumption, capping inflationary pressures and paving the way for BoE easing.
Sterling’s plays remain most attractive on the crosses, against the higher yielding AUD and more fundamentally sound EUR and firming CHF. Cable seen retreating to $1.97 while EURUSD seen above $1.52, implying further gains in EURUSD past the 0.77 level.
Loonie Hurt by BoC Words and ActionToday’s Bank of Canada decision to cut interest rates by 50 bps to 3.50% following yesterday’s release of weaker than expected Q4 figures confirms our recent bearish CAD calls versus EUD, AUD and even the USD. CAD’s post-decision sell-off accelerates after the BoC indicated “intensifying” and “significant spillover effects” from the US slowdown. The US-element implies that ongoing US data weakness will drag CAD crosses in the future, thus highlighting our stance favoring EUR, AUD, CHF and JPY against the CAD. While we cannot ignore the positive impact on the currency from rising oil prices, we can deduce that any periodic retreat in oil will be especially punishing for CAD. Another negative for the currency is the current account balance’s descent into deficit territory, which removes an important positive element to the currency’s safe haven status. USDCAD is seen remaining underpinned at the 0.9850 trend line support, eyeing parity before middle of the month. We also see rising probability of 101 in CADJPY ahead.
Aussie’s Waning MomentumShort term sentiment may be working against the Aussie in light of the overnight RBA decision to raise rates to 7.25%, which was accompanied by a statement indicating "
substantial tightening in financial conditions since mid-2007". The statement implies that the central bank will wait and see the impact of previous rate hikes combined with slowing global growth filter through the economy. Last night's unexpectedly flat reading in February retail sales was the second monthly deceleration, further signaling that private demand is starting to wane. The highly leveraged Australian consumer has already faced 13 rate hikes. But the price surge in wheat and copper continues to benefit overall growth. Markets will await the release of Australia’s February jobs report, which will be vital in influencing future interest rate expectations. Finally, the market requires evidence from Q1 CPI report before concluding whether the rate hike campaign has ended.
The neutral tone of the RBA policy statement and the sharp slowdown in February retail sales will reduce some of the positive bias enjoyed by the Aussie, thus, likely reducing the currency's potential to rebound from risk reduction episodes. But the ongoing rally in commodities as well as the robust yield foundation will likely provide decent demand for the currency in the current low yielding environment.
Sharp pullbacks in equities could potentially drag the Aussie to as low as 91 cents vs the USD but deeper declines vs the JPY at 92 yen. But renewed bouts of risk appetite will offset the downside currents as long as further rate hikes have not yet been completely ruled out. But we should not discount the Aussie’s high yield stance, which is and of itself a positive element underpinning the Aussie back towards 93 cents by month-end.
