Currency Bulls Still in Driver's Seat

Since early March there has been a clear trend toward a lower US dollar. Made vulnerable by the extended positioning, and frustrated by the stalling of downside momentum, the stronger than expected ISM data provided the spark for a bout of short-covering. The dollar’s recovery was been cut short by the weaker than expected US employment data.

The main force that has weighed on the dollar will likely continue to exert its pull. We think the most significant of these, within the current investment climate, characterized by high liquidity and low volatility, is the divergence of interest rate expectations. The Federal Reserve, the Bank of England and European Central Banks all meet. There is little doubt that the FOMC is on hold. The main focus remains on the Fed’s risk assessment. Given the still elevated core PCE readings, the slower earnings growth, and more importantly, the moderation of unit labor costs, are unlikely to prompt the Fed to change its assessment that inflation is a bigger concern than the risk of the economy slowing further.

To illustrate expectations, take a look at the September Fed funds futures. Assuming a stand pat policy in the coming months, fair value for the September contract is 94.75, implying an effective Fed funds rate of 5.25%. Assuming a 25 bp rate cut at the Sept 18 FOMC meeting, fair value is 94.85 (5.15%). After the employment data, the contract traded around 94.81, which implies approximately a 60% chance of a rate cut, is discounted.

This assessment is likely to offer stark contrast with the Bank of England and ECB. There can be little doubt that the Bank of England will signal a hike in base rates. The current base rate is set at 5.25%. The key issue in the market currently is whether the BOE raises 50 bp instead of 25. The three month interest rate futures contract in the UK (short-sterling) does not generate much insight into this issue because it is difficult to see the difference between say a 25 bp hike next week and another hike in June (or July) of the same magnitude.

The Bank of England has surprised the market a couple of times in the past year and while a 50 bp hike cannot be ruled out, we expect a more usual 25 bp move will be delivered with a hawkish statement that will keep the market from concluding that tightening is over. With price pressures still forecast to moderate later this year when last year’s utility price hikes drop out of the comparisons, and some indications that growth may be moderating, sticking to the gradualist approach is the prudent course.

There are no expectations for the ECB to hike rates, but ECB President Trichet is likely to signal the likelihood of a June hike. Growth in the euro-zone may have slowed slightly in Q1 from Q4 (due May 15), but the recent data shows that activity and business and consumer confidence remains firm. By all accounts Q1 06 will be the second consecutive quarter in which the euro-zone expands faster than the US.

A 25 bp rate hike in June lifts the ECB’s refinance rate to 4.00%. However, the market does not think that that rate hike will mark the peak of the monetary cycle. The market has gone a long way toward pricing in another 25 bp hike later in the year. The risk seems asymmetrically biased to the upside. That is to say that it is more likely that the euro-zone’s key rate peaks at 4.5% rather than 4.0%. Monetary and credit aggregates are still growing rapidly, energy prices remain high (and the ECB says it does not focus as much on the so-called core rates as say does the Fed). As the ECB has acknowledged, the risk is that price pressures increase later in the year and once again move above 2%.

Just because the market has already discounted the likely trajectory of ECB and BOE policy, it does not mean that the dollar won’t be sold-off. The process is more dynamic. The premium offered by the US over Europe is too narrow, at this point in the respective business cycles, to offer investors much of an incentive to hold US dollars. As a proxy for short-term interest rate differentials, look at the spread between US and German 2-year yields. Currently the US offers about 53 bp more than Germany. This is a little more than half of what it offered at the end of last year. The point is dollar weakness does not require a further deterioration of the interest rate differential. Current differentials are sufficient to be a drag on the dollar.

The technical damage inflicted on the euro and sterling ahead of the US jobs data have been mitigated though not completely offset by their recovery after the soft US jobs report. For the first time since mid-March the euro traded below its 20 day moving average, which now comes in near $1.3562. However, it managed to resurface above this area. A move above $1.3620 early next week will likely signal another run at the recent highs in the $1.3680 area. The recent price action reinforces the significance of the $1.3520-30 support area. On a 2-3 month view, a move toward $1.40 continues to seem the most likely scenario.

Sterling’s pullback has been more pronounced. It has been more than 2 weeks since sterling registered its quarter of a century high near $2.0133. Sterling subsequently retraced a little more than 50% of the last leg up that began on April 9th near $1.9600. Sterling had traded above the $2.00 mark for part of 11 consecutive sessions starting April 17th and running through May 1st. In 1991 and 1992, the last time sterling traded above $2.00, it did so for a total of 10 days. It fell below that notable psychological level late on May Day and has not managed to resurface above it since. However, we expect it to do so again in the days ahead. A move above $1.9950 would strengthen conviction that a low is in place.

The yen is a different kettle of fish. Since the start of the Golden Week holidays, the dollar has strengthened about half a yen to resurface above the JPY120 level for the first time since late February. Although the euro was bid to new record highs against the yen (owing more to the euro’s short life than an unprecedented valuation of European currencies against the yen), it was not able to sustain those gains and when Japanese investors return they will see the euro-yen cross little changed from where they left it.

With a rising trade surplus, it is not surprising that talk of Japanese exporter dollar sales has begun increasing. However, capital flows are more important that trade related flows and there are two important channels that will likely produce more yen sales in the days and weeks ahead.

First, Japanese investors have what appears to be nearly an insatiable appetite for foreign stocks and bonds. Anecdotal reports suggest the interest is not simply for assets in the mature economies, but emerging markets as well. With the destruction of the return on savings domestically, Japanese investors have little choice but to seek higher returns abroad. Whether one wants to consider these positions as part of the yen-carry trade or not, the important point is that Japanese investors themselves are significant sellers of the yen.

Second, speculators, for which the Commitment of Traders data may be a useful proxy, are gradually rebuilding short yen positions after dramatically reducing them in Fed and March. Although the net short position has already almost doubled since the low point in late March, it is still about half of its historic peak in early Feb. That is to say, the speculators do not appear overly short the yen at the present.

The Japanese equity market has been a significant laggard among major bourses. The Nikkei’s less than 1% gain this year contrasts with the more than 6% rise in the S&P 500 and more than 6% rise in European markets, including nearly a 10% rise in France’s CAC 40 Index and almost 14% gain in Germany’s Dax. Foreign demand for Japanese shares is likely to be weaker, assuming that the majority of investors chase returns. If this indeed materializes, it would negate some of the offset to the yen sales by Japanese investors and speculators.

With a recent string of soft economic data, including inflation, the consensus is for the BOJ to keep rates steady until after the July elections. That means that by the time the hike materializes, the BOE and ECB (and other central banks including Norway, Sweden and Switzerland) would have already hiked once with another hike coming into view. The interest rate weight on the yen seems likely to continue to be a feature in the coming months.

The US dollar faces initial resistance in the JPY120.50 area. Support is pegged a big figure lower near JPY119.50. The euro and sterling are likely to continue to trend higher against the yen. The immediate target for the euro is near JPY164, but there is potential toward JPY165 in the coming weeks. Sterling actually peaked against the yen in late January near JPY241.50. Look for a retest on this area as sterling heads toward JPY245.
Currency Bulls Still in Driver's Seat Currency Bulls Still in Driver's Seat Reviewed by magonomics on May 04, 2007 Rating: 5
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