Risk appetite stays resilient
Despite the global tumult from Japan, Libya, Portugal and elsewhere, investors seem to be embracing risk on the basis that the global recovery is on-going, as we suggested in last week’s update. The S&P 500 stock index in the US has regained about ¾ of the decline since Feb. while the Nikkei 225 in Japan has recouped just over half its post-tsunami collapse. The CRB commodities index has also regained about ¾ of recent declines. And the drop in US Treasury yields has now reversed sharply over the past week, with 10-year yields now up around 30 bps from recent 3.15% lows reflecting both reduced safe haven buying and increasing talk from Fed officials that QE3 is not on the table. We expect other Fed speakers to echo this sentiment and so we reckon with a further back-up in US rates.
Normally, a risk-on environment is frequently USD-negative, but against the backdrop of rising US rates, the buck may fare a bit better. In particular, we look for JPY-cross strength to re-emerge in the weeks ahead, barring any other unforeseen global calamities. Higher JPY-crosses, like AUD/JPY, CAD/JPY and EUR/JPY, could result from USD weakness against all but the JPY, with higher US rates supporting a higher USD/JPY. We will keep an eye on recent range highs in those JPY-crosses and a break above them will be a signal to us additional gains are in store. Next week’s action will be dominated by month-end liquidity and asset manager reallocations, so the price action could remain extremely choppy in the USD pairs, so we suggest paying extra attention to the JPY-crosses, which may display more of a trending pattern. Next week concludes with March US employment data and we expect the report to be generally positive for risk sentiment in that job creation has reached more supportive levels, though still not enough to seriously dent the unemployment rate.
Rate expectations driving the euro amid a deteriorating periphery
This past week, the euro shrugged off seemingly negative developments and continued its ascent despite ratings downgrades in the periphery and a delay in concrete policies regarding the short term EFSF. The longer term ESM will still accumulate 80B euro in paid-in capital, however the payments have been stretched to 16B euro per year over 5 years. S&P downgraded Portugal’s rating which came after a downgrade by Fitch and the downgrade of 30 Spanish banks on Thursday did little to weigh on the common currency. The rejection of the Portuguese austerity plan not only raises uncertainty about the government with the resignation of Prime Minister Socrates but greatly increases the likelihood that the nation will require a bailout. The EU’s Juncker stated, “the uncertainties concerning Portugal aren’t unknown uncertainties,” and noted “if ever the Portuguese government decided to ask for European aid, the instruments are now at hand to help Portugal”. Talk of austerity and contracting GDP in the periphery did little to change investors’ views on monetary policy as the debt concerns appear to be compartmentalized.
Several ECB officials have recently stated that the bank maintains a clear separation between its monetary policy and unconventional liquidity measures. As such, the market remained focus on inflation and ECB rate expectations which continued to drive the euro higher. A rate hike at the next ECB meeting in April is largely priced in and as such the risks are to the downside. Following the April ECB decision, slower overall growth or lower levels of inflation may deter the bank from starting a tightening cycle and may be met with euro selling. The market is currently anticipating about 100bps in rate increases over the next 12 months. Technically, the 1.4250/80 area is the highs of November ’10 and March ’11and remains the key resistance level to the upside. A sustained break above here is needed to see further upside potential. The daily Tenkan line currently comes in around 1.4050 and may provide support ahead of the psychological 1.4000 figure. Below here may see a deeper correction towards the Kijun line which is currently around the 1.3885 area.
Storm clouds gather on the UK’s economic horizon
It’s a quieter week for the UK after last week’s Bank of England minutes, a Budget and retail sales dominated the headlines. All three weighed on the pound, which is set to drop more than 1 per cent on a broad based basis at the week’s close.
Two things are dragging the pound lower: firstly, a deterioration in the economic outlook and secondly, a narrowing of the UK’s interest rate differential as investors start to price out the chance of near-term rate hikes from the Bank of England. For example, the market now expects the first hike in August, previously this had been May.
The growth outlook included in Wednesday’s Budget was revised lower for this year to 1.7 per cent, but the risks are to the downside. Fiscal consolidation and the harshest public spending cuts since World War Two don’t get going with a real gusto until this year, yet growth is already starting to falter. Retail sales fell by 1 per cent in February, dragging the annualized rate to a meager 1.2 per cent. This is lackluster at best and extremely worrying for an economy that relies on consumption for 70 per cent of its growth.
From April everyone who works in the UK will be subject to a higher rate of social security and the 40 per cent tax rate also kicks in earlier at GBP35, 000, compared with GBP37, 400. This is going to add to the squeeze on household incomes and further dents the growth outlook.
Added to this, although the Budget figures suggest that the UK will reach its long-term fiscal targets to virtually eliminate the deficit by 2015/16, because of the UK’s elevated headline inflation rate borrowing will be higher next year. The problem with the UK’s inflation is that it isn’t feeding into wage growth, so income tax revenue has not been increasing as one expects during periods of high inflation, yet social welfare payments and pensions are all indexed to consumer prices, which is aggravating the weak public finances.
Chancellor Osborne is sticking to his guns and continuing with his ambitious fiscal targets for this parliament. But if a slowdown in growth triggers a delay in the UK’s debt reduction plans the its sovereign credit rating will be threatened, Moody’s the credit rating agency warned last week. Osborne is keen to avoid this, so whichever way you look at it storm clouds are gathering on the UK’s economic horizon.
While Budgets tend to have muted impacts on financial markets, the pound’s decline was initially fuelled by the minutes of the last MPC meeting. Committee members voted 6-3 to keep rates on hold earlier this month, so the hawkish threesome had failed to draw anyone to their side. More interesting was the uncertain tone to the minutes, which suggests that the MPC are firmly in wait-and-see mode until they get a clearer picture for the outlook for growth.
This was reinforced when Spencer Dale, the Bank of England’s chief economist who voted for a rate hike earlier this month, said that he could be persuaded to swing his vote away from a rate hike if the recovery disappoints.
This has weighed on sterling crosses, especially EURGBP. Currently the market is pricing in nearly 100 bp of rate hikes in the Euro-area over the next 12 months, which compares with 75 basis points for the UK, boosting the cross. If we get a weekly close above 0.8810/20 then 0.8900 – the October highs come into focus before 0.9150 – the March 2010 high.
Is AUD strength here to stay?
AUD/USD strengthened to record post-float levels just short of the 1.0300 figure as risk stabilized into the close of the trading week. Subsiding concerns over Japan’s nuclear crisis played a role in broad based commodity upside this week and subsequent AUD strength. However, recent Aussie strength has also been driven by improving risk sentiments on the back of optimistic global growth prospects stemming from declining tightening expectations on a global basis, sans ECB.
Expectations for an RBA hike have been gradually scaled back with some market participants now expecting tightening to begin as late as Q1 2012. At the surface, it seems contradictory that the possibility of a less rapid appreciation in an economy’s target rate would see a concurrent strengthening to its respective currency. However, the situation in Australia and its surrounding region is quite complex. The near term growth outlook in China remains firm while Japan’s near term outlook seems bleak. Japanese Q2 ’11 GDP is likely to suffer directly from production disruptions as a result of the earthquake. However, medium term Japanese growth may rebound as rebuilding efforts are likely to have an inflating effect on Q4 Japanese GDP. The significance of this potential scenario lies within the realm of coal. 2H 2011 Japanese coal demand is likely to firm due to reconstruction efforts but coal demand on a global basis may benefit further from mounting public and political pressures as a result of the recent nuclear crisis in Japan. As Australia is one of the world’s top coal producers, expectations for firm 1H 2011 coal demand out of China and the potential for even firmer demand in 2H 2011 have also played a role in record AUD strength.
The main risk to extended Aussie strength, however, is Aussie strength itself. Higher coal prices may see Australia’s terms of trade reach record levels and should eventually pressure the RBA to restart a tightening cycle. While developed economies are behind the curve relative to emerging market economies in terms of tightening, higher commodity prices for extended periods is likely to see developed economies eventually play catch up – including the RBA. The likely result of semi-coordinated global tightening direction in response to higher prices may weigh on AUD as rate differentials may remain near current levels but commodity demand may see substantial declines.
We think near term AUD/USD strength may continue considering recent risk stabilization as well as the technical breakout above prior post-float highs. However, we maintain a cautious medium to longer term AUD/USD outlook on the potential for commodity demand deterioration resulting from central bank policy responses to higher prices.
Key data and events to watch next week
Monday – Feb. PCE, Feb. Personal Income & Spending, Feb. Pending Home Sales, Mar. Dallas Fed Manufacturing Activity, Fed’s Lockhart, Evans and Rosengren Speak
Tuesday – Fed’s Bullard Speaks, Jan. S&P/CaseShiller Home Price Index, Mar. Consumer Confidence
Wednesday – Mar. MBA Mortgage Applications, Mar. Challenger Job Cuts, Mar. ADP Employment Change, Weekly DOE U.S. Crude Oil Inventories, Fed’s Bullard, Lacker and Hoenig Speak
Thursday – Weekly Initial Jobless & Continuing Claims, Mar. Chicago PMI, Feb. Factory Orders
Friday – Mar. Employment Report, Fed's Plosser Speaks, Feb. Construction Spending, Mar. ISM Manufacturing & Prices Paid
Tuesday – German Apr. GfK Consumer Confidence, ECB’s Mersch Speaks, German Mar. Prelim. CPI
Wednesday – Mar. EZ Consumer, Economic, Industrial and Services Confidence
Thursday – German Mar. Unemployment Rate, Euro-Zone Mar. CPI
Friday – EZ Mar. final PMI Manufacturing, EZ Feb. Unemployment Rate
Tuesday – 4Q Final Total Business Investment, 4Q Current Account, 4Q Final GDP, Feb. Net Consumer Credit, Feb. Mortgage Approvals, Feb. M4 Money Supply
Wednesday – Jan. Index of Services, Mar. CBI Reported Sales, Mar. GfK Consumer Confidence
Thursday – Mar. Nationwide House prices
Tuesday – Feb. Jobless Rate, Feb. Retail Trade, Feb. Large Retailer Sales, Mar. Small Business Confidence
Wednesday – Feb. prelim. Industrial Production
Thursday – Mar. Manufacturing PMI, Feb. Labor Cash Earnings, Feb. Housing Starts, Feb. Construction Orders
Friday – 1Q Tankan Large All Industry Capex, 1Q Tankan Outlook
Monday – BoC’s Boivin Speaks
Wednesday – Feb. Industrial Product Price, Feb. Raw Materials Price Index
Thursday – Jan. GDP
Australia & New Zealand:
Tuesday – NZ Finance Minister English Speaks, NZ Feb. Imports, Exports and Trade Balance
Wednesday – NZ Building Permits, AU Mar. DEWR Skilled Vacancies, AU Feb. HIA New Home Sales, AU Feb. Job Vacancies
Thursday – AU Feb. Building Approvals, AU Feb. Retail Sales, AU Feb. Private Sector Credit, RBNZ Mar. Activity Outlook & Business Confidence
Friday – NZ 4Q Manufacturing Activity, AU Mar. Performance of Mfg Index, Mar. RBA Commodity Price Index
Friday – Mar. PMI Manufacturing