Week of May 8, 2011
A rocky start to May, or is it an opportunity?
“Sell in May and go away” has taken on a whole new meaning after the last few days. Major markets appear to have been uniformly caught excessively long of risk assets (stocks, commodities, and metals) and short USD, which we think was the primary driver of the past week’s declines. To be sure, there were some setbacks in the fundamental outlook for the global recovery, but nothing of the sort to justify double-digit percentage declines in many markets, except for excessive positioning, which we cautioned about in last week’s update. For example, many point to the sharp drop in the April US ISM non-manufacturing index from 57.3 to 52.8 as an ominous sign for the US recovery, and by extension the global rebound. But the ISM services index is a volatile series and prone to overshoots. Other US data for the week indicated the fragile US recovery is continuing apace, not rip-roaring but also not stalling: April ADP +179K private jobs added; April NFP +244K total jobs added; and April ICSC chain store sales up +8.5% YoY (prior +2.0%), despite higher gasoline prices. In short, we think fears of a significant slowdown in the US recovery are overblown at this point and that the attendant risks to the global recovery are also exaggerated. Growth and demand in Asia remains quite solid (China data next week will be an important barometer on this) and we think the sell-offs in risk assets is primarily a positioning exodus.
However, we would note a subtle shift in momentum between the US on one side and the UK and Europe, which are showing signs that recent growth has likely peaked, especially so in the UK. With the view that the global recovery is ongoing, we expect the commodity currencies (AUD, CAD, NZD, and NOK) to remain resilient against the majors (USD, GBP, EUR, and JPY) and for the USD to perform a bit better against the other majors. This view suggests looking for opportunities to sell those majors against the commodity currencies at advantageous levels (e.g. selling EUR/AUD, GBP/CAD, EUR/NOK, etc.).
Greece debt crisis heats up
As this is being written, news continues to break surrounding an emergency meeting of Eurozone finance officials to discuss some facet of the Greek debt crisis and the EUR is under pressure across the board. We doubt reports that Greece will seek to leave the Euro, so we are left contemplating the meeting is either to consider a request to amend Greek bailout terms or to prepare for a debt restructuring. If it’s to adjust bailout terms, we think the impact on the EUR will be relatively short-lived. If a debt default/restructuring is in the works, we also think the fallout may be more limited than at first glance. For months now, markets have been pricing in the prospect of a Greek debt restructuring, and with 10 year government bonds trading at around 57 cents on the EUR, a significant haircut is already priced in. What is likely not priced in is the amount of losses core (e.g. French and German) European banks would suffer if a restructuring finally materializes. There are further risks to Eurozone financial stability and the EUR from this, and it will ultimately depend on the terms of any restructuring or default. Of course, there may also be unexpected developments from the emergency meeting, as the subject was not disclosed. Still we are cautiously optimistic that the EUR has only gotten caught up in the overall risk sell-off, with an additional battering from late Friday headlines. The major pillars of recent EUR gains are still in place: the ECB is still on track to tighten in July; the Germans and French will not let the EUR break up; and the global recovery is still on track. We think EUR/USD back above 1.4450/4500 will signal the worst is past, but that EUR/USD below 1.4200/50 means greater downside potential.
UK public spending cuts start to bite
After the disappointing bounce back in UK growth in the first quarter initial signs suggest that the second quarter may not do much better. PMI data, which measure sentiment and activity in the manufacturing, services and construction sectors all came in below expectations for April.
The most worrying sign so far comes from the services sector. Not only does activity in this area contribute the most to GDP (approximately 70 per cent) but firms in April noted that cuts to public sector spending caused a decline in business.
This is concerning for two reasons. Firstly, public sector spending is only going to get cut further as the year progresses, and secondly, government spending rose in the first quarter and provided a boost to GDP. However, this prop to growth is being pulled away as we move into the second quarter, which is likely to dampen the economic recovery as we progress through to the middle of the year.
So what does this mean for interest rates and most importantly the pound? The answer isn’t clear-cut. Although interest rate expectations are driving markets and the there is now less than one hike priced into the UK rates curve for the next year, it is relative interest rate expectations that drive currencies.
The pound is still well supported versus the dollar as the market seems happy to continue to sell the greenback for as long as there is no end in sight to the Federal Reserve’s ultra-lose monetary stance. We expect it to continue to trade in a range between 1.6000 and 1.6700 for the time being.
Against the euro the pound has been under pressure. But after breaking through tough resistance at 0.9000, EURGBP sold off after the ECB’s Trichet was less hawkish than expected during his press conference last Thursday. So although the chance of rate hikes from the Bank of England have diminished markedly in recent weeks, this doesn’t lead directly to a weaker pound as investors are sensitive also to what other central banks are also doing.
Looking ahead, the Bank’s Inflation Report is released on Wednesday at 1030 BST. This will give us updated growth and inflation forecasts. It will be interesting to see how the Bank adjusts its outlook for prices after March’s decline in the headline inflation rate to 4 per cent from 4.4 per cent. Also watch out for any comment from Mervyn King regarding how long he thinks the current weakness in commodity prices may last and the impact on inflation.
Precious metals come crashing down
What a difference a week makes! The sharp rise of commodities in April has been swiftly undone in the first week of May. If you would like to know where commodities are headed, keep your eyes on silver as it led both moves – higher in April and lower in May. The past week in silver can be summed up in one word, breathtaking, as at one point it was down over 30%.
So what happened? In efforts to try to dampen volatility, the Chicago Mercantile Exchange (CME) has been raising margin requirements in silver. Typically over the past 6 months, the higher margin would lead to a mild correction which presented traders with an opportunity to establish their bullish bias at better levels. However, this time the CME has continued raising margins, 5 times to the tune of 84% over a 2 week period. On April 25th the initial margin requirement stood at $8,700, effective Monday May 9th (this upcoming Monday) the CME is set to raise it to $16,000! This was the most likely catalyst which led to the sell-off in silver, although news that George Soros and Carlos Slim (the richest man in the world) have been selling silver no doubt added to the panic.
In yesterday’s Commodities Corner we mentioned it may be prudent to wait for the ‘falling knife’ to stick in the floor, rather than try to catch it. After today’s strong US employment report it appears commodities may have done just that, as price action in Silver saw an hourly RSI positive divergence into the lows. Additionally, gold bounced off longer-term trendline support yesterday around $1460/65 and failed to make a lower low today. However, while commodities appear to have stopped their ‘free-fall’, it doesn’t mean we are ready to jump back onboard just yet. At the end of the day, rather than trying to pick a bottom, we’d prefer to establish a bullish bias only upon a break back above the top of the Ichimoku cloud around $36.55/65, in search of a move back towards $40-42. This way we would be more confident a meaningful bottom has formed. Conversely, there is an extreme risk of a continuation lower should gold break below the aforementioned trendline support which rises to $1470 on Monday.
Crude oil’s descent: Trend reversal or correction?
A number of factors may have contributed to Thursday’s precipitous oil market decline which saw crude prices print their second largest USD denominated loss to date – -$9.44 to $99.80/bbl and -$10.39 to $110.90/bbl in WTI and Brent, respectively.
The USD resurgence seems to have played a prominent role in oil’s dramatic swing lower and broader commodity selloff as Trichet’s exclusion of the term ‘vigilance’ injected doubt into the market in terms of the timing of the central bank’s next move – EURUSD plummeted towards the 1.4500 figure and has dropped even lower since to around 1.4380.
Demand destruction on the back of higher prices was also put forward as a reason for the steep drop in crude oil. Higher interest rates alongside inflationary concerns and its dampening effect on Chinese and Indian oil demand have been a concern for some time now and may have added momentum to Thursday’s oil price decay.
Additionally, rumors of potentially higher CFTC margin requirements for crude, similar to those recently implemented in silver, made the rounds adding fuel to the ‘crude selloff’ fire. While unsubstantiated at the moment, we would be remiss to completely dismiss the potential for this rumor to eventually become fact.
While all of the above are legitimate explanations for Thursday’s oil descent, we think the extremeness of the swings suggest exaggerated technical trading as the main driver of price action. Thus, any continued declines in crude may be short lived as there has been no significant shift in the fundamental oil market structure and may provide attractive risk reward value for longs.
The 100-day SMA in WTI crude oil looks key as the moving average has provided decent support since Q4 ’10 – WTI has only managed to dip below the 100-day SMA (currently around $97/bbl) by approximately $2 before resuming its uptrend since. Accordingly, we think the longer term crude oil uptrend remains intact and believe prices will trade within a $95/105 and $105/115 range for WTI and Brent, respectively, in the weeks ahead.
Key data and events to watch in the week ahead
United States: Tuesday – Apr. Import Price Index, Mar. Wholesale Inventories, Fed's Lacker Speaks Wednesday – Mar. Trade Balance, Fed's Lockhart & Kocherlakota Speak Thursday – Weekly Initial Jobless Claims, Apr. PPI, Retail Sales, Mar. Business Inventories, Fed's Plosser Speaks, Bernanke Testifies at Senate Friday – Apr. CPI, May preliminary U. of Michigan Confidence
Eurozone: Monday – German Mar. Trade Balance figures, May Sentix Investor Confidence Wednesday – German Apr. final CPI, Apr. Wholesale Price Index, ECB's Orphanides & Bini Smaghi Speak Thursday – EZ Mar. Industrial Production, ECB's Gonzalez-Paramo Speaks Friday – German 1Q preliminary GDP, EZ 1Q advance GDP, ECB’s Trichet, Bini Smaghi, & Stark Speak
United Kingdom: Monday – Apr. BRC Sales, RICS House Price Balance Wednesday – Mar. Trade Balance figures, Bank of England Quarterly Inflation Report, BOE’s Paul Tucker speaks Thursday – Mar. Industrial Production, Manufacturing Production, Apr. NIESR GDP Estimate
Japan: Sunday – BOJ Minutes of April 6-7 Meeting Wednesday – Mar. preliminary Leading & Coincident Index Thursday – Mar. Trade Balance figures, Apr. Eco Watchers Survey results, Apr. preliminary Machine Tool Orders
Canada: Monday – Apr. Housing Starts Wednesday – Mar. Int'l Merchandise Trade Thursday – Mar. New Housing Price Index
Australia and New Zealand: Monday – AU Apr. ANZ Job Advertisements Tuesday – NZ Apr. Card Spending, AU Mar. Trade Balance, Apr NAB Business Conditions & Confidence Thursday – NZ Apr. Business NZ PMI, Food Prices, AU Apr. Employment report
China: Wednesday – Apr. Trade Balance, CPI, PPI, Industrial Production, Retail Sales, Fixed Asset Investments Friday – Mar. Conference Board Leading Economic Index