Week of May 15, 2011
Larger risk retreat now looks to be underway
After last week’s rout in risk assets (commodities, stocks and JPY-crosses)/rebound in the USD, we were largely constructive on the move, viewing it as only a positioning-driven correction within a larger uptrend. Price movements in the past week, however, have now convinced us that a larger trend reversal lower is likely taking place. While there are plenty of individual stories and themes playing out, we prefer to focus on the strength of the global recovery as the primary driver. And here, we think recent data points to moderating global growth, as Asia shows signs of decelerating (see below) and major developed economies appear set to languish as austerity measures increasingly take hold. German factory orders and Eurozone industrial production both declined MoM in March, suggesting that the strong 1Q growth in the Eurozone is unlikely to be sustained. Anecdotally, we continue to hear market talk of sizeable leveraged names (hedge funds) exiting long risk/growth trades and turning more bearish. Additionally, a quarterly Bloomberg News survey also revealed a decidedly bearish shift in sentiment among global investors for the months ahead. Lastly, the impending wind-down of the Fed’s QE2 asset purchase program is cited by many as feeding in to expectations that US rates may rise and stocks may fall, though we don’t ascribe recent risk asset strength to QE2 at all. We will continue to look to incoming data for what it suggests about the strength of the global recovery and to inform our view of risk sentiment.
We think positioning is still a factor, but recent sharp declines in major currencies and commodities suggest that a potentially significant portion of the excess has been worked off, meaning the pace of declines may moderate in the week ahead. Still, we don’t think positioning is anywhere yet near short “risk” assets, so we will look to use rebounds in any consolidation periods as an opportunity to re-sell key commodities, and major currencies/ buy USD on dips. Please note, this is a reversal of the view we suggested in last week’s update. Technically, we are getting trend reversal signals in many major markets: The CRB commodity index has dropped below the daily Ichimoku cloud; WTI crude oil and silver have both dropped into the cloud, but so far are holding above the base (hopefully offering room for a rebound); Gold is lagging and holding well above the 1435/36 cloud top, possibly signalling it will play catch-up (see below); EUR/USD has dropped into the cloud; and the USD index has tested the bottom of the cloud from below. These developments suggest that there may still be some bounce left in certain commodities and currencies/pullback in the USD, but that another week like the last two would trigger unambiguous signals of an even larger reversal lower in risk assets/higher for the USD in the weeks ahead.
The UK leads the “soft patch” in global growth
Last week’s Inflation Report delivered what many had expected– a downgrade to the UK’s growth forecast for 2011. The Bank of England’s central projection for growth this year is between 1.8 per cent and 3.5 per cent. This is below the Bank of England’s February forecast of 2 – 4 per cent.
Inflation was revised higher, which was also expected. But the Bank surprised the market with its interest rate forecast. Its projections were based on interest rates rising to 1 per cent by the end of the year. This surprised the market since investors had been pricing out the prospect of any rate hikes this year after a spate of weaker data including first quarter GDP that was below the growth rate of Greece.
The Bank’s signal last week suggests that rates may be increased as early as August and then again at the end of the year. But with growth essentially flat since the third quarter of 2010 and PMI survey data for April pointing to the slowdown extending into Q2, we think that rates may remain on hold for some time yet.
Interestingly, in the aftermath of the Inflation Report Short Sterling futures, which measure interest rate expectations, have not had a significant move, suggesting that the market is not convinced the Bank will raise rates at all this year.
There are two reasons for this. Firstly, the outlook for growth has deteriorated. Austerity measures have just started to take hold and household incomes are likely to remain constrained for some time yet. That is bad news for the UK economy as it relies heavily on consumption and services to grow.
Secondly, the fall in commodity prices has the potential to affect UK inflation rates more so than in the US because the Bank of England looks at headline inflation, which includes energy and food prices. So if oil prices continue to come off then we could see CPI rates decline in the coming months. There is a caveat to this: processed food prices. They have risen strongly in recent weeks and have the potential to keep upward pressure on inflation for some time to come.
Putting that concern to one side, weak growth and the potential that inflation has peaked do not support higher rates. While the UK economy faces strong headwinds in the medium-term, if the Bank holds off on raising rates that may boost growth as we move into 2012. So there is a chance that this soft-patch is a temporary bump in the UK’s economic profile.
Sterling had a volatile week falling back from 1.6500 – the high post the Inflation Report - and closing the week below 1.6200, the lowest level since the start of April. The economic outlook is particularly cloudy, which makes it hard to predict the direction of sterling. We think the risk is for another down-move, with 1.6500 the high for now. Below 1.6180 – the top of the Ichimoku cloud, GBPUSD is no longer in a technical uptrend and we may see down to 1.6000.
The euro gets hit as sovereign crisis enters its second act
Since last summer the euro has shrugged off sovereign debt concerns. It brushed off the Irish bailout in November, and within days of the Portuguese bailout EURUSD was in touching distance of 1.5000. But since last week the prospect of a second bailout for Greece and a new phase of the crisis have spooked investors.
It appears that the market is starting to discount sovereign concerns, which makes it unlikely that EURUSD will move back to the 1.5000 level in our opinion. EURUSD closed last week on a weak note, below 1.4190 – the top of the Ichiomku cloud and the end of the EURUSD technical up trend. Below 1.4150 we may see a sharp decline to the 1.3950/60 zone, which is also the bottom of the Ichimoku cloud chart.
The decline in the euro is not only down to sovereign concerns. The single currency is also weakening along with other risky assets and it is moving inversely to the dollar, which has strengthened 4 per cent against its major trading partners since the start of May.
As risk aversion and the dollar re-bound grips markets then the euro will remain under pressure. However, we don’t anticipate the single currency to go down in a straight line. The ECB still seems committed to normalising interest rates at a quicker pace than the Federal Reserve and strong growth figures for the first quarter of this year have kept interest rate expectations elevated.
Right now there are another two ECB rate hikes priced in by year-end. This seems excessive when the peripheral economies are struggling and Portugal returned to recession in Q1, but unless we see a dramatic slowdown in inflation or overall growth rates then the ECB may hike rates again in July. If interest rate differentials do start to drive FX markets once more then the euro is the sure winner.
However, we believe that sovereign concerns may run for some time yet after Germany said it would not agree to extend more aid to Greece until the conclusion of an IMF audit in June on how well Athens is complying with the conditions of the first bailout. While Germany remains unwilling to pledge extra financial help to Greece then the euro may be on the back foot. After all, this time last year the euro was in free-fall when Germany and other nations failed to agree on the first rescue package.
Asian growth outlook subdued
This week, the People’s Bank of China (PBoC) raised banks’ reserve requirement ratio (RRR) by 50bps effective May 18. This is the fifth time this year the PBoC hiked the RRR which has reached a record high of 21%. This comes after an abundance of Chinese economic data was released on Wednesday. The data showed that while inflation ticked down slightly in April to 5.3% y/y from the previous 5.4%, it remains at elevated levels which is likely to be concerning to policymakers. Additionally, new yuan loans for April rose by much more than anticipated to 739.6B from the prior 679.4B, also an alarming indicator. This suggests that the PBoC may continue to tighten to withdraw liquidity and control inflation. As the world’s second largest economy and major consumer of commodities, expectations of continued tightening by China may keep pressure on risk sentiment as the policy measures are likely to weigh on growth. This can be seen by a lower than forecast April industrial production to 13.4% y/y (cons. 14.6% prior 14.8%) and an unexpected drop in retail sales to 17.1% y/y (cons. 17.6% prior 17.4%). As noted by PBoC Governor Zhou, “there is no limit to how far the required reserve ratio can be raised”.
On Thursday, Japan will release its first quarter GDP which is expected to show a contraction of -0.5% q/q from the prior -0.3%. The decline is largely due to the March 11 earthquake and a second consecutive quarter of negative GDP would confirm a recession. Recent indicators suggest significant deterioration in the Japanese economy with the most notable being a sharp drop in March industrial production by -15.3% m/m from the prior +1.8%. Weakness is expected to persist for some time and the expectations are for continued contraction before a recovery materializes. The Bank of Japan is set to meet next week and is not expected to make any changes at its policy announcement on Friday though the risk is for board members to support Deputy Governor Nishimura to increase asset purchases. While markets are risk averse, yen crosses are likely to remain under pressure, however the downside in USD/JPY may be limited as the threat of intervention lingers, suggesting more pronounced weakness may materialize in non-JPY dollar pairs.
Is gold about to lose its luster?
As we head into next week it appears that gold is setup for a potential ‘Wile E. Coyote’ moment. When analyzing other products that typically have a positive correlation with gold we’ve noticed a few startling technical developments. Of late, RSI has proven its value as a ‘leading indicator’ as it has preceded the actual move in multiple other markets. When focusing on a Silver chart, the daily RSI broke below long-term trendline support on May 2nd, meanwhile price broke below its corresponding trendline on May 4th. The USD index’s daily RSI broke higher one day in advance to price and the EUR/USD’s daily RSI confirmed the break below channel support in real-time.
Now as we turn our technical emphasis to gold, the daily RSI broke below trendline support on May 4th, however price has yet to break below its analogous trendline. On Monday this key support level rises to $1476 and if other markets serve as any precedent, it may only be a matter of time before gold bulls realize they have run off a cliff and there’s nothing left to support them. Should this long-term trendline give way, the downside could be swift and treacherous. Since the beginning of 2009, the 150-day sma has kept the overall bull market intact. Thus, we would expect it to provide support once again should it be tested. On Monday the 150-day sma should be around $1405 as it currently rises about $1 a day.
Key data and events to watch in the week ahead
United States: Monday – May Empire Manufacturing, Mar. Net TIC Flows, May NAHB Housing Market Index, Ben Bernanke Speaks Tuesday – Apr. Housing Starts, Building Permits, Industrial Production, Capacity Utilization Wednesday – FOMC Meeting Minutes, Fed’s Bullard Speaks Thursday – Weekly Jobless Claims, Apr. Existing Home Sales, Leading Indicators, May Philadelphia Fed. Index, Fed’s Dudley, Fisher and Evans to Speak Friday – Fed’s Dudley to Speak
Eurozone: Monday – EZ Apr. CPI, Mar. Trade Balance Tuesday – EU Finance Ministers Meet, German May ZEW Survey Wednesday – ECB’s Stark, Constancio & Bini Smaghi Speak Thursday – ECB’s Trichet, Tumpel-Gugerell Speak Friday – German Apr. Producer Prices, EZ Mar. Current Account, EZ May preliminary Consumer Confidence, ECB’s Mersch to Speak
United Kingdom: Monday – May Rightmove House Prices Tuesday – Mar. DCLG UK House Prices, Apr. CPI, RPI Wednesday – BOE MPC Minutes, Apr. Jobless Claims, Mar. Weekly Earnings, ILO Unemployment Rate Thursday – Apr. Retail Sales figures, May CBI Trends
Japan: Monday – Mar. Machine Orders, Apr. Domestic CGPI, Apr. Consumer Confidence Wednesday – Mar. Tertiary Industry Index Thursday – 1Q preliminary GDP figures, 1Q Housing Loans, Mar. Capacity Utilization, Mar. final Industrial Production, Apr. Nationwide and Tokyo Dept. Store Sales Friday – BOJ Target Rate, Mar. All Industry Activity Index
Canada: Monday – Mar. Manufacturing Sales, BOC Governor Carney Speaks Tuesday – Mar. Int’l Securities Transactions Wednesday – Apr. Leading Indicators, Mar. Wholesale Sales Thursday – BOC’s Carney & Lane to Speak Friday – Apr. CPI, Mar. Retail Sales
Australia & New Zealand: Monday – NZ May Performance Services Index, AU Mar. Home Loans Tuesday – RBA May Minutes Wednesday – NZ 1Q Producer Prices, AU Westpac Consumer Confidence, AU May DEWR Skilled Vacancies, AU 1Q Wage Cost Index Thursday – NZ May ANZ Consumer Confidence Index, NZ Budget, AU Feb. Weekly Wages Friday – NZ Prime Minister Key Speaks, NZ Apr. Credit Card Spending
China: Tuesday – Apr. Actual FDI