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The Week Ahead--Week of April 7th, 2013

Updated -  Apr 5, 2013 1:00:00 PM By Kathleen Brooks and Eric Viloria, CMT

Is the ECB on the cusp of cutting rates?

For yet another month the ECB sat on its hands and made no change to current policy at its April meeting. However, President Mario Draghi’s tone was noticeably more downbeat, as he said that the risks to the economic recovery, slated for the second half of this year, are to the downside. He also sounded concerned about the lack of credit for small and medium-sized businesses, particularly in the hard-hit south. However, so far the ECB’s concern is about all that these SME’s will get from the central bank, as the President also said that before new measures could be adopted they would require careful consideration.

The Eurozone crisis is turning from a sovereign crisis to an economic crisis; hence the stabilization of peripheral bond yields are not enough for the markets to remain sanguine on the currency bloc. This means that economic data is coming to the fore, and in the coming weeks and months industrial data, in particular PMI surveys, will be closely watched for further signs of deterioration.  The March PMI survey data showed deterioration in the currency bloc’s economy, which dented hopes that a recovery was taking hold. Even the core economies like Germany registered declines last month. The unemployment picture was also weak, the currency bloc saw 33,000 extra unemployed persons bringing the unemployment rate to a record 12%. Although the data was weak the euro actually closed the week nearly 200 pips higher versus the dollar. This was down to a couple of factors: 1, the USD dropped sharply after extremely weak Non-Farm payrolls data for March, and 2, the spread between German and US bond yields moved in the euro’s favor after the ECB kept rates on hold and US payrolls dragged Treasuries lower, helping EURUSD to stay above 1.30.

While the fundamentals suggest the EUR should be weaker than 1.30, the EURUSD seems to be supported for as long as the ECB remains on hold. We have seen the power of central bank easing to move the FX market – look at the Fed and the recent actions of the BOJ (see the Japan section for more) – thus, if we are to see another substantial decline in EURUSD expectations need to rise that the ECB will either cut rates or adopt some form of QE in the coming months. Although we think the bar is fairly high for more easing (not even a record high unemployment rate can do it), a further deterioration in the economic outlook, particularly in the core like Germany, France and the Netherlands, could force the ECB’s hands and weaken the euro.

The week has a fairly light economic calendar for the currency bloc, however, industrial production for February and investor confidence will be watched closely. The market expects industrial production to rise by 0.2%, but for the annual rate to decline even further to -2.5%. Any data misses are likely to be met by a wave of EUR selling after its strong performance last week. 1.2850 then 1.2770 are key support levels to watch in EURUSD. Key ECB speakers next week are  both German – Jorg Asmussen and Jens Weidmann - so they could dampen prospects of a near term rate cut from the ECB. On Friday 12th April the Eurozone finance ministers will meet in Dublin to discuss if Greece “deserves” its next tranche of bailout funds (EUR 2.8 billion). We have seen these funds get delayed before, thus the risk is for a positive surprise – with Greece meeting Troika conditions and receiving its next tranche of bailout funds without any complication. If this happens it could provide a   temporary boost to the euro.

Figure 1: EURUSD and German – US 10- year bond yield


The UK steps back from the triple-dip abyss

The economic data for the UK last week ended on a high note, with the service sector PMI rising to its highest level since August 2012. This was a much needed respite for the UK after dismal construction and manufacturing surveys. We have said in past notes that these sectors are the two weakest links for the UK economy, and if you strip them out then the economy is actually growing at a much healthier rate of about 1%, which is fairly respectable in the current climate.

This week we will get a further indication of whether the UK economy managed to avoid a triple dip recession with the release of industrial and manufacturing data for February. This is expected to show a slight increase, however not enough to reverse dismal figures for January. The trade balance for February is also released, which is expected to show a wider deficit of GBP 8.6 billion in February, from GBP 8.2 billion in January. Thus, next week we could see fears rise that the UK may not be able to avoid a triple-dip recession. Added to that, snow disruption caused by late-winter snow fall across most of the country last month could also add to the UK’s economic woes.

After the Bank of England remained on hold for another month in April, the focus is now on the Bank of England minutes released on the 17th August, to see how close the Bank came to more QE and then the Q1 GDP report due on 25th April. If the UK economy does drop back into recession then we think the BOE will react with GBP50 billion more QE at the May meeting. Thus, the economic data between now and then will be pivotal for GBP. After the Bank remained on hold last week and the service sector PMI surprised to the upside, GBPUSD surged to 1.5350. This was the highest level since February. This is a significant resistance level as 1.5340 is the base of the daily Ichimoku cloud, and above here is the end of the technical downtrend. Thus, the weekly close above this level is a bullish development for this cross. This opens the way for a move back towards 1.5400 and 1.55. However, we would be wary of weak industrial data causing a steep sell off. This data has a strong correlation with GDP, so any weakness could weigh on GBP as people ditch the currency in expectation of a triple-dip recession. 1.5195 is key support – the Tenkan line on the daily cloud.

The SNB bolsters its defense

Could the Swiss National Bank (SNB) be worried that it will need to defend its EURCHF 1.20 peg sometime soon? It looks like that after Swiss authorities boosted their FX reserves last month at the fastest pace for more than half a year. The value of Swiss reserves now stands at CHF 438 billion, up from CHF 430 billion in February.

The SNB maintains its peg by using its reserves to buy EUR, thus ensuring EURCHF does not fall below 1.20. The peg has been in place for nearly 2 years and it has been very successful. However, after reaching a peak of 1.2470 in January, this cross has sold off steadily and recently fell below key support at 1.2200 as the euro dropped nearly 10 big figures at one stage versus the dollar.

The market always gets spooked when the SNB reserves increase at an unexpected rate, as it could suggest that the Bank is getting ready to defend the peg, and potentially even raise it. However, we don’t think this is likely at this stage because: 1, the economic data is fairly strong in Switzerland, retail sales and the labor market data remain at stable levels consistent with relatively strong growth. 2, the peg is very expensive to maintain, thus the SNB may want to wait until a crisis in the currency bloc develops that threatens to dramatically weigh on the euro before acting. The bank may have accumulated extra reserves last month because of concerns about Cyprus, however now that has died down we think the pace of reserve growth will fall back to more normal levels in the coming months.

Even so, watch EURCHF this week, and any sharp declines towards 1.20 could be met by a wall of buying from the Swiss central bank.

Figure 2: EURCHF daily


US labor markets hits a soft patch

This week’s labor data out of the US was much softer than anticipated with weakness in the ADP report, weekly initial claims and BLS figures. Just last month momentum appeared to be picking up and talk of a sustained labor market recovery was making the rounds. So should this be viewed as a temporary setback or should investors be worried about renewed deterioration?

The March US employment report was extremely disappointing with job growth of only 88K. This was the first NFP print below 100K since June of last year and only the second time that monthly job growth was below the 100K level since August of 2011. The 88K headline print came from the addition of 95K private payrolls while government job loss contributed -7K. The decline in government jobs was mostly due to losses in US postal service employment which indicates that the impact on sequestration cuts which began in March have yet to significantly impact labor data.

The unemployment rate fell to 7.6% – however this coincided with a decline in the labor force participation rate to 63.3% which is the lowest since 1979. Furthermore, average hourly earnings showed no growth from the prior month. The only silver lining in the report was an upward revision to the prior 2 months figures which added a net 61K jobs.

Overall, the labor data points a bleak picture of the US job market and not surprisingly the data weighed on the USD. US treasury yields are lower as markets anticipate continued Fed stimulus and equity markets came under pressure after the encouraging economic releases. However, the disappointing figures represent just one data point and the broader trend should be taken into consideration. Looking ahead, US fiscal consolidation may adversely impact jobs and is a cause for concern. On the other hand, the central bank remains committed to achieving its employment mandate and Boston Fed President Rosengren said Friday morning that job weakness warrants “aggressive” Fed response. Therefore we are cautious about the outlook for jobs and for the USD.

Technically, the dollar index was unable to sustain a move above the 83.00 level and appears to be correcting lower for now. The index remains above key daily simple moving averages (SMA’s) which suggests the potential for continued upside. The 100- and 200-day SMA converge just below the 81.00 figure and will be a significant support zone moving forward.

Figure 3: Change in non-farm payrolls

Source: BLS

Fed QE tapering debate may be postponed for now

There has been a good deal of public debate from Federal Reserve members regarding the outlook for asset purchases or quantitative easing (QE). Currently, the Fed is engaging in purchases of $85B per month split between treasuries and mortgage-backed securities (MBS). This is being done in an effort to work towards the Fed’s dual mandate of maximum employment and price stability. Members such as Evans, Lockhart, and Pianalto have noted the 200K level for monthly job growth as significant if it can be sustained. Bullard said that he favors tapering QE in $10-15B increments as the economy improves and Williams said that the Fed could start tapering as soon as this summer.

For now, the focus for the Fed is clearly on labor markets. As Vice Chairman Janet Yellen said this Thursday, “reducing unemployment should take center stage for the FOMC, even if maintaining that progress might result in inflation slightly and temporarily exceeding 2%”. The unemployment rate continues to move towards the 6.5% level which the FOMC has stated as the threshold for maintaining exceptionally low interest rates. However it is declining for the wrong reasons (i.e. falling participation rate). The 3-month average in the NFP change is 168K while the 6-month is around 188K. With the dismal March NFP number the 200K level is moving farther away and therefore it is likely the debate about QE tapering will be put on the back burner for now as employment gains look to be losing momentum.

FOMC minutes from the March meeting will be released in the week ahead as well as speeches from Fed Chairman Bernanke and FOMC voters Rosengren, Evans, and Bullard. With the exception of Bullard, Fed speakers next week are some of the most dovish of the voters this year. We expect that they may express continued support for current policy and take a cautious outlook to the US economy. This may limit USD strength and may even weigh on the greenback depending on the nature of the comments. The US 10-year treasury yield is notably lower after a break below the 200-day SMA and expectations of prolonged asset purchases by the Fed would likely keep yields under pressure. We think that any talk of additional stimulus would be premature for now on the back of just one month of disappointing data. However, if there is any mention of increasing the pace or amount of purchases should conditions continue to deteriorate, markets may get nervous and the USD could respond negatively.

Can the BOJ achieve its inflation target in 2 years?

The JPY has declined markedly after the Bank of Japan announced new stimulus measures under the new leadership of Kuroda. The Bank set a 2-year time frame on achieving its 2% inflation objective as well as announced a significant increase in the amount and composition of asset purchases. For now, JPY weakness is likely to persist as the JPY falls to new multi-year lows against many of the majors. USD/JPY broke above March highs to reach its highest level since 2009, GBP/JPY is trading at its highest level since 2010, and AUD/JPY is at its highest since 2008.

Key officials and market participants question whether or not the BOJ can achieve this lofty goal. Japanese Finance Minister Aso recently said that it is not easy to achieve 2% inflation in 2 years and former BOJ deputy Kazumasa Iwata said that it is “impossible to achieve 2% inflation in 2 years” adding that it “won’t be easy even in 5 years”. The market is responding to the surprise of the aggressive measures and the JPY is adjusting accordingly. However, the JPY may be prone to corrections as doubts emerge about the effectiveness of policy.

Figure 4: Japanese CPI has only been above 2% briefly in the past 20 years

Source: Bloomberg

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