One of the most important decisions participants in the foreign exchange must make is whether to view the dramatic pullback in most of the major foreign currencies seen in the early days of the new year as a reversal of the trend or as simply an overdue correction. Our technical analysis sides with the latter and we anticipate renewed dollar weakness in the period ahead.
We would be forced to reconsider if the euro fell through the $1.2980 area or if sterling fell below $1.60. Although the dollar's sharp gains against the yen have left it over-extended, we see no compelling technical sign that a reversal is at hand. Just like ECB's Draghi wielding Outright Market Transaction scheme drove down Spanish and Italian yields, Japan's Abe's rhetoric has been sufficient to drive the yen down without lifting a finger or spending cent.
The IMF reported Q3 currency composition of foreign exchange reserves at the start of the week when many were on holiday. We offer the following observations. 1. As a whole, central banks drew down reserves during the financial crisis and have been rebuilding them. Total fx reserves stood at $10.78 trillion at the end of Q3 2012. This compares the estimated value of all above-ground gold (@~$1670 an ounce) of $8.49 trillion. 2. This represents a $610 bln increase over Q3 2011. This compares with the estimated value of the new gold produced in 2011 of about $125.5 bln. The bulk of the increase in currency reserves (~3/4 or $414 bln) came from countries that report the allocation of their reserves. China and some Middle East countries are strongly suspected not to report the allocation of their reserves.
The holiday week saw the dollar consolidate against most of the major currencies. The yen was the main exception as its losses were extended under the aggressive signals coming from the new Japanese government.
At the end of the week, the other key consideration, the US fiscal cliff made its presence felt. The recent pattern remained intact. News that gives the participants a sense that the cliff may be averted encourages risk taking, which means in the foreign exchange market, the sale of dollars and yen.
News that makes participants more fearful that the political dysfunction failed to avert the cliff and send the world's largest economy into recession, generally see the dollar and yen recover. This is what happened in very thin markets just ahead of the weekend as Obama's ling last ditch negotiating stance seemed to reflect a retreat from his earlier compromises.
The US dollar rebounded smartly at the end of last week as the realization that it was increasingly likely the US would go over the fiscal cliff. This has been our base case, but many seemed to expect it to be averted and were looking past it.
This week's pattern remains intact. The US dollar continues to trend lower against the European currencies, but is firmer within the dollar-bloc and against the yen. Spanish and Italian bond yields are lower, while the long-end of the Japanese curve is heavy. Equity markets are finishing the year with a firm note, with board gains in Asian, with the notable exception of Shanghai and Jakarta, and in Europe, with the exception of Stockholm. The euro is at 7-month highs today, pushing toward $1.3300. The next target is near $1.3385. Sterling has been bid to near the year's high set in late September just above $1.6300. There is little chart resistance until closer to $1.6500. The dollar's slide against the Swiss franc has extended to CHF0.91 and appears headed for CHF0.9000. The dollar-bloc is not participating in this move against the greenback. This week, for example, the New Zealand dollar has fallen as almost as much as the yen (1.03% and 1.08% respectively). The Australian and Canadian dollars are off 0.04% and 0.57% respectively. There are a few macro-developments to note:
The US dollar moved lower over the past week against the major currencies, with the notable exception of the Japanese yen. The greenback's technical tone has deteriorated. The euro and sterling appear to have convincingly broken above significant down trend lines. With the holiday season upon us, there seems to be no compelling technical reason not to look for a continuation of dollar weakness into the end of the year. Few are incentivized to fight the trend.
The extent of the Fed's easing, and the implication of its guidance, suggests an even more dovish posture than the expansion of QE3+ (remember it was purposely open-ended, unlike QE1 and QE2). While the euro zone economy appears to be contracting this quarter at a slightly faster pace than in Q3, the slowdown in the US is more dramatic. Growth may be more than cut in half from the 2.7% annual pace seen in Q3. The fiscal cliff is the main cause of consternation at the moment. Although there is private negotiations taking place, the public posturing is what investors have to guide them, and it is not particularly flattering.
Today is probably the first day in a while in which minute-by-minute rumors on the Fiscal Cliff will not be on the frontburner (with yet another late day rumor yesterday of an imminent deal turning out to be a dud, when it was reported that Obama's latest grand compromise was to lower his initial tax hike demand from $1.6 to $1.4 trillion, or still $600 billion more than last summer's negotiated number), with Ben Bernanke and QE4 taking center stage instead. By now it is a foregone conclusion that Ben will proceed with extending Twist as first predicted here, into an unsterilized bond buying operation, in effect confirming that there has been zero improvement in the economy, as another $1 trillion is about to be injected until the end of 2013, and more trillions after that. The good thing is that all pretense that the Fed cares about anything but the market is now gone. The bad thing is that the Fed will continue to take over the capital markets until it and the other central banks are the only traders remaining. The only question is whether the market, now well into massively overbought territory, will fizzle and snap back after Bernanke's news announcement, and will QE4EVA (as we believe QE3+1, aka QEternity-er, should be called) have been fully priced in by the time it was announced?
Some indication of progress on US fiscal talks, anticipation that the Fed extends QE3+ tomorrow, speculation of a cut in China’s required reserve, healthy Spanish T-bill auctions and a much stronger than expected German ZEW survey is encouraging risk-on plays, with the dollar and yen laggards, peripheral bonds firmer, and emerging equity markets extending recent gains. European shares are advancing for the seventh consecutive session.
News of greater political uncertainty in Italy and poor European data is spurring risk-off moves, with the dollar and yen firmer, emerging market currencies mostly softer, global equity markets lower and core bonds a bit firmer.
Following much weaker than expected German industrial production figures last week has been followed in kind by disappointing French and Italian output figures today. Italy reported a 1.1% decline. The consensus was for a 0.2% decline and the Sept series was revised lower. French output fell 0.7%. The consensus was for a 0.3% increase. Yet it is really the Italian political scene that is the key driver today with the benchmark 10-year yield up more than 30 bp, dragging up peripheral yields generally. Italian shares have been particularly hard hit and a couple of banks were limit down and stopped trading.
This week is the last before the holiday mood sets in. We identify ten considerations that will drive the capital markets.
We have been tracking the deterioration of the US dollar's technical tone over the past three weeks. That ended abruptly. Weak euro area data, a more dovish than expected ECB, and heightened political uncertainty in Italy, saw the euro reverse lower after briefly moving above an eighteen month-old downtrend.
The UK also cut its growth outlook, and poor data increases the likelihood that the BOE may have to resume its gilt purchases in the new year, though consumer inflation expectations have ticked up recently.
At the same time, there appears to be little progress on the US fiscal talks. Whenever a top official signals this, the dollar seems to tick up on risk-off considerations, though with diminishing impact. The stronger than expected November employment data is not sufficient to stay the Fed's hand and the FOMC will most likely expand the long-term assets purchased under QE3+ at its meeting that concludes on December 12.
UBS and Nomura have suggested that gold could rise next week as the Federal Reserve may announce further easing at the FOMC meeting – on Tuesday (11/12/12) and Wednesday (12/12/12). Nomura said it is worth considering whether the FOMC will announce further easing to replace so called ‘Operation Twist’. The research house noted that gold remains at the same level as during the October meeting, which suggests gold has not yet priced in any move by the FOMC – creating an opportunity for gold bullion buyers. Regardless of whether the FOMC actually eases at this point – Nomura thinks there is a non-negligible probability – gold is likely to rise. Therefore, Nomura expects gold to rise and prices in this probability as the December meeting approaches, just as gold rose when the September meeting was approaching.
A consolidative tone threatening to emerging in the foreign exchange market, as prices churn awaiting not only today's press conference following the ECB meeting, but also tomorrow's US employment data and prospects for an expansion of QE3+ at next week's FOMC meeting.
Five major central banks were to meet this week, with only the Reserve Bank of Australia poised to act. They did cut rates, but the accompanying statement did not tip the hand of the next move. The market took advantage of the jobs data's favorable optics to reduce the likelihood of a follow up cut in February to about 50/50.
The details of the employment report were really weaker than it appeared. The 13.9k increase in jobs is misleading as it was driven exclusively by part-time jobs. Full time work actually fell 4.2k, the first decline in four months. The unexpected decline in the unemployment rate to 5.2% from 5.4% in Sept and Oct was a function of a decline in the participation rate. The Australian dollar has traded now (barely) on both sides of yesterday's range. Offers in the $1.05 area continue to slow the Aussie's ascent.
After extending recent losses in Asia, the US dollar stabilized in the European morning.
The US dollar continues to trade heavily, with the euro and sterling edging to new multi-week highs and the yen consolidating its recent losses. The main consideration appears to be the looming fiscal cliff, weaker data and the prospects for additional QE to be announced next week by the Federal Reserve.
At the same time, tail risks emanating from euro area have diminished, even if the i's aren't dotted and the t's not crossed on Greece's new program, or if the negotiations over bank supervision in Europe at today's EU finance minister meeting, are more protracted.
Our assessment of macro fundamentals leave us inclined to favor the dollar on a medium term basis. However, we continue (seehereandhere) to recognize that near-term technical considerations favor the major foreign currencies, but the yen.