The US dollar is trading firmly. The official verbal commentary this week by Europe's Juncker and Japan's Amari were more disruptive noise a true signal. These mis-directional cues whipsawed short-term participants and served to obscure what was really happening. One of the most important take aways, it seems, from this week's action is the narrowing of the breadth of the dollar's decline. It is really limited to only the euro...
The newly elected Japanese Prime Minister, Shinz? Abe, has caused quite a stir. The leader of the Liberal Democratic Party, which scored a landslide victory in 2012’s election, he’s promised to restart the Japanese economy, whatever it takes. How will he do this? By “bold monetary policy”, what he means—and what he has said—is to end the independence of the Bank of Japan, and have the government dictate monetary policy directly. The perception is, the Bank of Japan will not only print yens and buy government bonds à la Quantitative Easing of old - it is also generally thought that Mr. Abe and the incoming Japanese government fully intend to target the yen against foreign currencies, like Switzerland has been doing with the euro. This perception is what has been driving the Nikkei 225 index higher, and driven the yen lower. But why was this decision triggered?
Same overnight pattern, different day. After a late day ramp in the US market, followed by a selloff in the futures after hours, taking the ES to trading session lows, we get the European trading crew which day after day sends the EURUSD soaring as Europe opens, pushing futures to unchanged or even green and easily negating the key news event of the day, in this case the full grounding of the entire global Boeing fleet which will once again weigh on the stock and DJIA. In the meantime, the big rotation behind the scenes in FX land continues, with the ongoing and very sudden pounding of the Swiss Franc taking the EURCHF to 1.2450, or the highest, since 2011. Same with the USDJPY which after another attempt to fall, rallies on more of the same regurgitated rumors. Not to mention the EURUSD of course, which as mentioned above has surged some 100 pips since the European open. In other words the overnight beating of the USD is enough to push the US stock market high enough in nominal terms, avoiding that there is no incremental cash flow. Then again, who needs cash flow when you have "multiple expansion."
There have been some large moves in the foreign exchange market in recent days. The euro posted its largest rally in four months last week. The yen has fallen to its lowest level against the dollar since June 2010 and extended the declining streak to nine consecutive weeks, something not seen since 1989. The Canadian and Australian dollar rose to multi-moth highs, as did the Mexican peso.
In last week's technical note, we suggested the key question whether the sharp drop in the major foreign currencies following the avoidance of the full fiscal cliff in the US was trend reversal or overdue correction. We favored the latter and looked for the underlying trends to continue. They did.
Now market participants face a different question. Given the out-sized moves, have the trends become stretched? The answer, we propose, is more nuanced than last week. There is not one answer for all the major currencies we review here.
After out sized moves in the foreign exchange market yesterday, a consolidative tone has emerged with a few exceptions. The big winner yesterday was the euro and with a narrow range of about a third of a cent today, the market seems as if it is catching its breath before assaulting important resistance near $1.33, which capped it in mid-December and at the very start of the new year. Sterling recovered from a test on $1.60 at mid-week, but lagged behind the euro. The pullback today is also more pronounced after the disappointing industrial output figures. Industrial production rose 0.3%, half the recovery the consensus expected after the 0.9% decline in October. The key disappointment was in manufacturing, which contracted 0.3% compared with consensus expectations for a 0.5% gain, following the 1.4% slide in October. The increases concerns that the UK economy slipped back into contraction following expansion in Q3. Support is now seen near $1.6080.
Think the Fed (with its balance sheet amounting to over 20% of US GDP), or the ECB (at 30% of GDP) is bad? Then take a look at the balance sheet of the Swiss National Bank, whose assets now amount to some 75% of Swiss GDP and which has now "literally bet the bank" in the words of the WSJ not once, not twice, but three times in a bid to keep the Swiss Franc - that default flight to safety haven - low, and engaging in what is semi-stealth currency warfare by buying other sovereigns' currencies for over two years now, although he hardly expect the US Treasury to even consider it for inclusion on its list of currency manipulators - after all, "everyone is doing it".
There are seven items that will be on the radar screen of global investors in the week ahead. 1. There is confusion over Fed policy. Despite the leadership (Bernanke, Yellen and Dudley) demonstrating their unwavering commitment to use heterodox monetary policy in an attempt to promote a stronger economy in the face of household de-leveraging and fiscal consolidation, many have read the FOMC minutes to imply an early end to the $85 bln a month in long-term asset (MBS and Treasuries). That December meeting was historic not because it marked the beginning of the end of QE, but the exact opposite, the nearly doubling monthly purchases and the adoption of macro-economic guidance (6.5% unemployment and 2.5% inflation) before rates are lifted.
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.