23 February 2011 at 14:10 GMT
With the growing BoE minority looking for rate hikes and a parade of ECB officials looking for the same, we have a strong EUR and GBP again today and the USD taking a backseat as interest rate spreads are all the rage. But should we expect 1.40 in EURUSD now or 1.30?
USD comeback easing off
The USD comeback yesterday on the strong bout of risk aversion – the strongest equity sell-off in the US, in fact, since the brief November consolidationon the heels of the actual QE2 announcement – has now faded again, particularly against the major European currencies, even if it remains at the strong end of the range against the pro-risk currencies. The focus on central bank expectations seems dominant at the moment and on that account, the market is pricing the market fairly, though we wonder what happens if risk aversion gains momentum again (more on this below).
Bank of England minutes
The Bank of England minutes showed yet another member crossing the aisle to the hawks, with 3 now having voted for a hike at this the last meeting (up from 2 previously), while there is still the one holdout (Posen) who continues to look for an expansion of the asset purchase target. A slim majority of six voted for the decision not to raise rates. The year-forward expectations shifted about 3 bps higher on this development and GBP responded with a rally, though there has been a bit of back and forth. Rate spreads at the 2-year duration are at new highs for the cycle and had equities not sold off yesterday, we might have seen GBPUSD already breaking higher through the range. It will be interesting for GBPUSD to see which theme is ascendant in coming days.
Odds and Ends
German Chancellor Merkel said that the EU is discussing a possible extension of the Greek rescue program, which is currently only three years, to put it more in line with the seven-year Ireland deal.
Hawk vs. Dove: the most avowed voting Fed dove, Charles Evans, said the stimulus is necessary for improving the “disappointing” recovery. Meanwhile, the most prominent voting FOMC hawk, Richard Fisher was out saying that the Fed has done enough and that he will not back any further stimulus for the economy.
Year forward RBNZ rate expectations ratcheted even lower overnight (about 12 bps) after the deadly Christchurch earthquake has further reduced the prospects for policy tightening as the country may now be in the throes of a recession. This leaves the greatest shifts in the differentials in the rate expectations universe at the moment in the likes of EURNZD.
Chart: EURNZD
EURNZD has rocketed higher as the market gets all worked up about the ECB’s supposed coming flurry of rate hikes (almost a full 100 bps priced in now for the year forward), while RBNZ rate expectations have swooned after the Christchurch tragedy.
Asia trouble? A very important data release out of Japan overnight, as the trade surplus contracted violently in January to the lowest level since early 2009 and was an outright deficit on an unadjusted basis. This is very interesting and one has to wonder if Chinese weakness is playing a role in this number, as exports grew a meager 1.4% YoY. Of course, much of the situation was due to a large increase in crude oil and other energy imports as the country experienced vicious winter temperatures relative to the norm. Going forward, this is one of those possible proxies for understanding the strength (or weakness) of Chinese demand since Chinese numbers are so unreliable.
Looking ahead
As long as rate expectations remain the focus, the upside remains open for the likes of EURUSD and GBPUSD and some of the other crosses like EURCAD and GBPCAD (though oil prices are competing for interest rate spreads for attention there.) All in all, however, the market’s message is very inconsistent – after all, we have seen an awful lot of strength in the long end of the bond market while the short end has sold off in the expectation of rate hikes. What does this mean for the yield curve? A vicious flattening - such that the German 2/10 spread is all the way down to around 160 bps from about 210 bps at the beginning of the year. That’s a huge move and it looks like the thumbscrews are being applied to some macro traders’ consensus thinking (of which we are also guilty) that the most likely rout for the ECB for dealing with the PIGS crisis would be via a continued loosening of policy. Then along came the Middle East situation and new inflation risks and here we are. How this will all end is very uncertain, but the prospect of a tighter ECB while the PIGS crisis remains unresolved is a frightening one for the eventual outcome. Eventually, we believe that the interest rate spread is a red herring that may lead us down a false path for a while (and could even see us at EURUSD 1.40 if we trade back toward the highs in equities) but will turn into a dead end eventually and the greater volatility potential, in our view, remains to the downside.
The next event risk on the radar is, of course, the Irish Election this Friday, with the opposition Fine Gael party expected to sweep to victory. According to the final pre-election polls, the party has about 40 percent support among the population, the highest level yet it has polled and right around the level of votes it will need to form a majority government with the Labour party (the expected coalition). In the wake of the election, the new leadership will try to renegotiate the EU/IMF bailout deal in terms of that deal’s interest rates, but have also talked up the idea of imposing haircuts on bondholders to reduce the overall burden. That latter step is inevitable, the question is the degree of the haircut and the timing and whether the haircut idea becomes contagious among the PIGS and brings down the European banking system while Germany refuses to fully commit to further bailouts. (Remember that European banks are far more leveraged than their US counterparts) This is the drama we face in the coming weeks for the EuroZone as the EU summits are quickly approaching next month.
Another facet of the current market activity that bothers us is this: if the market is so focused on interest rate differentials, then it is interesting to note that the likes of EURJPY and EURCHF and GBPJPY and GBPCHF have not put in stronger performances as interest rates at the front end of the curve have risen sharply again here. The tug of war seems to be between risk aversion and these spreads and it is curious to see risk aversion winning in one set of currency pairs (CHF and JPY pairs more or less) while interest rate spreads win in another set of pairs (USD pairs). Not very impressive, greenback!
Economic Data Highlights
- Japan Jan. Corporate Service Price Index fell -1.1% YoY vs. -1.3% expected and -1.3% in Dec.
- Japan Jan. Adjusted Merchandise Trade Balance out at ¥192B vs. ¥712B expected and ¥580B in Dec.
- Australia Q4 Wage Cost Index out at +1.0% QoQ and +3.9% YoY vs. +0.9%/+3.8% expected, respectively and vs. +3.5% YoY in Q3
- Australia Q4 Construction Work Done out at +0.8% QoQ vs. +1.3% expected
- Switzerland Jan. Producer and Import Prices rose 0.1% MoM and 0.0% YoY, both as expected and vs. +0.3% YoY in Dec.
- Bank of England voted 6-4 to keep policy rate unchanged (3 for a hike, 1 for increased asset purchases)
- UK Jan. BBA Loans for House Purchase out at 28932 vs. 29250 expected and 28907 in Dec.
- EuroZone Dec. Industrial New Orders out at +2.1% MoM and +18.5% YoY vs. -1.0%/16.2% expected, respectively and vs. +20% YoY in Nov.
Upcoming Economic Calendar Highlights (all times GMT)
- Canada Dec. Teranet/National Bank HPI (1400)
- US Jan. Existing Home Sales (1500)
- EuroZone ECB’s Weber to Speak (1715)
- US Fed’s Hoenig to Speak (1730)
- US Fed’s Plosser to Speak (1830)
- UK Bank of England’s Miles to Speak (1830)
- US Weekly API Crude Oil and Product Inventories (2130)