Liquidity in the driver’s seat – for how long?

The dovish FOMC is having the intended effect as the Aussie squirts to a new record high against the rest of the major currencies. Will this continue for mere days or several weeks? 

Once again, we can’t recommend Caroline Baum’s column on the FOMC statement from yesterday enough, as it reminds us of how we are to understand why the markets react the way they do to the Fed’s actions: by insisting on keeping rates low forever at all points on the yield curve (as long as it can control them, at least), it forces the market to look elsewhere for investments and causes everyone to bid up commodities, equities and riskier bonds. And as we live in a global market place, the most stimulus from the Fed’s activities ends up in emerging markets. Still, as we indicated late yesterday in the wake of the meeting, the Fed has added no further liquidity to the situation in the here and now, and will face massive embarrassment, as Ms. Baum indicates, if its projections prove off base and is forced to move earlier – precisely because it proved so effective in encouraging too much speculation. There is thus a natural and inevitable braking mechanism to any response to a liquidity boost as long as the solvency question remains unaddressed. A rather clever post from FTAlphaville also graphically plots the FOMC rate projections of the various members and shows that the projections are actually less dovish than the statement itself indicates. Worth a read.

In that light, while QE1 and QE2 both proved far more successful in keeping the liquidity train running beyond our expectations and QE3 may prove the same, my base expectation is that this has added little new to the situation, especially considering how far we have come off the lows and considering the ongoing risks of a slowdown in China and the risks stemming from the EU sovereign debt crisis (mostly due to the political risk – it is a question of willingness to commit to the union, not whether there is a technical solution – that is what we must look out for as the January 30 summit approaches.

Two possible scenarios here: 
One: we quickly get over this within the next few days and EURUSD keeps more or less under 1.3240 on a daily close basis as the market ponders whether anything has effectively changed and on a shaky outcome of next week’s EU summit. Portugal moves toward formally requesting a second bailout. AUDUSD tops out anwhere from here to the 1.0750 area (or just above on a false break).

Two: this move proves rather durable as EU officialdom is able to put up a good show of solidarity at the summit next week. Meanwhile, EU bond auctions go well as the market gets set for the mother of all LTRO’s at the end of February from the ECB and the EURUSD moves into the 1.33-1.35 range and the USD stays on the defensive until the beginning of March. AUDUSD potentially puts in an all time high in this scenario.

I still prefer the first scenario, but the odds have shifted in favor of the second scenario after yesterday’s FOMC meeting and the market’s enthusiastic response.

When does the RBA begin to protest?
The Aussie continues to fly high as the recent CPI data already provided a reduction in expectations for further cuts and as the liquidity bonanza from the Fed and BoE (essentially expected to move once again once the current buying program expires) as well as all of the ECB measures has the market in the Aussie’s thrall, with its AAA rating and “better than detectable” yield. Adding to the upside pressure on the Aussie was a deputy chairman of the Russian central bank saying that the bank may begin buying Australia dollars as soon as early February. If the global asset and commodity markets keep up a head of steam here on the theme of QE forever, it is tough to see what will hold the currency from pushing through the major resistance level just above 1.0750. Looking at the Aussie’s broad strength, we wonder how long it will be before the RBA and Australian government begin to complain very loudly about what is going on - it is already doing damage to key Australian export industries. At some point, they will have to join the “currency wars” along with Switzerland and Canada, the latter of which has felt the need to keep rates far below ideal levels due to the desire to keep from losing further competitiveness from currency appreciation.

Doh, Canada!
A data point we neglected to discuss yesterday was Canada’s small decline in house prices in November, according to the Teranet/National Bank home price index. The previous two months showed no appreciation either, though it doesn’t appear the data is seasonally adjusted and this is a generally a weak time of year for house prices. Still, house prices are up over 7% year-over-year and we’re on the lookout for a rollover in Canada’s housing market and for signs that the world’s most overleveraged consumer is looking to mend its balance sheet. As for the CAD, it continues to play the “in between” role of staying the weakest of the commodity currencies when the global liquidity bonanza kicks into high gear (playing a distant second fiddle to the strong Aussie and to a lesser degree Kiwi) and then flipping to the stronger side when risk appetite sours. Sort of a weak echo of the greenback – stronger when risk appetite is off and weaker when it is on. The valuation in AUDCAD long ago became severely broken and remains an interesting one to watch going forward. USDCAD has had a look just below parity again today.

Chart: USDCAD
A key technical development for USDCAD today, which more firmly took out the 1.0050/80 support (now resistance) area and is having a look below parity today ahead of the 200-day moving average at 0.9950. Crude oil is back on the road higher today as well.



US Economic data
The weekly jobless claims number was a bit weaker than expected at 377k vs. 356k last week, but the 4-week average is virtually unchanged and this is a volatile time of year for claims. The Durable Goods and core Capital Spending data for December was very strong, though we are still looking for whether the expiration of tax incentives will see these numbers fall in January. The strong regional US manufacturing PMI’s this month suggest the incentives are proving less influential than we would have guessed.

Looking ahead
To close the week, we have a inflation and retail sales data for December out of Japan overnight and then the US Q4 GDP estimate, which is expected to roll in at 3.0%. Otherwise, let’s see whether the market gets a reality check over the weekend and early next week with the EU summit or whether asset prices can continue to churn higher through the uncertainty, confident in the warm cozy blanket of the Bernanke put.


Economic Data Highlights

• Germany Fed. GfK Consumer Confidence out at 5.9 vs. 5.6 expected and 5.7 in Jan.
• Sweden Jan. Consumer Confidence out at -1.3 vs. -7.0 expected and -7.4 in Dec.
• Sweden Jan. Manufacturing Confidence out at -14 vs. -11 expected and -11 in Dec.
• Sweden Dec. PPI out at -0.2% MoM and -2.1% YoY vs. -0.4%/-2.3% expected, respectively and vs. +0.3% YoY in Nov.
• Sweden Dec. Trade Balance out at +2.8B vs. +6.5B expected and vs. +3.8B in Nov.
• Sweden Dec. Unemployment Rate out at 7.1% vs. 7.0% expected and 6.7% in Nov.
• UK Jan. CBI Reported Sales out at -22 vs. -6 expected and +9 in Dec.
• US Dec. Chicago Fed National Activity Index out at +0.17 vs. -0.12 expected and vs. -0.46 in Nov.
• US Dec. Durable Goods Orders out at +3.0% and +2.1% ex Transportation vs. +2.0%/+0.9% expected, respectively
• US Dec. Capital Goods Orders Nondefense Ex Aircraft out at +2.9% MoM vs. +1.0% expected
• US Weekly Initial Jobless Claims out at 377k vs. 370k expected and vs. +356k last week
• US Weekly Continuing Claims out at 3554k vs. 3500k expected and 3466k last week
• US Weekly Bloomberg Consumer Comfort Survey out at -46.4 vs. -46.0 expected and -47.4 last week
• US Dec. Leading Indicators out at +0.4% vs. +0.7% expected and vs. +0.2% in Nov.
• US Dec. New Home Sales out at 307k vs. 321k expected and 314k in Nov.

Upcoming Economic Calendar Highlights (all times GMT)

• US Jan. Kansas City Fed Manufacturing Survey (1600)
• New Zealand Dec. Trade Balance (2145)
• Japan Dec. National CPI (2330)
• Japan BoJ to publish meeting minutes (2350)
• Japan Dec. Retail Trade (2350)