FOREX TRADING

HIGHLIGHTS OF THE WEEK

• Fed Chairman Bernanke delivers semi-annual testimony to Congress, in which he noted uncertainty in the economic outlook but stuck to his guns in continuing to prudently plan the ultimate withdrawal of the extraordinary monetary accommodation.
• Chatter of U.S. double-dip recession remains in the headlines. High frequency and leading indicators do support a slowdown, but the indicators are nowhere near levels required to flash a re-entry into a recession. A mid-cycle slowdown remains the most likely outcome.
• No sign that the housing market is breaking free from the doldrums. Starts slip more than market expectations, and while existing home sales beat market expectations, they still backtrack by 5.1% in June.
• In Canada, markets were unscathed by the widely anticipated 25 basis point rate hike by the Bank of Canada (BoC). Reactions, however, followed the ensuing dovish BoC communiqué.
• BoC affirmed that fiscal austerity measures relating to the European sovereign debt crisis appeased the risk of an adverse outcome and lifted the likelihood for sustainable long-term growth, but the global economy will recover at a more moderate pace than previously anticipated. The BoC observed that the Canadian economy has largely developed as anticipated, except for growth in business investment which seems to be constrained by uncertainties surrounding the global outlook.
• We expect a protracted renormalization of the overnight rate, with gradual hikes of 25 basis points through the latter half of 2010 and 2011, albeit interrupted by occasional pauses. The overnight rate should reach 1.25% and 2.50% by the end of 2010 and 2011, respectively.

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Highlights

• Dark clouds gathering on the horizon
• Looking for another slide in risk assets
• Sterling reacts well to budget
• Banking sector fears set to keep the EUR nervous

Dark clouds gathering on the horizon

US housing data in the past week revealed the extent of the artificial and temporary support provided to the US housing market by the home buyer tax credits. The data had been expected to show decent gains on a final flurry of home closings before the end of June deadline to close, but the sharp declines showed that many home buyers were unable to secure financing. Housing data is only expected to deteriorate from here out as an extension of the tax incentive program seems highly unlikely in the current deficit reduction environment. Given the still high levels of foreclosures and underwater mortgages, as well as a large ‘shadow inventory’ (homes that would be on the market if conditions were better), it appears US housing is about to see a ‘double dip’ decline. The implications for household spending are quite ominous, as the wealth effect of deflated home values and still depressed stock market portfolios generate a negative feedback loop to consumption. Add in still high unemployment levels (and the failure to extend unemployment benefits due to deficit concerns), and we have another negative feedback loop undermining US consumption. Together, these threaten to see the US recovery falter sooner than we expected, which has also altered our view on the broader global recovery. (more…)

There have been further signs of improvement in financial markets over the past week and volatility continues to decline. That said, many markets continue to trade with pretty high risk premiums, elevated volatility and reduced liquidity.

Yesterday, BNP Paribas’ long-term issuer default rating was downgraded to AAfrom AA by Fitch. Standard & Poor’s yesterday published a review of the asset quality of the Spanish financial system, which included an upward revision of expected losses for the real estate sector.

Conditions in covered bond markets in Portugal, Ireland and Spain have been worsening lately, and the problems in the Spanish and Portuguese banking sectors remain an important theme. It is notable that there has been some stabilisation in the covered bank spreads in the past two days.

Over the past few week, most sovereign spreads have been relatively flat in PIIGS. Spanish spreads have narrowed substantially following a couple of strong Spanish bond auctions last Thursday. In core countries such as France, the Netherlands and Belgium, spreads have narrowed a little over the past week.

Money market tensions have eased further. In particular, the FRA/EOINIA spreads have tightened. The improvement is also evident in swap and credit markets, but corporate issuance remains very low.

The euro has advanced a little versus the dollar, but it is questionable how sustainable this move is. Implied volatility in majors FX crosses has declined sharply from recent weeks, but is still at elevated levels.

Global stock markets have had a good run during June. (more…)

• People’s Bank of China (PBoC) this weekend announced that it will abandon the defacto USD peg that has been in place since mid 2008 when the global financial crisis accelerated. Instead China will return to a managed float targeting a basket of currencies. This will largely be a return to the exchange rate system from before the financial crisis.
• PBoC has tried to tone down expectations of a major appreciation. It ruled out a major one-off revaluation and left the daily trading band against USD unchanged at 0.5%. In addition, PBoC this morning left its reference rate against the USD unchanged, but has allowed CNY to appreciate in the spot market and on balance it now appears PBoC is allowing CNY to appreciate.
• There are two reasons for China’s move this weekend. First, with signs of a solid recovery PBoC is increasingly turning its focus from supporting growth to containing inflation and preventing asset bubbles. Second, there will probably be a significant political payoff from just a minor appreciation. The announcement just ahead of the G20 summit next week is no coincidence.
• We have left our CNY forecast unchanged. We only expect a modest 4% appreciation against USD over the next year. Although this is now only slightly more than the market expects, we maintain our recommendation to hedge longer-term CNY expenditures because we expect USD/CNY volatility to increase.
• The market reaction this morning has been positive with a marked improvement in risk sentiment as markets focus on a possible positive impact on global growth

China returns to managed float targeting a basket of currencies

People’s Bank of China (PBoC) Saturday announced that it will abandon the de-facto peg of the renminbi (RMB) that has been in place since mid 2008, when the global financial crisis started to escalate, see Statement on RMB exchange rate policy. On Sunday PBoC clarified its position further in a Q&A statement. So far it appears that China will basically return to a managed float with a reference to a basket of currencies started in July 2005 and prevailing until the global financial crisis accelerated in mid 2008. However, the statements from PBoC leave two important questions unanswered. First, will China allow RMB to appreciate and if so by how much and second to what degree will it allow more flexibility and volatility in the RMB exchange rate.

In our view we are unlikely to see major changes in the short run. China will allow RMB to appreciate slightly against USD and volatility in USD/RMB exchange rate will increase substantially compared to the past two years. It is important to note what China did not do this weekend. First, it did not announce a minor one-off revaluation of RMB as it did in 2005 when it kicked off the managed float exchange rate regime. Second, China did not widen the current 0.5% daily trading band against USD. There has been some speculation in the market that both a minor one-off revaluation and a widening of the daily trading band would be part of China’s initial move away from the USD peg. Hence, what China did this weekend was the minimum that could be expected. That said, the announcement was a surprise, as the consensus view was that the European debt crisis had postponed a RMB appreciation against USD well into Q3.

Why does China move on the exchange rate now?

The first reason is that the Chinese government’s concern about Chinese and global growth is receding. Instead the government is increasingly focusing on containing inflation and preventing asset bubbles. The return to a de-facto USD peg has always been regarded as a temporary response to the global financial crisis and not a permanent state for China’s exchange rate policy. In its policy statement PBoC says that it has now become desirable to move ahead with reform of the RMB exchange rate regime, because of the solid upturn in the Chinese economy and a gradual recovery in the global economy. Not least has it been important for the Chinese government that the latest Chinese data for May showed very strong exports and an increase in the surplus on the trade balance.

The Chinese government is increasingly focusing on preventing the economy from overheating. In May inflation exceeded the government’s 3% target for 2010 as a whole and in our view it could be close to 4% by year-end. In its Q&A statement PBoC says that RMB reform will benefit China, because it will help curb inflation and asset bubbles and strengthen effectiveness of macroeconomic tools. In other words, a return to the “old” exchange rate policy will give China greater flexibility to use its exchange rate policy actively to cool down the economy if needed and greater autonomy in its monetary policy.

The second argument is political and is particularly important for the timing of the announcement. As we have argued earlier there will probably be a substantial political and economic payoff for China from just a minor appreciation of its currency. This explains why China chose to announce the end of the USD peg just ahead of the G20 meeting in Toronto next weekend. China hopes that the announcement will be enough to prevent its exchange rate policy from becoming a major issue at the G20-summit. In addition, it hopes that this will be enough to prevent China from being designated “currency manipulator” in the Treasury report that US Treasury Secretary, Timothy Geithner, has delayed to give China room to move on its exchange rate policy. Finally, there is increasing risk that punitive legislation targeting China’s exports might be approved by the US Congress later this year.

How much will China allow RMB to appreciate?

The big question is if China will allow RMB to appreciate against USD and if it does, by how much? In our view China will allow a modest appreciation. In its statements PBoC effectively rules out a major one-off revaluation by saying that the adjustment of the RMB policy will follow the principle of gradualism. In addition, PBoC does everything to tone down any expectations of a major appreciation by saying that the current RMB exchange rate is not far from equilibrium and for that reason there is no argument for a major appreciation.

This morning PBoC left its reference exchange rate against USD unchanged at 8.8275 compared to Friday. The reference exchange rate is used to fix the daily +/- 0.5% trading band. The unchanged reference rate was a disappointment. However, PBoC has since allowed CNY to appreciate further in the spot market (see chart) and overall CNY has appreciated by 0.4% against USD since Thursday. Thus on balance it appears that PBoC is allowing CNY to appreciate slightly.

We expect CNY to continue to appreciate slightly this week ahead of next weekend’s G20- summit. In our view it would be an own goal by China if it does not allow some appreciation following this weekend’s statement from PBoC. This would certainly bring China’s exchange rate policy on the agenda at the G20-summit. However, to get a clear view of how much China will allow CNY to appreciate, we will have to see how much China allows the exchange rate to appreciate after the G20-summit.

We have left our exchange rate forecast unchanged (see table on next page) even though China has decided to resume appreciation slightly faster than we expected. However, we acknowledge that the main risk now is that CNY appreciates more than we expected particularly on a 3M and 6M horizon. CNY forwards have appreciated significantly overnight. The 12M USD/CNY NDF now discounts a 3% appreciation, which is slightly less than our expectation of a 4% appreciation on a 12M horizon.

With the appreciation in CNY forwards its has become less favourable to hedge CNY expenditures. However, we maintain our recommendation to hedge CNY expenditures on a 12M horizon (or longer). This recommendation is based on our expectation that CNY will appreciate slightly more than is currently expected in the forwards but also on our expectation that volatility in USD/CNY will increase.

Market implications

The expectation that China will now allow its currency to appreciate has improved risk sentiment in the market substantially this morning. Financial markets have chosen to regard a Chinese appreciation as positive for global growth because it increases the likelihood of trade tensions between the US and China, will boost real income and domestic demand in China and let other markets increasingly benefit from China’s strong demand. We feared that the shortterm impact might be dominated by concerns about slower growth in China, because CNY appreciation would be regarded as part of monetary tightening. This has so far not been the case.

Most Asian stock markets are substantially higher this morning including Shanghai. Stock market futures suggest a positive opening for stock markets in both Europe and the US today.

As expected Asian currencies besides JPY appreciated markedly overnight with particularly KRW and MYR benefitting from China’s decision to resume appreciation. Commodity currencies have benefitted from higher commodity prices. USD in general has weakened.

For a our view on the longer term impact of China resuming appreciation for financial markets see Research – Asia: Recovery still looks strong.

Sunrise Market Commentary

• Core bonds profit from surprise drop in US retail sales
  On Friday, markets started the session in a positive mood, but a disappointing US retail sales release spoiled the game. Investors picked up core bonds again going into the weekend. This week, we look out whether the cautious easing of tensions on the intra-EMU government bond market can be maintained.
• Euro enters calmer waters
  On Friday, EUR/USD basically tracked the swings in global investor sentiment. As was the case for the stock markets, the damage from a poor US retail sales release was only temporary in nature. EUR/USD regained even the 1.2150 resistance area. This suggests that the single currency might be entering calmer waters. EUR/GBP tested also the lows, but the test was rejected and a nice rebound occurred.

The Sunrise Headlines

• On Friday, US Equities opened lower after a weak retail sales report, but reversed their losses in the last hour of trading. This morning, Asian shares start the week in a positive mood.
• Herman Van Rompuy, president of the European Union, has blamed the strength of the euro in recent years for blinding the eurozone to its underlying fiscal problems.
• New Zealand’s central bank chief warned this morning that the country needed to cut its high debt or face punishment by markets with higher lending rates and the risk that its debt servicing costs may become intolerable. (more…)

U.S. Review

Decision-making in a Time of Economic Uncertainty

• Well, they never said decision-making would be easy. Recent data on employment, GDP, and personal income highlight the complexity of information, which is sometime contradictory and adds to the difficulty of decision-making now.
• Currently, the impact of short-run stimulus programs is ending while we remain uncertain about the sustainable path of growth going forward. One leading indicator, jobless claims, suggests that the sustainable pace of economic growth will be disappointing to many public officials hoping for a jump in public revenues and jobs.

Decision-making in a Time of Economic Uncertainty

Recent data on employment, GDP, and personal income highlight the complexity of information, which is sometimes contradictory and adds to the difficulty of decision-making. Employment rose just 41,000 ex-Census with gains across sectors. The pace of gains satisfies very few. Hiring is just barely enough to technically sustain the recovery but not fast enough to catch up with what a more typical recovery would see. Moreover, the pace of job gains is not sufficient enough to generate the income and tax receipts household and policymakers need or have come to expect.

First quarter GDP came in at 3.0 percent, a trend-like number, but real final sales came in only at 1.4 percent. The underlying demand in the economy remains subpar relative to the typical recovery. Therefore, the crunch for decision-makers is that there is a recovery but it remains disappointing relative to expectations and, therefore, disappointing relative to financial market expectations that were discounted in equity and bond market prices. Within the GDP accounts, personal consumption spending and equipment spending appear to be holding their own. The problems appear in the residential and commercial real estate sectors as well as state & local government spending. Hence, the recovery is both below average and different in character relative to earlier recoveries. These aspects add to the challenge of decision-making for the second half of the year, when we expect growth to remain subpar.

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Risk-aversion dominated the headlines at the end of the week with the euro tumbling beneath the 1.20-level against the dollar to a fresh 4-year low at 1.1974. The major US equity bourses were sharply lower as the much-anticipated May labor report missed estimates, dragging the Dow Jones, S&P 500 and Nasdaq all lower by around than 3%. Sparking market jitters and ultimately triggering a renewed bout of risk-aversion was the morning announcement from the Hungarian Prime Minister’s spokesperson – in which he identified the Hungarian economy as being in a "grave" state in which the previous government "lied" about economic figures and that "it would not be an exaggeration" for talk of default. The revelation hit the global markets and prompted a spike higher in the VIX index, which climbed higher by more than 14% from Thursday’s close to above 33.6.

The highly-anticipated May labor report largely disappointed as markets had been factoring in a blockbuster report. Consensus forecasts had been looking for a surge in non-farm payrolls to 536k for May, instead adding 431k jobs versus 290k from April. The private payrolls figure sharply missed estimates at 41k, falling short of calls for an increase to 180k from a downwardly revised 218k in April. The inflated non-farm payrolls are largely attributed to temporary government census workers and will not be sustainable over the coming months. The unemployment rate dipped to 9.7%, better than expected versus 9.9% from April.

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Ahead of a very important day of macro-economic releases from the U.S., and ahead of the Non-farm Payroll numbers on Friday, major forex pairs have struggled to break through Swing Point R1 and S1 areas in European trade. The long side of global equities allowed a short-Usd move to be put in place overnight, but the cash markets were not able to easily hold the positive momentum built up in the futures market, after a move higher from Wall Street.

Forex price action is revealing an obvious reluctance from speculative interest encamped on the long side of the Usd to give up ground too easily. It is also clear to see that the momentum unleashed as each global trading region opens and closes is just not backed with enough volume to break new ground on stocks, and is allowing only tentative move in forex to test dollar index support areas.

Ahead of the 08:15 ET ADP and 08:30 ET Weekly Jobless Claim numbers the markets may just consolidate recent moves. The 10:00 ET ISM numbers will then trigger equity direction, just in time to affect the European market close. The impact of a potentially large NFP number on Friday, because of the farcical way that the survey is completed, in what is obviously a jobless U.S. recovery, will weigh heavily on equity and forex sentiment.

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