Monday, February 14, 2011

Forex Weekly

By George Tchetvertakov

Review: 4th- 11th February 2011

• Oil prices fell dramatically to close last week at $85.32 after
Egyptian President Hosni Mubarak resigned and handed power to the
military, easing concerns over the disruption of crude-oil supplies
from the Middle East
• Despite improving macro-data, the Fed re-iterated its ultra-low
policy stance. Earliest policy tightening likely to be early 2012
• BoE passed up the chance for an ahead-of-the-curve rate hike as
Inflation Report looms this coming week
• Portuguese long-term bond yields reached record highs. The broad
issue of EFSF/IMF/EU funding may not wait until March to be resolved
if market speculators push Portuguese yields to the brink
• Surprise PBOC policy action (+25bp) taken in their stride by
market participants. China remains on a clear and long-term tightening


The Egyptian political crisis managed to exert some effect on FX rates
last week. Mubarak's refusal to stand down as President contrary to
popular opinion gave global equity indices a jolt and heightened fears
of broader instability in the region. Commodity prices have been
sensitive to events ongoing in Egypt (especially oil) since the end of
January. Asian stocks fell more than 1% with some indices taking their
heaviest losses for nine months; in the US, the S&P 500 managed to
hold above 1,300 - falling as low as 1308.47 before recovering to
close above 1,327. The strong lift in equities came on the back of a
public resignation by Mubarak. The issue has ebbed away somewhat as
media attention focused on celebrations and chickens being counted but
the realisation over the weekend that Egypt remains in a transitional
state with an evident quasi power-vacuum has led to heightened USD
demand in the early part of this week. This nervousness should persist
in the short-medium term as 6 nations report CPI figures - India,
China, Canada, UK, US and Sweden. Assuming inflation remains a topical
issue because of rising commodity prices and stronger than expected
recovery rates in the developing world, exposure to currencies where
domestic markets are overheating is likely to be most effective.

In the US last week, the lack of significant macro data intensified
the focus on Ben Bernanke (Fed Chairman) as he made a crucial speech
to the House Budget Committee. Following a puzzling employment report
on Jan 4th market participants were keen to gauge what flat job growth
alongside a falling rate of unemployment actually means for the US
What we were looking for in the speech was how the chairman
characterized the sharp drop in the unemployment rate in December and
January. He said that the decline in the unemployment rate and
"improvement in indicators of job openings and firms' hiring plans"
provide "grounds for optimism on the employment front."

Bernanke also said: the unemployment rate probably will remain
elevated for some time" and "inflation is expected to persist below"
the levels the Fed sees as consistent with its mandate". In Fed
speak this means that it will be several years before the unemployment
rate returns to a more normal level and a sustained period of job
creation is needed to ensure the durability of the recovery. In short,
Bernanke didn't dismiss the decline in unemployment as an anomaly,
but by the same token, he remains focused on headline payroll

Despite heightened anticipation of the speech, Bernanke refrained from
altering comments he made earlier this month. We were expecting to
hear re-affirmation that the Fed remains in ultra-loose mode – and
this was the broad tone of the speech. Bernanke reiterated his core
view that the Fed should be patient and accommodative despite the
better-than-expected macro data observed in recent months.


The ECB President, Jean Claude Trichet indicated that the Euro-zone
needs stricter rules on budgets and other elements of economic policy
and "an appropriate economic union" to function properly.

The Portuguese 10yr bond yield climbed to its highest level since the
launch of the Euro last week after the European leaders meeting in
Brussels failed to establish concrete plans for ongoing reform -
delaying the final outcome until March 24th. Demand for peripheral
sovereign debt remains a key price driver for all EUR pairs as
investors continue to monitor the persistent debt problems in Europe,
in wait for a viable, long-term solution.

An unexpected fall in German IP (-1.5% vs. 0.2% exp.) capped EUR gains
against the US Dollar. Despite the figure and nervousness surrounding
peripheral sovereign debt, risk tolerance remained high allowing
equities to post fresh multi-year highs.

A factor that came out of nowhere and punished EUR pairs across the
board was the shock exclusion of Axel Weber as future ECB President.
Currently the head of the Bundesbank, Axel Weber is considered to be a
strong hawk on the ECB board and was thus seen as a direct source of
confidence for Europe and the Euro. Considering the ongoing crisis in
Europe's periphery, Weber was likely to be a steady hand in a rough
storm. EUR/USD sold off rapidly on the news. A range of candidates
will now vie for the ECB's top spot. Each candidates' preferred
core policy stance may influence investor opinion of the Euro and any
firm announcement may lead to EUR rallies (if hawkish candidate is
selected) or EUR declines (if dovish candidate is selected).


Inflation concerns were the theme for GBP pairs last week and it
remains so this week as the BoE is due to publish its eagerly awaited
Inflation Report on Wednesday. Last week, inflation concerns rose as
UK PPI (1.7% vs. 1.3% exp.) indicated the fastest pace of UK factory
gate inflation for over two years. Britain's 'high inflation
without strong growth' problem is being attributed to imported
inflation via commodity prices rather than domestic causes. BoE
policymakers will be concerned because the inflation is becoming a
problem for business and consumers alike.

In our view, persistent consumer inflation above the BoE's target
rate is slowly beginning to augment future inflation expectations.
Also, BoE assurances that inflationary effects would fade after the
financial crisis have not rung true. This week's CPI estimate is
likely to show further upside pressures on prices – Y/Y inflation is
currently 3.7% but a print above 4% is very likely according to a mean
average of analyst expectations.

The BoE left interest rates unchanged last week, the APF was also kept
unchanged at £200bn. The BoE is clearly hesitant about taking
pro-active steps ahead of the market on interest rates. The thinking
seems to be that if rates were raised, the current level of UK GDP
growth would be too anaemic to avoid deflationary effects. Market
participants have not taken the BoE at face value however and see a
60% chance that the BoE will raise interest rates by 25bp at its next
meeting on March 10th.


With tension in Egypt fading away as an active FX theme, runs into the
Dollar, Yen and Swiss Franc are subsiding. The overall impact of
political unrest in Egypt has been localised so effects on major
currencies have been fairly minimal. The Swissie lost more ground last
week against its G20 counterparts. Heaviest losses were against USD
(-1.77%) and EUR (-1.61%).

The global risk-profile wasn't helpful for CHF pairs while further
downside was induced due to a very unexpected fall in month-on-month
inflation (-0.4% vs. -0.1% exp.). For us, the surprise was the fact
that commodity price pressures are not being felt as much as in other
territories (e.g. UK). The SNB could not justify a hike in Q1 on the
back of such a weak headline CPI figure although a negative number was
expected. Probably the most important aspect for the SNB will be the
lack of feed-through from headline to core inflation. Core inflation
remains subdued and within the SNB's remit because volatile
components such as food, energy, fuel as well as other seasonal
products are excluded. Intervention in EUR/CHF is a long-shot given
the stability in core inflation.


The PBOC surprised all market participants with a 25bp rate hike,
taking the official Chinese rate to 6%. This was the second increase
in just over a month and indicates the PBOC doing all it can to cap
inflation effects. Despite the shock value of the announcement, market
participants were largely expecting further PBOC tightening so the
price action wasn't incredibly volatile. Investors were quick to
understand that the PBOC hike is actually a positive sign because the
Chinese economy is growing strongly thus requiring adjustment –
rather than hiking because they have lost control of inflation in a
desperate attempt to contain rapid growth. Going forward, further rate
hikes are likely as part of a normal tightening phase within the
business cycle.

Very interestingly, last week's hike comes at a time when macro data
is outperforming across the globe; compared and contrasted to last
year when China was being seen as the primary avenue of world economic
growth. Consequently, any meaningful Chinese slowdown and/or overly
hawkish policy have a good chance of being offset by other nations
with strong rates of recovery.
*Preview: 14th- 21st February 2011*

Looking ahead
• Bond auctions take centre stage – Belgium (Tuesday), Portugal
(Wednesday) and Spain (Thursday). Speculative attempts to destabilise
Portuguese bonds are possible and likely
• Two key interest rate decisions: Bank of Japan and Riksbank. BoJ
will stay on hold while Riksbank should hike 25bp
• UK Inflation report and CPI data will probably show upward
revision to inflation and downward revision for GDP growth – GBP
pairs likely to see higher volatility
• In the US - CPI , Fed Minutes, IP and Housing data are the key
macro data readings
• G20 Meetings in Paris may have an effect on G20 FX if the US/China
currency war spat is re-kindled or action is announced to combat
rising oil prices. If political uncertainty in Egypt persists,
economic uncertainty is almost sure to follow

At the start of this week it was the Euro's turn to take centre
stage. EUR/USD has shed 0.5% in the first trading session of the week
following the London open on Sunday. Investors are incredibly vigilant
given the mass of EUR themes in play. Peripheral bond auctions are
anticipated to be crucial for investor confidence and considering that
last week we saw quasi-speculative attacks on Portuguese government
bonds, it is a possibility that an auction on the weaker side prompts
further pressure from speculators. The EFSF/EU/ECB may be called upon
if yields rise/prices fall too far, too quickly. Also, rumours of a
rescue plan for German bank WestLB have added to existing concerns
about European banks.

Event risk is present for SEK traders as we expect the Riksbank to
resume with its series of rate increases. We see a 0.25% hike as
almost certain. In addition to the announcement, the Riksbank will be
publishing an updated Monetary Policy Report on Tuesday. The report is
likely to indicate or at least hint that policy expectations have
changed (so market participants should expect more hikes over the next
12-18 months).

We see the current interest rate in Sweden rising to 3.0% before the
end of 2011 and up to 4.75% in 2012. Sweden has largely avoided the
effects of the financial crisis and has even managed to avoid
large-scale fiscal adjustment that's been so gravely needed in other
nations. A slowdown in economic activity due to weakness in Europe for
example poses a risk to this view. Swedish economic data will have
added importance in the meantime. Equally, excessive SEK strength
could also weigh on economic growth and prosperity leading to
questions being raised about the practicality of tightening monetary
policy too soon.

In the past month China, Indonesia and India have all raised interest
rates as a way of combating inflation and maintain stable inflation
expectations. The problem facing the UK for example and other
developed economies alike is inflationary effects without the growth
to show for it. Current inflation is mostly cost-push driven from the
supply side. It is not demand led which means taming inflation when
demand is weak would only mean a larger financial burden for
consumers, especially mortgage-holders.

The likely beneficiaries of the seemingly all encompassing inflation
outlook that's pervading most G20 economies are the risk-on
currencies such as NZD, CAD, AUD, Scandies and potentially the Euro if
other factors don't interfere. On the other side of the spectrum are
countries that are likely to be languishing in negative real interest
rates for some time and thus should take comparatively longer to
attract investor capital flows (USD, GBP). The Fed is most likely to
tolerate higher inflation over the next year which more or less
cements negative real interest rates in the US at least until the
start of 2012.

Positive real interest rates, GDP growth, stable but rising inflation
and hawkish policy are the prime conditions for currency appreciation
– emerging economies are closer to meeting these conditions (or
they've already met them) than developed nations are which explains
the broad based appreciation of commodity currencies against
traditional alternatives such as USD, CHF, JPY, GBP over the course of
this recovery since 2009.

The Eurogroup meets on Monday and the broader Ecofin on Tuesday.
Setting a firm fiscal framework will be the focus. Some form of
agreement will be seen as a strong positive by market participants in
the long-term and could even induce a good-will rally in the
short-term as investors breathe yet another sign of relief. However,
unless we see a direct change to the EFSF's modus operandi, G20 FX
is unlikely to be affected signficiantly. The size (amount) and scope
(type of asset class) of EFSF buying is the key. A resoultion is most
likely in March but a an agreement now is possible. If the scheduled
European auctions don 't proceed smoothly, tension will be high
amongst European policymakers to find a quick, firm solution to the
European sovereign debt problem. We could see hasty action on behalf
of European Finance Ministers and Central Bankers if market rumours
and opinion take the same course as they did with Greece and Ireland
in 2010.

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