Eight FX Considerations for the New Week

The US dollar begins the week mostly firmer.  The notable exception is the Japanese yen, which has seen some position adjustment ahead of the outcome of the BOJ meeting tomorrow.  In Asia, and Europe thus far, the dollar has found support near its five day moving average and the 38.2% retracement of its latest leg up (from Jan 16), both of which come in near JPY89.30.  The recovery of the yen took a toll on Japanese stocks.  The Nikkei lost 1.5% and posted an outside down day (trading on both sides of Friday's ranges and finishing below Friday's low).

The euro has been confined to an exception narrow range of about 15 ticks on either side of $1.3315.  A break of support in the $1.3260-80 area would lend credence to our argument that a top of some import is being carved out, with a potential double top at $1.34.   Sterling saw follow through selling on top of the pre-weekend losses.  The euro traded at 10-month highs against sterling above GBP0.8400, but is reversing lower near midday in London.  A modest bounce in cable seen in the European morning ran out of steam near $1.5900, which likely now marks the upper end of the new range.


Equity markets are mixed, with the MSCI Asia-Pacific seeing a 0.2% decline, dragged down by Japanese shares, and to a lesser extent Taiwan, Korea and Malaysia.  European bourses are higher with the Dow Jones Stoxx 600 advancing almost 0.5%, led by utilities, basic materials and technology.  While the US market is closed today, before the weekend the three main gauges, Dow, NASDAQ, and S&P 500 closed at 5-year highs.  This week's earnings feature technology giants Apple, Google, IBM, and United Technologies.

There was a potentially important development in the US fiscal drama.  Some Republicans in the House of Representatives are proposing a three-month extension on the debt ceiling to give more time to negotiate a long-term deal.  It is not yet immediately clear if the measure has sufficient Republican support--remember Bohener's Plan B?--or if Obama will agree to it, after having the lack of interest in a short-term fix.  Still it shows some fluidity of the situation and should ease what little concern that had really been that the US would default.

In a very tight election in Lower Saxony, the real winner, regardless of the formation of the new state government is the Free Democrat Party, and by extension German Chancellor Merkel.  Merkel's CDU party depends on a coalition with the FDP, but over the past year, the FDP has been trounced in most state elections.  The conventional view that the national election later with year would result in another grand coalition was predicated on the inability of the FDP to deliver.  Some feared it would not even meet the 5% threshold to secure parliamentary membership.  In Lower Saxony, the FDP defied expectations and received almost 10% of the vote, more than twice what the opinion polls suggested.  Yet, FDP party head and Economics Minister Roesler offered to resign and threw his support toward Bruederle, the head of the party's parliament caucus, who is regarded as more dynamic and with some hope he can revive the party's fortunes.  A formal leadership decision in May.    The SPD and Greens eked out a surprise victory, but  Steinbrueck, the SPD candidate for Chancellor,  apologized for his gaffes in the national campaign, which may have cost the SPD votes in the local contest.     

The most anticipated event of the week is tomorrow's conclusion of the BOJ meeting.  The pressure on the BOJ from the new Abe government is widely recognized and with its recent economy assessment, in which most regions were downgraded, the BOJ cannot be content either.  There is, therefore, little doubt the BOJ will take action.  However, the impact of some of the measures that have been discussed like open-ended QE or a 2% inflation goal is questionable.  What does open-ended QE mean when the BOJ has increased the amount of assets it is buying repeatedly ?  How is a 2% inflation goal credible when it has failed to achieve its 1% goal?    Similarly, a cut in the interest paid on reserves is possible, but it is not clear how that would be inflationary or stimulative.   Our fundamental and technical analysis warns that the market is vulnerable to disappointment or a "sell the rumor buy the fact" type of activity. There has been some position adjustment today as the dollar still has not been able to sustain a move above JPY90. In terms of intent, the imagery we still think apropos is blowing (hot) air underneath the (yen's) parachute to increase the likelihood of a soft landing and reduce the antagonism that its strategy engenders.  

There are two aspects of the technical condition of that are worth underscoring.  First, we think there was significant deterioration of the major foreign currencies, with sterling convincingly violating a 7-month uptrend line, the dramatic weakness of the Swiss franc, and new multi-week lows for the Australian and Canadian dollars.  The euro has fared best, but technically appears vulnerable.  Second, we note that implied volatility in the currency markets has trended higher in recent weeks. Before the weekend, 3-month euro vol reached its highest level since Oct.  It reached a low in late Nov near 6.4% and now is near 8.6%.  3-month yen vol is at its highest level since Sept 2011 near 11.2%.  On the eve of the election announcement in mid-Nov, it was near 7%, having bottomed a month earlier near 6.55%.  Sterling vol is at its highest level in four months near 7.3%.  It bottomed in middle of last month near 5.25%.

The euro area finance minister meet today.  Cyprus aid package is not ready and it won't be for at least a couple more months.  Greece is progressing towards another tranche amid fresh call from the IMF than even if the country stays on track, it will need another 9 bln euros of assistance (perhaps in the form of further official sector concessions, Merkel has hinted in the latter years of its current program).  There may also be some discussion of Spain.  Perhaps the one notable action from the Eurogroup is that Juncker who has been the leader, with mixed reviews, including last week's gaffe about the euro, is stepping down.  His likely replacement, the new Dutch Finance Minister Dijsselbloem, has been widely tipped.  

A more pressing issue for investors is the implication of the repayment of LTRO funds by the banks starting next week.  Speculation that it would tighten financial conditions saw euribor yields rise sharply.    ECB's Coeure tried to calm market anxiety by indicating that he did not expect an impact on Eonia from the settlement.    The implied yield of the  March 13 Euribor futures contract has been trending higher since early December. The backing up in money market rates in Europe did not coincide with a stronger euro. We anticipate some stabilization in euribor in the days ahead, awaiting indications of the size of the repayments.  Forecasts generally seem to range between 100-200 bln euros of the roughly trillion euros outstanding.

In addition, we draw your attention to the following events and data:  Australia's Q4 CPI on Tuesday could sway expectations for the RBA meeting in early February.  Presently there is about a 40% chance of a 25 bp rate cut discounted.  Although the headline pace of inflation likely accelerated, the core rate appears stable and has not been an obstacle to easier RBA policy.  The release of the BOE minutes will likely reaffirm market expectations that a resumption of QE is not imminent, even though the economy appears to have contracted in Q4 (first estimate released on Friday, Jan 25).  Europe reports the flash PMI readings in Thurs.   A critical issue is if Germany, which appears to have contracted in Q4, is in a recession (as defined by two consecutive quarters of contracting GDP (though note that technically, a recession in the US is determined by National Bureau of Economic Research and it uses a broader definition).   I

In emerging markets, we note that the tone of Mexico's central bank statement was more dovish than expected before the weekend.    It effectively removed any lingering threat of a hike, though we do not expect a rate cut either.  Israel goes to the polls and barring a significant surprise, we do not expect much of a market reaction, though note that the dollar has found bids ahead of 1-year lows near ILS3.70.   Three emerging market central banks meet this week, Turkey, the Philippines and South Africa.   The only action we expect is a 25 bp rate cut by South Africa.  The rand has been the weakest since the start of the year, losing 4.5% against the dollar, but many have their sights on the ZAR9.0, the high from October and again in November.