EUR: We Must Be Getting Close…

THE STORIES IN THE CURRENCY MARKET

• EUR: WE MUST BE GETTING CLOSE…
• USD: SHRUGS OFF WARNINGS ABOUT FURTHER DOWNGRADE
• GBP: BOE TO BOOST ASSET PURCHASES
• AUD: INCOMING RBA MEMBER IS A DOVE
• CAD: BUILDING PERMITS BEAT BUT SLOWS FROM DEC
• NZD: LABOR MARKET CONDITIONS TO IMPROVE
• JPY: TRADE ACTIVITY IMPROVES

EXPECTATIONS FOR UPCOMING FED MEETINGS

EUR: WE MUST BE GETTING CLOSE…

The euro ended the North American trading session unchanged against the U.S. dollar on the eve of the European Central Bank’s monetary policy announcement. Typically the ECB rate decision is a major event risk for the foreign exchange market, but this month, investors are far more focused on the ongoing negotiations in Greece.  Another day has passed without the announcement of a deal but investors are encouraged by the progress that is being made.  Prime Minister Papademos has met with the Trioka to put the final touches on the rescue plan and has taken it to a meeting with Party Leaders.  There is still no word on whether Party Leaders will agree to the austerity measures but it appears that they have agreed on EUR2 billion worth of spending cuts which includes significant layoffs in public sector jobs and a reduction in the minimum wage.  Up for discussion are pension cuts and the establishment of an escrow account to guarantee Greek debt repayments.  If the talks go well, the Greek government could put a rubber stamp on the deal by Thursday, paving the way for Eurozone officials to release bailout funds.  Euro area Finance Chiefs are moving ahead with a meeting tomorrow, which suggests that they believe a deal is close. One of the hot button topics that still need a decision is how to handle the ECB’s Greek bond holdings. There are early indications that the ECB may be willing to exchange their Greek bond holdings in the secondary market at a price below its face value.  This does not mean they would take a loss on their bonds – instead they would be forgoing profits.  To achieve this, the ECB can either sell its bonds to the EFSF at its original purchase price or Greece could purchase the bonds directly from the ECB at the original purchase price using EFSF funds or bonds.  Hopefully a decision will be made on this in the coming days.  The Germans are particularly optimistic about a deal.  According to a spokesman for the German government, the country is preparing plans to hold up to 3 parliamentary votes on Greece’s debt swap offer as quickly as next week.  The optimism of European policymakers is contagious with EUR/USD investors holding the currency pair at a 7 week high.

Meanwhile the European Central Bank is expected to leave monetary policy unchanged tomorrow.  Since the last monetary policy meeting, there have been signs of improvement in the Eurozone economy with manufacturing and service sector activity accelerating in the month of January. The German labor market also improved helping to boost investor, business and consumer confidence.  Everyone in Germany is feeling better about the economic outlook which will hopefully translate into greater consumer spending.  At bare minimum however, it mitigates the risk for a double dip in the Eurozone this year.  Last month, the ECB said there were “tentative signs of stabilization” of economic activity and with further improvements since then, we expect ECB President Draghi to adopt a slightly more upbeat tone.  Inflation has declined but not by much.  Having cut interest rates by 25bp in both November and December, the ECB has taken steps to keep inflation from falling sharply.  According to the last monetary policy announcement, the central bank expects inflation to stay above 2 percent for several months to come, before declining below that level.  Yet the main reason why the ECB is expected to hold policy steady is because they have already provided a tremendous amount of liquidity.  Aside from cutting interest rates by 50bp last year, they started a Long Term Repo Operation that offered unlimited amounts of 3 year liquidity to banks in return for collateral with credit ratings as low as Single A. Flushed with liquidity, banks have become more willing to buy sovereign debt and lend in general, helping to ease credit conditions around the world.  At the end of February, they will be conducting another massive LTRO program and the ECB does not plan to ease monetary policy further ahead of the liquidity injection.  The central bank will want to wait and see how the second 3 year refinancing operation impacts the market before cutting interest rates again.

USD: SHRUGS OFF WARNINGS ABOUT FURTHER DOWNGRADE

The U.S. dollar strengthened against all of the major currencies today despite a warning by Standard & Poor’s that the U.S. credit rating could be lowered again in the next 6 to 24 months if a medium term fiscal plan is not developed.  Political gridlock in Washington and opposition to raising the debt ceiling last year prompted S&P to strip the U.S. of its prized AAA rating in August.  If the winner of the November elections fails to come up with a credible plan to reduce the deficit, the U.S. could face another downgrade by S&P and/or a follow up move by Fitch and Moody’s.  No U.S. economic data was released today but according to Federal Reserve President Williams who is a voting member of the FOMC this year, the Fed may need to increase asset purchases if growth falters.  He believes that there is limited headroom to buy Treasuries but there is room for purchases of mortgage bonds.  Like Bernanke, he does not buy the recent improvement in the labor market.  Instead, he believes that the unemployment rate will exceed 8 percent into 2013 and be well over 7 percent by the end of 2014. With this in mind, the need for more QE is hotly contested within the Fed because of evidence that the U.S. economy is improving.  The weekly jobless claim report is the only piece of U.S. economic data on the calendar tomorrow. Claims are expected to remain below 400k, providing neither encouragement nor concern about the outlook for the labor market.  Chinese inflation numbers are scheduled for release this evening and a sharp slowdown in price pressures could resurrect speculation for an interest rate by the People’s Bank of China.

GBP: BOE TO BOOST ASSET PURCHASES

Throughout the past year, the Bank of England’s monetary policy meetings had very little impact on the British pound because outside of an increase in Quantitative Easing in October 2011, the central bank remained on hold for most of the year. Tomorrow however, the BoE rate decision should have a big impact on sterling because the BoE is expected to raise asset purchases by GBP 50 billion to GBP 325 billion.  Since the January monetary policy meeting, there was more deterioration than improvement in the U.K. economy.  Retail sales rebounded in the month of December, but early signs of consumer spending in January showed a pullback in demand. Consumer confidence indicators have been mixed with little improvement in the labor market.  Prior to the last monetary policy meeting, the U.K. ILO unemployment rate rose to its highest level in 16 years and in December it stayed at that level.  Manufacturing and service sector activity accelerated in January but these improvements were undermined by the contraction in GDP in the fourth quarter which raised concerns about the U.K. economy falling back into recession.  Before the PMI numbers were released, investors had been looking for asset purchases to increase by GBP75 billion but the acceleration in economic activity coupled with the rise in equities and stabilization in the financial markets led to the tempering of expectations.  Yet the main reason why the BoE is expected to ease at all is because of inflation.  Consumer prices have been declining rapidly in the U.K. The most recent figures that we have from the U.K. dates back to December when the annualized pace of CPI growth fell from 4.8 to 4.2 percent.  Since then, there have been early hints that prices have fallen further according to the British Retail Consortium’s Shop Price Index.  Although annualized CPI growth is well above the central bank’s 2 percent target and 3 percent pain threshold, the BoE is very concerned about the possibility of inflation undershooting their 2 percent target in the medium term.  Throughout the past year, they have stubbornly predicted a sharp decline in price pressures even as CPI reached a high of 5.2 percent.  In the past year, inflation has indeed fallen sharply as the effects of last year’s VAT tax increase and higher energy prices drop out of the annual calculation. According to their November inflation projections, without a further expansion in asset purchases, CPI could undershoot their 2 percent target by as much as 75bp in the medium term.  The BoE currently expects CPI to fall to 2.2 percent by the end of the year, which would represent a sharp decline over a very short period of time.  Considering how close this projection is to their 2 percent target, there is an underlying urgency within the central bank to ease now to avoid the need to loosen monetary policy aggressively and stoke additional inflation pressures later on if inflation undershoots.

AUD: INCOMING RBA MEMBER IS A DOVE

The Canadian and New Zealand dollars weakened against the U.S. dollar while the Australian dollar remained relatively unchanged.  Canada’s housing starts, adjusted to an annual rate, printed better than expected at 198,000 units in January following a rise of 200,000 units in December of 2011.  The slight decrease was attributable to sharp declines in Quebec and in Atlantic Canada, but the pace remained robust during an unseasonably warm winter.  Strong homebuilding activity will likely be a boost to the Canadian economy in the short term, but could also turn into overbuilding that could wreak havoc in the long term.  Canada’s Prime Minister Harper urged his Chinese counterpart to approve proposed investments by Manulife Financial and Bank of Nova Scotia as part of a broader effort to win greater access for Canadian companies in the Asian country.  Harper is seeking to attract Chinese investment in Canada’s natural resources and sell more oil to Asia, while winning business for Canadian companies.  The other commodity dollars gave up earlier gains as optimism amidst uncertainty about whether Greek leaders would agree to meet the requirements for a second international bailout, causing investors to seek safer assets.  Incoming Australian central bank board member Heather Ridout aims to bring more attention to the nation’s overvalued exchange rate.  Investors are currently pricing in a 60 percent chance the central bank will lower borrowing costs when it meets next month.  Ridout agreed in an interview she is a dove and will bring the perspective of the country’s manufacturers to the RBA, which unexpectedly left its benchmark rate unchanged at 4.25 percent yesterday.  The New Zealand dollar reached a 5-month high before turning negative today.  Looking ahead, Thursday’s jobs data will be closely watched as a strong employment number will help provide support for the Kiwi.  The unemployment rate is expected to have fallen to 6.5 percent in the fourth quarter from 6.6 percent in the prior quarter.

JPY: TRADE ACTIVITY IMPROVES

The Japanese yen weakened against all the major currencies with the exception of the British pound.  Japanese bank lending improved slightly from 0.4 percent in December to 0.6 percent in January.  As lending picks up, we can expect to see increased spending by businesses.  The current account also came in better than expected showing a surplus of 0.75 trillion yen for December 2011 following a 0.48 trillion yen surplus in November.  However, falls in household- and corporate-related indexes caused Japan’s service sector sentiment index to slide to 44.1 in January.  The survey showed consumers’ confidence about current economic conditions declined from 47.0 in December.  The outlook index, indicating the level of confidence in future conditions, rose for the first time in seven months, edging up to 47.1 from 44.4 in the prior month.  Wheat prices in Japan may decline in April by the most since October 2009, putting food makers under pressure to cut prices.  The price of wheat imported by the government may drop by about 10 percent a metric ton on average, according to SMBC Nikko Securities.  That would help the milling industry save almost 29 billion yen in costs a year, Japan’s Flour Millers Association estimates.  The reduction in wheat prices for the first time in two years may increase deflationary pressures after consumer prices in Japan declined for a third straight year in 2011.  Lower food costs could boost personal spending, which has shown signs of rebounding amid a deepening export slump.  Bank of Japan Deputy Governor Kiyohiko Nishimura today urged China to liberalize capital flows if the country wants to internationalize its currency.  Speaking at a roundtable conference sponsored by the Organization for Economic Co-operation and Development, he also called for establishing a direct exchange market between the yen and yuan.  He also mentioned the idea of direct trade settlements between the yen and yuan.  Such a move would help reduce transaction costs, as the price will be set directly without the U.S. dollar as the intermediary.  Later tonight Japan will release its core machinery orders for the month of December.  November showed an expansion of 14.8 percent mainly from major orders for ships and trains, while December is forecast to post a contraction of 4.8 percent due to firms exercising caution amid weakening exports and slowing overseas economies.

EUR/GBP: Currency in Play for Next 24 Hours

Our currency pair in play for Thursday is EUR/GBP.  Economic data we expect from the U.K. includes December industrial production, manufacturing production, and trade balances all at 4:30 AM ET / 9:30 GMT.  The Bank of England will make its monetary policy announcement at 7:00 AM ET / 12:00 GMT.  Shortly after, the European Central Bank will release its rate decision at 7:45 AM ET / 12:45 GMT which will be followed by ECB President Draghi’s press conference at 8:30 AM ET / 13:30 GMT.

EUR/GBP has been in a range for the past month and is now trading in an uptrend, which we determined with double Bollinger bands.  The nearest level of support is at 0.8329, where today’s low, and the 20- and 10-day SMAs all converge.  Should the pair fall through that level, heavy support will be found at the January low of 0.8221.  To the upside, nearest resistance is at December’s high of 0.8422.  If the pair breaks out from there, significant resistance will be encountered at 0.8500, a psychologically significant level as well as the price where the 100-day SMA lies.