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USD: Rate Differentials vs. Growth

Last updated 3/7/2011 5:13 PM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

THE STORIES IN THE CURRENCY MARKET

• USD: RATE DIFFERENTIALS VS GROWTH
• EUR: SOVEREIGN DEBT TROUBLES RETURN?
• GBP: BOE ANNOUNCES SENTANCE REPLACEMENT
• NZD: TO UNDER PERFORM?
• AUD: STRONGER CONSTRUCTION ACTIVITY
• CAD: OIL AND GOLD PRICES CONTINUE TO RISE
• JPY: MORE THREATS OF DOWNGRADE

EXPECTATIONS FOR UPCOMING FED MEETINGS

USD: RATE DIFFERENTIALS VS GROWTH

Despite the lack of U.S. economic data, it has been a volatile trading day. When the U.S. markets opened, the dollar was trading lower against most of the major currencies and stocks were primed for a rally. However less than an hour after the opening bell rang on Wall Street, currencies and equities started to decline, giving up all of its earlier gains to end the day in negative territory. As a result, the dollar managed to appreciate against many of the major currencies including the euro, British pound, Australian and New Zealand dollars. Downgrades in the tech sector can be blamed for part of the move but the real reason why currencies and equities sold off is because of oil. 

Interest Rate Differentials versus Growth

Foreign exchange traders usually have short attention spans and we have seen evidence of this in recent days with the market quickly shifting its focus from interest rate differentials to growth. Up until this morning, everyone was talking about how the latest rise in oil prices increases the pressure on foreign central banks to fight inflation with higher interest rates without much regard to the impact that tighter monetary policy and higher prices will have on growth. The rising price of gasoline has been discussed but not many people had considered the fact that it would be difficult for stocks to hold onto their gains when oil prices are rising. Some U.S. companies hedge against a big move in oil prices but not many may have hedged beyond $100 a barrel.  Oil prices should come crashing down once the situation in Libya is pacified, but for the time being, a resolution to the conflict in the region appears to be a long ways away. As mentioned in our note this morning, every $10 rise in oil prices cuts U.S. economic growth by 0.2 percentage points and raises the price of a gallon of gasoline by 25 cents. One month ago for example, when oil was at $90 a barrel, the average price of at the pump was $3.119 compared to the current average of $3.51 a gallon. This means that if oil prices remain high, the Fed may be forced to lower its growth forecasts. For smaller economies that are more sensitive to the price of crude, the impact on growth could be even larger. However that does not mean that concerns about growth is now the primary driver of flows in the foreign exchange market and that the dollar will rise from here. Instead, it will be a lingering concern until the ECB or another central bank talks about raising interest rates again, bringing rate differentials back to the forefront. We saw this happen with the European sovereign debt crisis which was a big issue one week and not so much the next and so we would not be surprised to see the same dynamic occur with the oil crisis.

The Latest Perspectives from the Fed

Meanwhile a number of Federal Reserve Presidents delivered speeches today, giving us a fresh look at what they are thinking about Quantitative Easing with oil prices above $100 a barrel but the only thing that is clear is the growing division within the FOMC. On one side of the spectrum is Fed President Fisher, who is a voting member of the FOMC this year and he said today that does not support extending asset purchases beyond June and in fact may vote to cut short a second round of QE. Fed President Evans, who is also a voter was more neutral as he acknowledged recent improvements in the U.S. economy and the labor market in particular, but said the “hurdle is pretty high” for altering QE because “ oil prices are a headwind for the real economy.” This suggests that he is comfortable with current policy and wants the asset purchase program to be completed. Fed President Lockhart on the other hand said the central bank should not rule out additional asset purchases but given the information that he has today, he “would be very cautious about extending asset purchases after June.” Lockhart is not a voting member of the FOMC. 

EUR: SOVEREIGN DEBT TROUBLES RETURN?

The euro rose to a 4 month high against the U.S. dollar intraday before succumbing to selling pressure. The 1.40 level is proving to be a tough one for the EUR/USD to break but this should not surprise anyone because it is both a psychologically and technically significant level. In fact, the euro has proven to be surprisingly resilient in the face of Moody’s 3 notch downgrade of Greece's sovereign debt rating, Irish spreads trading at new highs, IMM data showing euro long positions at its highest level since early 2008 along with continued tensions in Libya. Even if the EUR/USD continues to pullback, the uptrend in the currency pair should remain intact as long as it does not fall below 1.3750. Rate hike expectations continue to drive the move in the euro and as long as oil stays above $100 a barrel, the pressure is on for the ECB to raise interest rates.  ECB President Trichet spoke this morning reminding us about his focus on inflation. This means euro strength could still be one of the dominant themes in the foreign exchange market this week as long as the sovereign debt crisis does not come back to haunt the euro, creating doubt around an ECB rate hike. Yields on Portugal’s 10 year bonds also hit a record on growing concerns that Portugal could become the next major European nation to request for a bailout. Euro leaders are meeting this Friday to come up with a plan to tackle the debt crisis. If they fail to reach an agreement for the March 24-25 summit, Portugal could be “closed out the market” according to rating agency Fitch. Our colleague Boris Schlossberg reported this morning that Moody’s decision to downgrade Greek debt to B1 from BA1 with a negative outlook stemmed from their concern that “structural reforms are subject to implementation risk, that revenue collection remains a challenge and that the country could face solvency risk in post 2013 environment that could force Greek authorities and investors to participate in a voluntary distressed exchange before that time. If fresh fears regarding Greek debt problems create further disturbance in the EZ sovereign debt markets delaying the prospect of an ECB rate hike, the EUR/USD correction could become much more severe as momentum traders quickly abandon the pair.” For the time being however, the longs clearly run the show and the broad assumption is that the ECB will proceed as planned.”

GBP: BOE ANNOUNCES SENTANCE REPLACEMENT

The worst performing currency today was the British pound which lost value against all of its major counterparts. Despite the lack of U.K. or U.S. economic data, the pound weakened for the third consecutive trading day. We have not heard a peep from U.K. monetary policy officials throughout the recent rise in oil and we are not likely to do so until after the Bank of England meeting. There is no doubt that $100 oil has made monetary policy officials more uncomfortable but the question is whether that will be enough to push the MPC to raise interest rates. We do not expect a rate hike to be delivered on Thursday but when the minutes are released a few weeks later, there is a good possibility that another MPC official has joined the hawks by voting for a rate hike. Part of the weakness of the pound could be attributed to the fact that its most hawkish member will be stepping down on May 31 ^st . He may well preside over a rate hike before his departure, but he will be replaced by Ben Broadbent, a Senior European Economist for Goldman Sachs. Despite his private sector ties, Broadbent has spent time at the Treasury and the Bank of England. His views have long been aligned with the Bank of England’s and he is likely to vote with the majority in the first few meetings.  Sentance was ultra-hawkish and there is very little chance that Broadbent will fill his shoes even though he may share some of his views.  The BRC retail sales report and the RICS house prices balance are due for release this evening. Consumer spending is expected to pullback after a strong January while an improvement is expected in house prices.

NZD: TO UNDER PERFORM?

The rise in oil prices helped to drive the Canadian dollar higher against the U.S. dollar despite a 5.1 percent drop in building permits. Having recovered quite a bit last year, the Canadian housing market is showing signs of slowing and this week’s housing market figures are expected to confirm that. For the past week, the Canadian dollar has been hovering near its 3 year high and despite a persistent rise in commodity prices, it has failed to find enough momentum to make a push towards 95 cents. The reason is because Canada is in a tough position – higher oil prices benefits oil producers but at the same time, threatens growth in its largest trading partner. Hopefully this week’s employment report will help to clarify just how strong the Canadian economy is and provide traders with some insight into the country’s ability to offset softer U.S. demand with higher domestic growth. Meanwhile the Australian and New Zealand dollars continued to weaken despite better than expected data. Australian construction sector PMI increased in the month of February from 40.2 to 44.6, while New Zealand building permits rose 9.6 percent. With the Reserve Bank of New Zealand’s monetary policy meeting looming, it may be difficult for the NZD/USD to rally this week. Some investors believe the RBNZ could lower interest rates in response to the economic shock created by the latest earthquake and even if they do not cut rates, the central bank will probably be cautious and pessimistic, which may be enough to drive the NZD/USD lower. Last night, rating agency Fitch said they will continue to monitor the earthquake's impact on New Zealand's finances, which suggests that they could be mulling a downgrade. Either way, we expect the New Zealand to underperform all of the major currency pairs this week, particularly going into the RBNZ meeting.

JPY: MORE THREATS OF DOWNGRADE

The Japanese Yen traded higher against all of the major currencies thanks to better than expected economic data and risk aversion. The leading index and coincident index edged higher in the month of January and even though the leading index fell short of expectations, the Japanese Cabinet raised its assessment of the coincident indicator for the first time since October 2009. Japanese economic data has been gradually improving but political troubles have made real progress difficult. On the one hand inflationary trends are improving with Bank of Japan Deputy Governor Yamaguchi pointing out that CPI growth has returned to around zero but on the other, rating agencies are worried about the political mess. Rating and Investment Information(R&I) is a domestic rating agency that warned of a possible downgrade to Japan’s sovereign rate before the April elections. They are worried that the deepening political problems will delay or prevent any meaningful progress towards fixing public finances. If they downgrade Japan’s debt rating, they would be the first domestic rating agency to do so. Standard & Poor’s cut Japan’s credit rating in January for the first time since 2002 while Moody’s warned last month that they could also downgrade Japanese debt. This evening, trade and current account numbers are due for release from Japan and for the first time since January 2009, Japan is expected to report a trade deficit. 

EUR/CHF: Currency in Play for Next 24 Hours

EUR/CHF will be our currency pair in play for the next 24 hours. Switzerland’s unemployment rate is scheduled for release at 1:45AM NY Time / 6:45 GMT followed by German factory orders at 6:00 AM NY Time  / 10:00 GMT.

EUR/CHF is currently trading in a range, which we define using Bollinger Bands. Although 1.32 has been the recent high of the range and 1.27 the low, the near terms levels that the currency pair has to contend with is much closer.  At 1.3040 we have the100-day SMA and recent highs. A break above that level would open up the door to a move up to year to date high above 1.32. On the downside, should EUR/CHF trickle lower, support should be found at 1.2800, the first standard deviation Bollinger Band.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.