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FX: Inflation, China and European Tragedy

Last updated 10/17/2011 4:56 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

• FX: INFLATION, CHINA AND EUROPEAN TRAGEDY
• EUR: NO FAST AND EASY SOLUTION FOR EUROPE
• GBP: HOUSE PRICES SOAR, INFLATION COULD RISE
• AUD: WHAT TO EXPECT FROM RBA MINUTES
• CAD: BUSINESS SENTIMENT DETERIORATES
• NZD: SERVICE SECTOR ACTIVITY SLOWS
• JPY: CABINET CUTS ECONOMIC ASSESSMENT

EXPECTATIONS FOR UPCOMING FED MEETINGS

FX: INFLATION, CHINA AND EUROPEAN TRAGEDY

Currencies and equities sold off across the board today as investors returned to the safety of the U.S. dollar.  Comments from German officials were a reality check for investors who believed that a Grand Master plan for Europe could come weeks after the EFSF was expanded to EUR440 billion, a decision made nearly 3 months ago.  If there is one thing that we learned in recent years is that the Europeans have a knack for missing deadlines and based upon the challenge of getting the July EFSF expansion approved and recent comments from European officials, there is a greater chance that the October EU Summit and the November G20 Summit will be a bust than a success. The tragedy of Europe is that there are way too many cooks in the kitchen and until European officials change their tone and start to publicly agree on terms for a European deal, there is very little reason to be overly optimistic.  When a recovery in the markets is being driven by hope and not facts, reversals can be sharp and frequent. 

There are a number of economic reports scheduled for release this week but with investors no longer fazed by weaker U.S. numbers, the surprise elements remain with the Eurozone and China.  Chinese GDP, retail sales and industrial production numbers will be released this evening and the pace of growth in the third quarter along with degree of consumer demand could determine how risk trades over the next 24 hours.  Although the domestic economy should have performed relatively well, we believe that China is not immune to slowdown in global growth and should have suffered from weaker external demand in the third quarter. If GDP growth slows materially, we can expect a deeper sell-off in risky currencies such as the euro and Australian dollar along with more robust demand for safe havens such as the U.S. dollar and Japanese Yen.  If growth holds steady around 9.5 percent, then a wave of relief could sweep through the currency market, driving all of the major currency pairs higher.  There is also quite a bit of U.S. economic data on the calendar, but the Chinese numbers will probably set the tone for trading, with the U.S. numbers having a more nominal impact on the dollar.  We will be looking forward to U.S. producer prices and the Treasury International Capital Flow report.  The TIC data will measure foreign demand for U.S. dollars after the first downgrade of the U.S. credit rating.  Although the dollar lost value in August, it recovered quickly the following month, which means foreigners may not have been spooked significantly by the downgrade.  Inflation numbers are important but don’t expect a big impact on the dollar because PPI will not change enough to sway the central bank’s policymaking decisions. Meanwhile the Empire State Manufacturing index rose from -8.82 to -8.48 in the month of October. Economists had anticipated a more significant rebound but demand did not recover as much as they had expected. However given that the contribution of NY manufacturing activity to national manufacturing output is small compared to the Philadelphia and Chicago regions, we need to see similar deterioration in Philadelphia or Chicago for investors to adjust their QE3 expectations. Industrial production activity rose 0.2 percent last month, which was in line with expectations but still weak when taking into account the downward revision to last month's report.  

EUR: NO FAST AND EASY SOLUTION FOR EUROPE

The price action in the euro today shows how a lot can change in a very short period of time in the EUR/USD.  The euro enjoyed a nice rally during the European trading session that took the currency pair above 1.39.  However as the day progressed and U.S. traders joined the market, the euro gave up all of its gains and then some to end the North American session sharply lower against the U.S. dollar. With no Eurozone economic data scheduled for release this morning, the reversal in the EUR/USD was caused entirely by comments from the Germans who dashed the hopes of investors that have been waiting for a Grand Master Plan to save the euro. Over the past few weeks, there has been a general belief that behind closed doors, European officials are working on a large rescue plan for the Eurozone. However European officials have gone to lengths to temper the market's expectations, dashing hope that a deal will be reached before the G20 leaders Summit in November. German Finance Minister Schaueble and Chancellor Angela Merkel said that the EU Summit would not present a definitive solution to the Eurozone debt crisis. Although U.K. Finance Minister Osborne expects "something quite impressive" from the Oct 23 EU Summit, if Germany refuses to agree on bank recapitalization, an expansion of the EFSF or a new package for Greece, the meeting will be another bust. At this point, it is not even clear if EU policymakers will be able to agree on releasing the next tranche of aid to Greece before the end of the month. These recent comments illustrate how much of a challenge it is to come up with a plan that all 17 Eurozone nations will find agreeable. Given the amount of time and effort that it took to have the July EFSF expansion approved, doubling or tripling the size of the EFSF, will be an even steeper uphill battle. Investors are finally beginning to realize that there is no fast and easy solution to the Eurozone's sovereign debt crisis and we will be lucky if an agreement can reached before the end of the year. With this in mind however, there is still a small chance that the conflicting comments from European officials represent a smart strategy of managing market expectations. If they dropped hints that a deal is in the works, there would be more short covering in the euro and the currency's reaction to the announcement would be far more tempered. Instead, they would make a much bigger splash if they disagreed for weeks, keeping the general market short euros and then suddenly announcing a big comprehensive plan, squeezing the currency pair sharply higher.  German newspaper Der Spiegel also reported that a number of economists expect France to be the next country to suffer from a downgrade.  Although we do not believe this is likely, the mere prospect of further downgrades is enough to add pressure on the euro.  

GBP: HOUSE PRICES SOAR, INFLATION COULD RISE

Like the euro, the British pound also lost value against the U.S. dollar but compared to the other major currencies, sterling suffered from the shallowest sell-off. Part of the reason could be the stronger housing market numbers reported overnight.  According to Rightmove, house prices rose 2.8 percent in October which was the strongest rise in 2 years and pushes the values of homes in London to the highest level ever. Although house prices rose 2.8 percent this month across the country, in London in particular, asking prices rose a whopping 5.2 percent to an average price of GBP450,210 or $710,000.   Considering the current global economic environment, the sluggish pace of growth in the U.K., and the overall tightness of credit, the persistent strength of the London housing market is nothing short of impressive.  The strong housing market is a problem for the Bank of England because their recent efforts to ease monetary policy will exert further upside pressure on house prices by boosting inflationary pressures.  In fact, inflation will be the main focus of U.K. traders on Tuesday with consumer prices scheduled for release. The recent increase in producer prices suggests that consumer prices could also trickle higher.  The annualized pace of CPI growth is actually expected to rise to 4.9 from 4.5 percent in the month of September.  This is well above the central bank’s 2 percent target and the 3 percent pain threshold.  The head of the central bank will be forced to pen a letter to the U.K. Chancellor explaining why they chose to raise their asset purchase program in an environment where prices are rising.  The central bank’s mandate is to keep inflation low and they have failed miserably even though they will continue to argue that prices will decline as growth and demand slows.  

AUD: WHAT TO EXPECT FROM RBA MINUTES

The price action of the commodity currencies is an example of what rises the sharpest can also fall the steepest.  The Australian, New Zealand and Canadian dollars sold off aggressively today on the heels of broad based risk aversion.  There were a few pieces of data released overnight that added to the pressure, but the commodity currencies traded primarily on risk appetite.   This morning Canadian economic reports showed foreign purchases of Canadian dollar denominated assets slowing in the month of August to C$7.92B.  After robust demand in July, a pullback is natural and therefore not worrisome particularly since overall demand for Canadian assets remain well above average levels. However businesses grew less positive about future sales in the third quarter on concerns about U.S. and global growth, which does not bode well for the Canadian dollar.  The New Zealand dollar was also weighed down by the slowdown in service sector activity.   New Zealand’s PMI index fell from 53.8 to 53.2.  In Australia, weaker new motor vehicle sales weakened but more importantly, the RBA minutes are scheduled for release this evening and investors are worried that the minutes will contain more cautionary comments from the Reserve Bank that would be bearish for the Australian dollar. When the RBA last met in early October, they surprised the market by clearly telling us that they are open to the idea of easier monetary policy. In the monetary policy statement, the central bank said "an improved inflation outlook would increase the scope for monetary policy to provide some support to demand, should that prove necessary."  In other words, if inflation declines due to weaker economic conditions, the RBA will be ready to cut interest rates.  This represents a major shift for the central bank because they are finally acknowledging the concerns of investors who are discounting 70bp of easing by year's end.  Although the RBA noted that the terms of trade in Australia are very high and investment in the resources sector is picking up, the deterioration in the labor market, cautious spending behaviors and the earlier rise in the exchange rate has  led the central bank to admit that "near-term growth is unlikely to be as strong" as they previously expected.  If the RBA focuses exclusively on the risks to Australia’s economy, the Australian dollar could extend its slide towards parity. However if the minutes sound relatively wishy-washy on rate cuts – meaning they floated the idea out there but are a long ways to committing to a rate cut, the AUD/USD could enjoy a nice relief rally.

JPY: CABINET CUTS ECONOMIC ASSESSMENT

Renewed concerns about the Eurozone drove the Japanese Yen sharply higher against all of the major currencies.   The rally in the yen comes in spite of the Japanese government’s decision to lower their assessment of the economy for the first time in 6 months.  The Cabinet believes that the Japanese economy is still recovering although the pace of recovery is decelerating due to the persistent difficulties caused by the earthquake earlier this year and the slowdown in global growth.  The strong Yen is obviously a problem as well.  Although the currency did not make new lows in since August but remains near its record high which is certainly problematic for the Japanese economy.  As a result, the government cut its view on exports, private consumption and factory output.  Japanese Economy Minister Furukawa followed up the report with a warning that the government will remain “fully vigilant” toward its currency.  Last Friday, Dow Jones reported that the Japanese government is set to announce a round of new measures to curb yen strength.  Little details were provided but it is generally believed that government will encourage Japanese companies to invest overseas by boosting its facility for financing US$ purchases.  They are also considering giving subsidies to encourage Japanese companies to keep research and development functions in Japan.  However what investors want to see is either a further increase to the intervention war chest or a tax on currency transactions which is highly unlikely.   Unless one or both of these measures are introduced, the Japanese Yen is not likely to see much pressure from Japanese monetary or fiscal policies. Meanwhile last night’s industrial production numbers were revised down from 0.8 to 0.6 percent, validating the central bank’s decision to downgrade their economic assessment.  Capacity utilization on the other hand was revised sharply higher which is very encouraging.  Tonight, department store sales figures will be released along with machine tool orders. No major improvements are expected in consumer spending. 

GBP/USD: Currency in Play for Next 24 Hours

The GBP/USD will be our currency pair in play for the next 24 hours. U.K. consumer prices will be released at 4:30 AM ET or 8:30 GMT followed by U.S. Producer Prices at 8:30 AM ET or 12:30 GMT and the Treasury’s International Capital Flow report at 9:00 AM ET or 13:00 GMT.

Despite today’s pull back, the GBP/USD remains in an uptrend which we define using Bollinger Bands.  Support is at the first standard deviation Bollinger Band at 1.5709.  If that level is broken, the next area of support will be the 20-day SMA at 1.5582.   Should the GBP/USD trickle higher, resistance will be found at Friday’s high, which also coincides with today’s high at 1.5835.    

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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.