Posts from — July 2007

In the past week, EURUSD has lost more than 200 pips from its record highs.   But recent evidence shows signs of a retracing, with support for the euro regaining strength.  But it’s not like currency traders have fallen back in love with the euro.  Most of the movement in the currency pair in recent days has to do with softness in the US dollar, rather than any inherent strength in the European currency.

The data emanating from the continent is contradictory, to say the least.  Recent sentiment reports in Germany and France have bordered on terrible.  Retail Sales in Germany printed last night at a disappointing gain of 0.7%, versus 1.2% expected.  But unemployment fell by 45K, bringing the unemployment rate in Germany to 6.3%, the lowest level in that country in 14 years.  The forex market, understandably, is perplexed as to do what to do with this information.  And so trading in EURUSD right now consists of range trading within 40-60 points, with a market consensus of about 1.37.

The fundamental status of the US dollar is important in this situation because the euro is where the forex market likes to register its response to status changes in the greenback.  But even considering that, there’s no real direction for the currency market to follow.  The PCE deflator was released this morning, and the inflation register came in at 1.9%, excluding most food and energy costs.  This fits into the Fed’s comfort level of 1-2%, but the PCE deflator has a tendency to understate inflation.  Along with that, consumer spending met expectations with a gain of 0.1%, but the pace of growth is the slowest in nine months.  Home prices are also a concern, with the S&P/Case-Shiller index reporting that home prices in 20 US cities fell 2.8% in May—the biggest fall in more than six years.  But those negatives are tempered by the fact that disposable income in the United States rose 0.4% last month, outpacing spending for the first time in months.  The forex market did what it usually does with conflicting data like this: nothing.  The dollar barely moved at all against the yen and the euro after the release of the government report.

Currency traders may be confined to range trading in the near future, especially when it comes to EURUSD.  If you had to choose between the euro and the dollar, however, then your safer bet would be to go for the euro.  The ECB is only charged with maintaining price stability while the Fed has a dual mandate of controlling inflation and promoting growth.  Because of this, the ECB is likely to raise interest rates in September despite French President Nicolas Sarkozy’s concern for the negatives of a strong currency.  In contrast, chances are good that the US Fed will lower interest rates by the end of this year.  And so yield-hungry currency investors will abandon the dollar and flock to the euro.

One way to capitalize on this flow is to invest in a managed currency fund.  Bloomberg reported this morning on record returns achieved by these funds this year, and they are an excellent way to diversify your portfolio.  There are a number of very good funds out there right now, and one of the best in FXCM’s Sentiment Fund.

Global equities markets took a beating last week. The phenomenon began in the United States (on the back of subprime mortgage concerns) and it spread to the financial markets in other countries. For the forex market, the primary impact of the losses was a return of risk-aversion. The risk appetite of currency traders has waned, and as a result, the yen-based carry trade has begun to unwind. The US dollar has also appreciated significantly as investors run to the safety of US assets. But the search for yield and the changing fundamentals of the market complicate matters, and the current trends may not last.

Regarding the carry trade, it is risk aversion driving the FX market. Japanese fundamentals stink, with Retail Sales disappointing to the negative and deflation sill a concern. But the yen continues to gain as greater market volatility hurts the carry trade. But this is all dependent on the equities market. If the Dow recoups its losses this week, we will see a renewal of the yen carry trade.

The US dollar also saw some improbable gains this past weekend. With investors more conscious of risk, the stability offered by dollar-denominated assets is more appealing. Americans, concerned about losing their gains overseas, repatriate their holdings into US dollars. For international traders, the US dollar becomes a store of value, just like holding gold or silver. Emerging markets in Asia were especially hard hit as overseas investor sunned riskier assets in favor of American ones. This particular phenomenon is controlling the currency market, overpowering economic factors that would pull back the US dollar (like the disastrous Existing Home Sales report).

But the forex market changes very quickly, and if last week’s equities market decline proves temporary, then we could see both a resumption in the carry trade and a plunge in the US dollar. The yen already began giving back some of its gains in European and Asian trading this morning with EURJPY, GBPJPY, AUDJPY and NZDJPY all riding upwards. And the US dollar cannot maintain its status as a store of value forever.

The latter situation is pretty interesting. The dollar benefits from its use as the currency of choice in international trade and as the primary denomination in foreign reserves. We have talked in the past about how other countries are starting to move away from the US dollar both in terms of international trade and in terms of foreign reserves. And there are reports in Bloomberg today of increasing protectionism with regard to foreign ownership of assets in the United States and Europe. This hurts the dollar and the euro because it makes dollar- and euro-denominated assets less attractive. And US fundamentals do not look like they are going to get better anytime soon. A recent Fed report suggests that even the weak US dollar may not help the trade deficit. We may see temporary gains in the greenback and the yen, but a long-term outlook does not bode well for either currency.

Despite last week’s small gains against the euro, the U.S. dollar fell against the European currency on speculation of further weak U.S. growth. It may seem like old news, but investors fear further losses on securities backed by subprime mortgages to weaken the U.S. economy. Today, Germany’s IKB Deutsche Industriebank AG reported losses directly linked to the U.S. subprime mortgage crisis. Along with last week’s Deutsche Bank report, this indicates corporate debt to be at risk from the weak housing market. The dollar fell to 1.3678 against the euro this morning, a 0.3 percent drop from last week.

The risk of owning corporate debt has sky-rocketed, also a factor in the euro gain. Bond buyers have been demanding higher risk premiums on corporate debt as risk-aversion has increased. According to index data by Merril Lynch, the spread that investors demand on corporate debt instead of holding U.S. Treasuries has widened 20 basis points this week to 128 basis points. Investors fear corporate debt will be taking hits from the subprime meltdown.

Currency Outlook and Strategy:
Tomorrow at 8:30 a.m. the U.S. Commerce department is due to release a report on U.S. consumer spending. Economists from a Bloomberg news survey speculate personal spending rose 0.1 percent in June, the least since September. Ever since U.S. personal spending has slowed from a 5-month high in December, the dollar has fallen 3.5 percent against the euro. Even though a weak spending forecast is already factored in the EUR/USD price, there is room for a further fall if the U.S. Federal Reserve decides to lower interest rates. Kenta Inoue, economist and currency analyst at Mitsubishi UFJ Securities in Tokyo, states: “I expect the U.S. economy to slow and the Fed to lower rates in the 4^th quarter. There is still room for rates to rise in Europe, so investors will start to favor European currencies over the dollar.”

And this brings up another question: Will the European Central Bank raise their federal funds rate above the current benchmark of 4.00 percent? There is much speculation the ECB will hold onto the current rate after its next meeting on August 4^th, but is likely to raise rates later in September. This increase may mean further appreciation in the euro, a main worry of French President Nicolas Sarkozy. But recent data has shown an appreciating euro has not hurt the euro-region as a whole. Exports from the EU rose 9 percent in 5 months through May from a year earlier, the second fastest pace in 6 years. This begs the question why an appreciating euro has not hurt exports. The reason is that against the currencies of the EU’s 25 trading partners, the euro has increased less than half as a much as against the U.S. dollar. Exports to the U.S. may have been hurting, but with Germany as the world’s largest exporter, exports to other countries have more than made up for losses.

Another benefit from a rising euro has been lowered costs of oil, which is priced in U.S. dollars. The price of oil has risen 26 percent this year to $76.73 a barrel today. Despite hurting some European corporations like Airbus and Peugeot (charts), the overall euro-region seems to be withstanding the euro impact. The ECB is forecasting economic growth at 2.6 percent for 2007.

Yesterday’s report on the extremely sluggish U.S. housing market sent equities markets crashing, investors dumping corporate debt, and currency traders unwinding carry trades. New U.S. homes sales for June fell 6.6 percent. This number has jumped significantly from the 2.2 percent decrease in May. According to a Bloomberg article, this may be a no end to the real-estate slump. The housing issue has even breached the international level as a report today by the U.K.’s Nationwide Building Society showed home values to have risen only 0.1 percent in June, the slowest in 15 months.

The faltering confidence in the equities markets has also brought shifts in forex. Despite having been on a six-week run against the dollar, the pound took its biggest fall in the last five months. The pound dropped 1.0 percent in one day to $2.0305 at 1:04 p.m. in London from $2.0491 late yesterday. On July 24^th the pound had reached $2.0654, its highest level since May 1981. The pound and the euro also took major hits against the yen, indicating investors are losing confidence in their carry trades with the Japanese currency. Against the yen, the pound fell to 241.27 from yesterday’s close of 243.21. Steven Barrow, chief currency strategist at Bear Stearns Intl. Ltd. in London, states: “There’s a reasonable degree of panic going on with the whole mortgage and credit issue and that has encouraged risk aversion.”

Currency Outlook and Strategy:

The sharp fall in the pound has allowed the 14-day RSI for the GBP/USD to fall below 70. This indicates that a reversal will not come anytime soon. Kathy Lien, chief currency strategist at FXCM expects “room for more losses” in the pound. In addition, traders have taken steps to hedge against the risk of a rallying yen. The cost of options protecting against gains in the yen rose to a 3 year high. This movement of risk aversion indicates a revival in the carry trade may not happen anytime soon. Neil Jones, head of European hedge fund sales at Mizuho Financial Group Inc. in London, states: “Investors are looking for some short-term protection on their exposure to the yen strengthening.”

History has shown us an interesting pattern where the EUR/JPY pair has followed a very similar trend to that of the U.S. Dow Jones Industrial. As the Dow takes hits so does the EUR/JPY. See more on this pattern in an article by FXCM technical currency strategist Jamie Saettele. Overall, the leveraged-buyout financing era has taken a huge fall. There is much uncertainty as investors are shifting their portfolios toward less risky assets. Steve Pearson, chief currency strategist at HBOS Treasury Service PLC in London, reflects: “[The] three year period where financial market volatility has declined to low levels is over.” For now it is best to let the markets react and then change strategy.  

The GDP release for the second quarter came out strong this morning, printing at 6.4% annualized growth versus 3.2% expected. This was on top of a revised 0.6% pace for the first quarter of 2007. The dollar was already trading upwards early this morning and in European trading in anticipation of a positive release. EUR/USD had fallen as low as 1.3650, and it is hovering at about 10 pips over that right now. For a good primer on how you should trade an event risk like the US GDP report, try the GDP analysis on DailyFX.

US GDP rebounded for a variety of reasons. Rising exports, aided by the weak dollar, made up for the high input costs of $70 oil. There was a gain in commercial construction, balancing out the slump in the housing market. And finally, there was a significant rise in government spending last quarter, which probably cannot be sustained and certainly should not be counted on for future growth.

But the engine of the US economy is consumer spending, with consumption comprising 70% of GDP. And this sector only rose 1.3% the past three months, a troubling amount considering the 3.7% rise in the first quarter of this year. If the American consumer is tapped out, and that looks to be the case, then that does not bode well for growth the rest of the year.

The report this morning did beat expectations. And it probably fooled the traders in the Fed Futures market that have priced in a 90% chance of an interest rate cut by the end of the year. But economic prospects in the United States are not aligned for expansion either. Risk aversion seems to be killing the market (and the carry trade) as well. It is in times like these that it seems the best that individual traders can do is tread water. And that’s why managed funds seem so attractive. Most forex managed funds will not offer returns much different than mutual funds, but they do provide extra diversification important in market downturns. And one of the best that you might want to check out is called the Sentiment Fund by FXCM. Trading has been up and down in the forex market recently, and it’s hard for even the professionals to stay on top of things. And so it’s helpful to have an experienced hand at the top.

Today’s fall in Asian major currencies prompted a decrease in the Chinese yuan against the U.S. dollar. The Chinese currency dropped 0.1 percent to 7.5655 against the dollar at 5:30 p.m. in Shanghai from yesterday’s close of  7.5581. Despite taken off the fixed-exchange rate against the dollar in July 2005, the Chinese central bank sets the yuan against a basket of currencies. The currency is not on a peg, but more correctly on a band with some limited freedom of movement.

The only problem is that no one knows for sure what the currency basket is composed of. The Chinese are very secretive about this aspect of their monetary policy. Tim Shea, currency analyst at FXCM, believes the basket is 40 percent U.S. dollar, 20 percent euro, 20 percent yen, 10 percent AUD, and 5 percent ringgit. The biggest worry for the Chinese government is the yuan appreciating too quickly.

It was clear today that the People’s Bank of China lowered the yuan in response to its neighboring counterparts. If the yuan gains too much against the other regional competitors, Chinese exports will become less competitive in the global market. Tetsuo Yoshikoshi, a market analyst at Sumitomo Mtsui Banking Corp., states: “Yuan’s decline is in line with the region and the broad dollar strength.” He also reports the yuan’s midpoint has been reflective of overnight U.S. dollar movement recently. This finding is indicative of a currency basket populated mostly by the US currency, but that still allows room for Asian currencies.

Despite U.S. political pressure, the People’s Bank of China has been keeping the yuan appreciation rate at a minimum, just enough to keep a stable, high-paced economy running. The central bank has been able to control the currency by buying large sums of U.S. dollars. This in turn has brought the foreign-exchange reserves to a record high. Against the dollar the yuan is in fact only allowed to move by 0.5 percent, being held on a so called central parity rate. Other than the yuan already being tightly controlled by the central bank, only a select number of financial institutions can trade the currency under a special license in Shanghai. The fact is, it is very difficult to get liquidity in the yuan, making it very hard to trade speculatively.

It remains to be seen whether select U.S. lawmakers can build enough support to pressure the Chinese to strengthen the yuan. With the current increase in FDA safety inspections of Chinese imports, this may already be the type of leverage the U.S. needs.

Yen carry trades have dominated the forex market for the past couple of months.  With international equities markets booming and high yields to be found in other countries, traders have been borrowing the yen on the cheap to finance their investments.  That has brought the yen to multi-decade lows against all the highly traded currencies.  But yen crosses look to be in line for a corrective decline.

The engine for carry trade demand has been the search for higher yields elsewhere in the world.  And the relative ease with which those yields could be found encouraged currency traders.  However, global equities are falling and credit spreads are beginning to widen.  Forex investors are seeing these developments and reacting with worry.  They are paring risk and liquidating their carry trade positioning.  As evidence of this situation, USD/JPY touched 119.12 per dollar in New York trading this morning, its lowest level since May 1.  EUR/JPY has regressed as well, falling to as low as 163.88 per euro.

The other factor contributing to the carry trade unwind is the possibility that shorting the yen will cease to be a one way bet.  There is growing speculation that Japan may intervene in the fx market to prop up its currency, and it certainly has the foreign reserves to do some damage.  Bank of Japan board member Tadao Noda spoke yesterday about the risks associated with a weak currency.  Hiroki Tsuda of the Finance Ministry warned the market that currencies should reflect economic fundamental and that the government would be watching the forex market for irregularities. The impact of both of these statements is that, if believed, they could serve to lower capital outflows from Japan.

There are fundamental signs that the Japanese economy is ready for an appreciation of its currency.  Consumer spending seems to be recovering, with CSPI printing at a year-over-year growth of 0.6%, a 10-year high.  Household spending has been in positive territory since the beginning of this year, suggesting that price action is likely to drive yen crosses even lower.  Forex professionals have been predicting movement in the yen to 115 for months now, and there have been reports in Bloomberg about Japanese housewives keeping the carry trade afloat.  It has been very tempting to be short the Japanese yen in recent times; you can earn the carried interest without threat of a swing back in favor of the yen.  And while you may have made a good deal of money this way, it might be time to look elsewhere for your investments.  One of the worst moves a forex trader can make is to fall in love with his own trades, and the time is now to unwind the carry trade and find some other vehicle for growth.

Better than expected profit reports by Amazon.com and Boeing marked a strong opening for U.S. stocks this morning. Average profit growth from 40 percent of companies in the S&P for the second quarter rose 9.6 percent. This number beat expectations of 5.8 percent growth by Bloomberg analysts. In response, the dollar has made a major recovery. The dollar traded at $1.3709 against the euro this morning, after having reached a record low of 1.3852 yesterday. This change in direction could mark the start of a major rebound. The U.S. dollar had fallen 1.5 percent this month against the euro. Camilla Sutton, co-head of currency strategy in Toronto at Scotia Capital Inc., states: “Currency markets are looking to equities for direction.”

But investors need to be aware that other factors on the euro side are in play as well. Additionally, today’s report on existing homes sales by the National Association of Realtors was disappointing. Looking on the European side, the euro also fell against the pound and the Canadian and Australian dollars. There has been much speculation that the U.S. housing slump may affect the Euro region as well. Gareth McHale, currency trader at Bank of Ireland Global Markets, says, “There are rumors that a couple of German Banks will be downgraded on subprime.” This year’s booming European economy may see a future slowdown.

Currency Outlook and Strategy:

The long overbought EUR/USD pair may not be breaking 1.40 anytime soon as sellers have reluctantly accepted lower prices. In the short term expect some uncertainty, especially as today’s report on existing homes sales fell below analyst expectations. The National Association of Realtors reported a 3.8 percent drop in existing homes sales, which puts the current annual rate at 5.75 million, the worst since November 2002. Analyst expected an annual rate of 5.86 million. Additionally, Countrywide Financial Corp. stated yesterday that the increasing number in homeowners falling behind on home equity-loan payments has cut into profits. Moreover, this news supports Bernanke’s lowered GDP growth forecast for 2007 stating the U.S. housing slump has been the biggest detrimental factor in the economy.

There is no doubt the poor U.S. housing market will continue through 2007. The question is whether the rest of the economy will be affected as more homeowners are having a hard time making their mortgage payments. This spells uncertainty in the long turn. In the short term the EUR/USD is unlikely to go back to last week’s high seeing that the momentum in the pair has been exhausted.    

In the London market last night, EUR/USD underwent the correction that we had predicted yesterday.  The euro fell amid concerns that the forex market was overextended.  But there’s another currency that has performed even better against the US dollar: the British pound.  GBP/USD seems to reach new multi-decade highs every day.  The early momentum in this pair might have been about the interest rate differential between the two countries, but that is not the driving factor anymore.  If it was, then we would have seen a correction already because of the recent dovish data.  The Bank of England is still on track to raise interest rates to 6.00% this year, but the actual decision might not be for another couple of months.

The real reason for the success of the pound is the growing popularity of British assets.  British assets are denominated in pounds, and so when foreigners want to buy British assets, they are compelled to purchase pounds on the forex market.  Just recently, the investment fund of the Dubai royal family bought a stake in HSBC Bank, and the Chinese government bought shares in Barclay’s Plc.  DailyFX.com has some great analysis on the rise of the cable.  The demand for pounds is skyrocketing, and that is the main driver of growth in GBP/USD.

This very phenomenon is the reason that the US dollar has been so stable and strong through the years despite the twin deficits (budget and trade).  The demand for US stocks, US real estate and US Treasuries never waned, and the US dollar was the prime beneficiary.  But the global environment has changed.  Iran recently asked Japan to pay for its oil in yen instead of dollars.  Six Middle Eastern countries (Saudi Arabia, Kuwait, UAE, Qatar, Bahrain and Oman) are planning to drop their dollar pegs and establish a single currency for the region.  The growing protectionism in the United States (the scrapped deals for Dubai Ports World and CNOOC) certainly does not help matters.  American real estate is not as attractive in this market with prices sinking and the bottom in danger of falling out.  And US equities are not doing as well from an international perspective due to the depreciation of the US dollar.

In the face of the shifting paradigm, the pound did hit some stumbling blocks in the forex market today.  GBP/USD declined from its 26-year high last night, falling as low as 2.0539.  But the fall was not due to changes in the currency’s fundamentals.  Rather, the losses in the US equities markets triggered a bout of risk aversion, and the carry trade unwind led many currency traders to pare back on pound holdings.  But futures traders have positioned both the US stock market and the British pound for a rebound in later trading.  The sterling is looking like the currency du jour in the forex market, and traders would be smart to go along for the ride.

The Canadian dollar rose to a 30-year high following a report that showed retail sales in May having increased at the fastest rate in almost ten years. Retail sales rose 2.8 percent in May, up from the .2 percent increase in April. This news prompted investors to speculate interest rate hikes by the Canadian central bank, which is what caused the spike in the Canadian dollar. The currency rose to 96.39 U.S. cents this morning in Toronto from 95.52 at yesterday’s close.

Today’s high has marked a 12 percent gain this year alone. David Watt, senior currency strategist at RBC Capital Market in Toronto, states the retail report suggests a very strong underlying demand in the economy. He expects interest rate hikes by the central bank in September. Another factor helping the Canadian dollar gain is the price of crude oil jumping to $74.12 a barrel this morning. Half of Canada’s commodities exports is crude oil. On July 10^th the Bank of Canada raised the benchmark lending rate to 4.5 percent by a quarter percentage point. But also stated a further increase is likely to be needed. The central bank will meet again on August 5^th.

Similarly to the Canadian dollar, the pound rose to a 26-year high against the U.S. dollar on speculation that the BOE will raise interest rates to cool a booming economy. The Bank of England’s biggest worry is inflation. Unable to the tame the economy to its below target inflation level of 2 percent, BOE Deputy Governor John Gieve has strongly suggested that interest rates will be raised. Michael Klawitter, currency analyst at Dresdner Kleinwort in Frankfurt, speculates the BOE to be hawkish and increase rates to 6.25 percent. The pound rose to $2.0643 today from yesterday’s close of $2.0593.

Currency Outlook and Strategy:

According to a Bloomberg article, the number of wagers on an advance on the pound has outnumbered bearish investors the most since October 1993. This indicates an overall bullish sentiment that could push the pound even higher against the dollar. Kathy Lien, chief currency strategist at FXCM, indicates that the GBP/USD will further increase only if foreign investments continue to flood into the U.K. economy. She has reasoned that the lack of U.K. protectionism and resulting influx of foreign investments has been the root cause of the strengthening pound. Last week, Chancellor Angela Merkel stated her intentions of restricting foreign investments into Germany. This may redirect flow from Germany to the U.K. In turn, there will be reason for the pound to gain even further.

On the technical side, technical currency analyst Jamie Saettele at FXCM states that even though the GBP/USD is overbought, as seen by the high RSI of 80.92, there is still room for an upward trend. (See full article) Time Shea, currency analyst at FXCM, puts a different spin on things with: “Everyone talks about housing in the USA, and how that’s preventing The Fed from raising. We’ll see more data on that this week. But look at the UK. House prices are still rising by 10% a year. That rate of growth has held for about 2 years now, despite 5 rate hikes. The housing dynamic is very important for both the GBP and the USD right now, but the story on the different sides of the pond couldn’t be more different.” The conclusion is: expect interest rate increase by the Bank of England.