Posts from — July 2007

EUR/USD has been establishing fresh highs almost daily for the past two weeks.  The upward movement in the currency pair is due to a variety of factors pointing to both euro strength and dollar weakness.   Economic growth within the Eurozone is forecast to be 2.6% in 2007, putting the 13-country region at a pace behind only Great Britain among the industrialized world.  Also, most currency analysts expect at least one more rate hike this year, probably in October.  Money follows yield in the forex market, and that is certainly true with the euro.  And when analyzing this currency pair, it is impossible to ignore the recent comments of ECB members Stark and Papademos when they talk about the strength of the economy and the threat of inflation.

The weak dollar is also to blame for a lot of the support underneath EUR/USD.  Subprime mortgage losses and concerns in the credit market overall have scared off a lot of dollar investors.  Countrywide Financial Corp., the country’s largest mortgage lender, reported its third straight quarterly decline in profit and lowered its forecast for next year.  The price of credit has surged as traders continue to be worried about the possibility of the subprime crisis spilling over into other parts of the economy.  If the issues spread into the larger credit market, we will see a significant knock on growth, and it is this problem that has led to the significant dollar selling in the forex market.  Yesterday, we talked about how the weak dollar made US assets cheap and attractive.  But if the dollar continues to slide, then the assets being held drop in value.  Just the perception of dollar weakness can ignite a massive sell-off in dollar-denominated assets.

It is not certain, however, that we will see the bottom fall out in the US dollar.  Today’s currency trading has provided mixed signals for the future.  French consumer spending was a positive, coming in at 1.6% vs. 0.7% expected.  Italian Retail Sales was a slight disappointment, however, rising only 0.1% vs. 0.3% expected.  Even worse, the manufacturing PMI reading fell to 54.8.  Not only is that lower than the 55.5 forecast, but it is the first time the reading fell below the 55.0 level since February 2006.  The Eurozone economy is much more dependent on manufacturing and exports than either the United States or Great Britain, and this may be the first sign that the high exchange rate is dampening European growth.  The mixed bag of data threw currency traders for a loop and kept the euro trading around 1.3800.

So what can we expect from the forex markets in the future?  New French President Sarkozy is still clamoring for more political say in the decisions of the European Central Bank.  What that means for us is that he wants a larger emphasis placed on stimulating growth as opposed to containing inflation (low interest rates).  ECB President Trichet should be able to resist this intrusion, and the monetary policy makers are likely to raise rates to 4.25% by October of this year.  That is fundamentally positive for the euro, especially since the US Fed is likely to keep rates constant for the rest of 2007.  But technical analysis of the forex market does paint a different picture, as most signs point to the euro being overbought and the US dollar being oversold.  As such, instead of seeing the EUR/USD march toward 1.4000, we should instead see a correction and a rise in the value of the dollar.

Inflation has always been an important concern for currency analysts, if only because it has a direct relationship with interest rates.  Central banks have a mandate to keep inflation under control, and so signs of rising inflation indicate a strong currency.  But the new paradigm of an increasingly international economy could leave monetary policy makers impotent in the face of global inflationary surges.

Commodity prices are near record highs, and interest rates do not have the power to completely moderate supply-side inflationary pressures.  Oil is selling for almost $80/bbl, and there are market analysts who believe we are likely to see $100 oil by 2008.  That would put oil at the $100 level one full year before Goldman’s now infamous oil projections of last year.  Gold and food prices are also through the roof (they are the primary driver of high prices in Australia and New Zealand).  With growing demand for commodities from developing economies, price pressures are not in line to let up anytime soon.  In the forex market, the most prominent consequence of the commodity boom is the incredible rise of the three major commodity currencies (Canadian dollar, Australian dollar and New Zealand dollar).

But more troubling for fans of domestic monetary policy is that inflation is also being stoked by rising prices for finished goods and services.  This phenomenon has surprised many observers because it seems counterintuitive to the idea of globalization.  Free trade was supposed to lead to higher efficiency and lower prices.  But with emerging markets all over the world on the rise, we are seeing more and more wealth in the developing world.  A booming economy naturally leads to higher prices, and the Chinese yuan, Indian rupee and other emerging market currencies have appreciated significantly this year.  Goods from these countries are now more expensive, and so as we buy imports from the rest of the world, we see China and India and Brazil exporting inflation.

Growing wealth in the world’s developing areas has other consequences of inflation as well.  Rich foreigners buy assets in the developed economies, and more buyers drives up the price of these assets.  This is partly the cause of exploding real estate prices in London.  For those concerned about the US dollar, we should note that the weak dollar makes US assets especially attractive.  It is as if US products were being sold at a discount relative to prices in the past.  This is why foreign ownership of US securities reached record levels last May.  But forex traders should still keep track of the current state of the US dollar.  Traders like to invest in markets that are growing (and economies that are healthy.  So while a weak dollar might be good for the US economy, a weakening dollar is bad.  And with central banks less powerful in the face of the new global economy, we might not be able to do anything about it.

As the U.S. dollar fell to record lows against the euro last week, technical analysis may indicate an earlier than expected rebound in the short run. Last week traders speculated long-run rebounds due to the U.S. economy benefiting from a weak dollar and from pressure on the ECB by Nicolas Sarkozy to cool a strengthening euro. But as traders have been eyeing the Relative Strength Index (RSI) on the EUR/USD pair, there is a possibility of a short-run rebound.

The RSI measures the strength of a currency pair price movement typically within the past 14 days. When the RSI is over 70 there is a good chance the price movement will fall. At over 70 most sellers who have been looking to sell perceive the current price to be the best price. On the other hand, buyers will likely wait for the price to fall when the RSI is in fact over 70.

Thus, in the context of the current EUR/USD pair, the RSI is at 76.34 today hinting at a future fall in favor of the dollar. The U.S. currency did in fact make a small gain to $1.3817 per euro this morning. This level is up from last week’s record low of $1.3845, but not enough to indicate an actual rebound. Nevertheless, the high RSI value may indicate a rebound sooner than expected.

Currency Outlook and Strategy:
On July 25^th, the National Association of Realtors is due to report figures on last month’s existing U.S. home sales. It is expected that U.S. existing-home sales have fallen the lowest in 4 years. This could further hurt investor confidence in the dollar. Looking across the Atlantic, European Central Bank Executive Board member Lorenzo Bini Smaghi states he is not worried about euro appreciation. But Nicolar Sarkozy, newly elected French President, thinks otherwise.

Tim Shea, currency analyst at FXCM, concludes: “This week in the Euro looks very quiet news-wise. We’ve got next to nothing on the European calendar, and pretty much just housing data and GDP in the USA. So, watch the housing numbers and the Dow for some direction, and don’t forget about $75 per barrel oil.”  

During the second day of Ben Bernanke’s testimony, the Fed Chairman revealed his worries about the subprime mortgage default crisis. He estimated $100 billion in losses on loans to homeowners with poor credit. Additionally, the Fed has not been clear about its exact forecasts for economic growth for the rest of 2007. Uncertainty and fear of a weak housing rollover into the economy has cause the dollar to drop against most major currencies. This morning the U.S. dollar traded at $1.3811 per euro, down from yesterday’s close of $1.3804. Today’s low marks a .2 percent loss this week. Against other currencies the dollar fell against the yen, the pound, the New Zealand dollar, and the Australian dollar. This week’s low of $2.0548 against the pound marks a 26-year low.

The U.S. currency’s bad shape marks a change from risky assets to more risk-aversive strategies. Samarjit Shanker, director of global strategy for the currency group of Bank of New York Mellon in Boston, states: “Subprime concern is pushing people to reduce some appetite for riskier assets, which will benefit the yen.” As it may benefit the yen, U.S. and European government debt has become more appealing as well. The yield on the 10-year U.S. Treasury fell to its lowest in 7 years as investors are looking to minimize risks in their portfolios. The yield fell below 5 percent for the first time in a month to 4.94 percent. Likewise, the German 10-year bund, which is used as Europe’s benchmark, fell 9 basis points to 4.45 percent. This marks a 17 basis point fall this week.

Outlook and Strategy: Will the EUR/USD break 1.40?

The remaining question among currency speculators is whether the EUR/USD will break 1.40. Economic data from the first half of the year has shown a very strong European economy compared to a sluggish U.S. one. Investors are expecting these trends of growth to continue, thereby forecasting two further interest rate hikes by the ECB. They also expect the Fed to hold onto its current benchmark. If these interest rate forecasts hold true, then a 1.40 EUR/USD break is very feasible. But other factors need to be considered as well. Nicholas Sarkozy, the newly elected French President, is a euro dove and feels the ECB holds too much power. He does not want to see a stronger European currency that will hurt European exporters.  

A weak dollar may actually help the U.S. economy and in turn allow for a rebound. The weak currency is perfect for the tourism sector and will also help U.S. exporters. Barring a complete housing meltdown, the weak dollar may rebound if the U.S. economy enjoys steady growth. Currency analyst Tim Shea at FXCM states: “…while there’s still significant upside potential to 1.40, where there’s likely to be strong resistance, I don’t see a lot of reason for it to go beyond that, barring a big blowup event in the US. The weak USD is giving the US economy a big helping hand. Combine that with robust employment data, and we could see a good turnaround in the USD in the second half. A major divergence on the MACD on weekly chart data shows that the EUR/USD rally is looking pretty tired.” The conclusion is that the EUR/USD is unlikely to break 1.40.
 

The Chinese government has been under a great deal of pressure recently to allow the country’s currency to appreciate.  The yuan has been on a managed flat regime since July 21, 2005, when it was first taken off its fixed dollar peg.  And since that date, the yuan has actually appreciated 9.3% against the dollar.  But that has not done much to cool China’s overheated economy.  Most market observers agree that the domestic stock market is overpriced and likely nearing the bursting point of a bubble.  China’s exports are hitting record highs bringing with them enormous trade surpluses that only exacerbate the trade inequality between the United States and China.  US lawmakers have whipped themselves into a frenzy criticizing China and its exchange rate regime (saying the yuan is undervalued).

China has tried to deal with these problems in a variety of ways.  Earlier this summer, the government raised the country’s capital gains tax, hoping to cool the stock market rush.  Just last night, the central bank raised borrowing and lending costs by 0.27%.  But market speculators suggest that in conjunction with the release of that decision, the government also sold large quantities of yuan on the open market.  And so between the announcement of the interest rate hike and the close of trading at 5:30 PM in Shanghai, the yuan actually fell 0.14% to 7.5740.

Most analysts believe the yuan is on track to gain in value, however.  Standard Chartered Plc, which does 2/3 of its business in Asia, forecasts a gain of 1.9% to 7.42 by the end of this year.  By the end of 2008, the yuan should be all the way up to 7.00 per dollar, according to bank forecasts.  But the appreciation is expected to be modest in character as the Chinese government is loath to use the currency to manage the economy.  An undervalued currency is still too important for the export-driven economy, and inflation and liquidity (while at high levels) are not at crisis points yet.  And so look for the yuan to stay undervalued with relation to the dollar for the time being.

Speaking of the US dollar, forex traders saw a consolidation of the currency after Fed Chairman Bernanke’s congressional testimony yesterday.  The greenback stemmed its losses and looks as if it has entered a period of relative stabilization.  The US dollar might even be ready to break out against the pound, euro and yen in the coming days and weeks.  For a more detailed evaluation of those and other popular currency pairs, check out DailyFX.com’s 2007 Third Quarter Forex Market Outlooks.

Bernanke spent a good deal of time on the subprime mortgage crisis, even admitting that the total losses could amount to over $100 billion.  But most of his testimony concerned the growth and inflation forecasts for the US economy in 2007.  This is in marked contrast to his predecessor as Chairman, Alan Greenspan who loathed forecasts and projections.  Bernanke’s style is formatted to a more transparent rendering of Fed decision-making, and this is good news for forex traders.  More information and more transparency mean less volatility in the currency markets.  Admittedly, a decrease in volatility is less exciting for some traders, but I would gladly sacrifice the excitement (and anxiety) for more safety and security in my investments.  Especially since, over the long run, Bernanke’s style is conducive to a more profitable investment strategy.

The Chinese economy has grown at its fastest rate in 12 years during the second quarter. China’s GDP growth has increased to 11.9 percent from a year ago. This figure has exceeded all expectations from 23 economists at Bloomberg. Inflation has risen to 4.4 percent in June, the fastest rate since September 2004. The Chinese economy is on fire and needs cooling. The most obvious is a change in monetary policy. There is much speculation the Chinese central bank will increase interest rates and in turn this will strengthen the yuan. But is revaluation by direct policy of the yuan needed?

According to Glen Maguire, chief Asia economist at Societe Generale SA, a strict revaluation by the central bank is needed in order to quell the surge. He indicates the yuan may even need to appreciate as much as 3.5 percent in a single day. A stronger yuan would slow down the economy by making exports more expensive and thereby reducing China’s enormous trade surplus. U.S. lawmakers have been very keen on a strengthened yuan, claiming that U.S. companies have been taking hits by its artificially low value. Senator Charles Grassly has spoken on the issue extensively stating the Chinese currency has not risen fast enough.

Despite U.S. and Chinese economists having met and agreeing on the same direction for the yuan, the Chinese central bank does not want a fast acceleration. Bank of China Governor Zhou Xiaochuan has stated he does not want the yuan to accelerate nearly as fast as the U.S. would prefer. Other currency analysts do not see the yuan appreciating to unprecedented levels anytime soon. According to Tim Shea, a currency analyst in the Sales and Trading Department at FXCM, “China has shown since the initial dropping of the peg in 2005 that the strengthening of the yuan would happen gradually and at their own pace.” He points out, “…that a 3 percent change in one day would be a move of 2200 pips, the equivalent of all the movement made since January. This would not be in line with past policy.”

We have also seen changes in Chinese fiscal policy to help the cooling process. Inflation has actually outpaced the return on bank deposits spurring investments in the equities market. The benchmark CSI 300 stock index for the Chinese market has gained 87 percent this year. In response, fiscal measures have included legislation allowing the 20 percent tax on interest income to be reduced or even taken away. As a result, fixed-income investments have increased to 26.7 percent in the first half of the year from a year ago. Even though this increase in savings is modest in comparison to the spurring equity run, a future meltdown of the Chinese economy is unlikely. With the right fiscal and monetary policy the Chinese economy will continue to grow at a controllable pace. The yuan will strengthen, but most likely at a pace unsuitable to U.S. lawmakers.

Commodity currencies have been beating up on the US dollar and the Japanese yen recently and yesterday was no different.  The Canadian dollar, the New Zealand dollar and the Australian dollar all hit new highs, an occurrence so common in that last couple of weeks that’s most traders simply yawned.  Some of the underlying support for these currencies comes from high commodity prices, especially oil and gold, of course.  But much of the gains should also be attributed to weakness in the US dollar and the yen carry trade.

It is pretty easy to spot the strength the commodity currencies have derived from greenback bears.  The data released in the respective countries has not been really great.  Canada’s inflation numbers yesterday printed lower than expected.  Australia and New Zealand have not released much data recently, and what has been released has been worse than expected.   But the rise of the Loonie, Aussie and Kiwi cannot be stopped.  And that can be traced back to the sluggishness of the US dollar.  And the market consensus after Fed Chairman Bernanke’s speech is that US interest rates are likely to stay the same for some time.  Bernanke also seemed more concerned about the slumping housing market than he has been in earlier speeches.  And so the commodity currencies should continue to benefit from the weak dollar.

The other factor fueling the fresh highs in this area of the forex market is the yen-based carry trade.  The interest rate advantage for Australia and New Zealand compared to Japan is enormous, and currency traders just cannot seem to get away from the high yields.  And that differential is likely to get higher as the futures market lists a 66% probability that the Reserve Bank of New Zealand will raise the country’s interest rates, already the highest in the industrialized world, at its next meeting.  Most currency analysts are pricing in another rate hike this year for the Royal Bank of Australia as well.

The appetite for risk (as well as the hunger for yield) in the market is tremendous, and the surging carry trade is reflective of that.  AUD/USD is at an 18-year high and NZD/USD is at its highest level since the currency was floated in 1985.  While the amazing rate of appreciation might be hurting the country’s exporters, the situation is only exacerbated by the weak greenback.  It is because of this phenomenon that the Canadian dollar is up 12% already this year, with the USD/CAD hitting 1.0416 this morning, its highest level since 1977.  But the latter pressure is not likely to go away anytime soon as many analysts are touting the weak US dollar as good for the American economy.

The U.S. dollar changed little after today’s testimony by Federal Reserve Chairman Ben S. Bernanke. In his report to the House Financial Services Committee, Bernanke stated the economy will continue to grow at a modest pace picking up slack next year. The Fed Chairman expects the economy to grow 2.25 to 2.5 percent in the last quarter of 2007. In February, the Fed had expected growth to be at 2.5 to 3 percent this year. Despite acceptable growth, Bernanke expects dampening effects of the housing market slowdown, and remains worried about inflation.

The dollar dropped to 121.93 yen this morning from 122.34 yesterday and EUR/USD fell to 1.3797 from yesterday’s close of 1.3781. Michael Woolfolk at the Bank of New York states: “Any worries about weakening growth conspire to push down the dollar.”

But real question is where interest rates will go. The current benchmark for the main U.S. interest rate is 5.25 percent. Core consumer prices have shown a decrease in inflation to 1.9 percent, a significant drop from 2.4 percent in February. However, gross domestic product rose .7 percent in three months, which has been the worst rate of increase in 4 years. Overall, slow growth and little inflation have investors speculating that interest rates will remain unchanged. The Federal Open Market Committee will have its next meeting on August 7^th to determine where the main interest rate will be.

Looking specifically at the U.S. housing slump, a government report today showed builder confidence to have fallen to its lowest level in 10 years. Builder confidence is measured by the amount of new building permit activity. This is a better measure of builder confidence than housing starts, which are strongly correlated to changes in weather. The report reveals 1.41 million new permits were made in June, down from the 1.52 million for May. Further, the National Association of Home Builders stated that the home builder sentiment index fell this month to its lowest level since 1991.

The already weak U.S. dollar may see a bleak future. It is unlikely that the Fed will raise interest rates. But it is likely that the housing slump will further hamper the economy. So far the housing slump has not spilled over into other sectors, yet the continuing negative reports have not stopped either.

It seems like every day the euro hits another high.  At least, that’s been the story of the forex markets for the last five days.  A combination of dollar weakness and the market’s belief in the Eurozone economy has pushed the euro to new heights.  Yesterday was no different.  Bear Sterns officially warned their hedge fund investors that there was no value left in the fund.  With fears of the subprime crisis already strong in their minds, traders were worried that foreign investors would seek to move away from US assets.  Especially after the recent diversification of foreign exchange portfolios (basically, the selling-off of US Treasuries), the Bear Sterns news triggered a dollar decline.  Even the poor German ZEW survey released yesterday did little to stem US losses.

But today’s news may signal a top in the EUR/USD pair.  Consumer prices in the United States rose 0.2% in June. It is the smallest gain in five months but still a reversal from the drop in headline PPI seen yesterday.  Core prices also rose 0.2% versus an expected increase of 0.1%.  Housing starts also rose 2.3% this morning, providing further support for the greenback.  Lastly, Fed Chairman Bernanke is scheduled to give his semiannual report to Congress at 10:30 AM.  Today’s data probably eliminate the possibility of interest rate hikes in the near future, leaving Bernanke free to remain hawkish on inflation.  That’s why DailyFX.com reports that his speech is likely to be dollar bullish.  EUR/USD has been trading within a range of 80 points for the last five days, but if Bernanke’s speech goes as expected, we could see a dollar-positive breakout.

Euro bulls should also be concerned about recent developments regarding the European Central Bank.  New French President Nicolas Sarkozy has called for European finance ministers to be granted more influence in monetary policy decision-making.  The most direct consequence of such a move would be a loss of political independence for the ECB, and that would not be good news for the euro.  German policy makers have traditionally been for an independent central bank, but a recent Bloomberg.com report suggests that German Chancellor Angela Merkel may be coming around to Sarkozy’s viewpoint.  ECB President Jean-Claude Trichet has warned against the disastrous consequences of such a development, even suggesting that it may violate the European Commission Treaty.  This is an important situation for traders to stay on top of because if Sarkozy is successful in imposing political control upon the ECB, we could see the bottom fall out of the euro soon afterward.

In the highly volatile forex market the dollar rebounded slightly from a previous falling trend. A government report today unexpectedly showed a record level of U.S. securities bought by foreign investors in May. Holdings in U.S. stocks, bonds, and notes rose to a net $126.1 billion in May, up from a net $80.3 billion in April. This surge is an indication that confidence in the U.S. economy has not diminished. Economic data in May suggested that the housing slump did not necessarily spill into other sectors as had been feared. Economists had predicted that international investors would buy a net $72.5 billion in U.S. long-term securities for June, but in fact a net $105.9 billion was bought.

The dollar traded at 122.30 yen at 9:42 a.m. in New York up from 121.89 yen yesterday. Against the euro the U.S. currency traded at $1.3783, a significant increase from the July 13^th record low level of $1.3814. Earlier gains in the dollar were due to a report showing an increase core prices for May. Core prices, which exclude energy and food, rose 0.3 percent giving investors reason to speculate that the Fed will not be cutting interest rates. However, it remains to be seen what Fed Chairman Ben Bernanke will report during tomorrow’s testimony before Congress.

The gains made by the dollar are only short term. Investors should be careful and not overly optimistic as both the European and England Central Banks are about to raise interest rates. European Central Bank Council Member Nicholas Garganas is wary of inflation pressures from stronger than expected economic growth. This would prompt the ECB to raise the interest rate above the six-year benchmark of 4 percent. Likewise, inflation in England exceeded the central bank’s 2 percent target level for a 14^th month in June. Interest rates will likely be increased to cool the economy.