The Week Ahead
- US employment data in focus
- Bank of Japan underwhelms
- RBA likely to cut
- The SNB talks tough on the Swissie
- Is the UK economy really that weak?
- The Eurozone's growth pact
US employment data in focus
Earlier this week, the Federal Open Market Committee (FOMC) held its 2-day policy meeting. The bank kept policy on hold and upgraded the economic assessment, however comments from Ben Bernanke - which did not provide any new insight in our view - kept Treasury yields low, equity markets supported, and the dollar soft with QE3 speculation back into focus.
Fed projections showed upwards revision to real GDP growth with forecasts of 2.4%-2.9% for 2012 up from the prior 2.2%-2.7% estimate and the unemployment rate forecast was lowered to 7.8%-8% this year from the previous forecast of 8.2%-8.5%. Though the release of Friday's 1Q GDP growth came in weaker than anticipated, the data was consistent with the FOMC statement that economic growth will “remain moderate over coming quarters and then pick up gradually”. At the press conference, Bernanke made comments indicating that the Fed won't hesitate to take action if necessary and said that “tools remain on the table”. With the prospect of QE3 still on the table, market action will be sensitive to economic data surprises as investors price in or out expectations of additional purchases.
As such, next week's labor data - ADP employment change, weekly jobless claims, BLS labor report - will be key towards driving market attitudes of whether or not QE3 will be implemented. Last month's employment report was disappointing, but Fed officials noted that it is just one data point and therefore does not require action. If the data continues to deteriorate, stimulus speculation may mount and the dollar is likely to suffer as a result. On the other hand, in the event of positive labor figures expectations of more easing may fade which would be supportive of the dollar outlook. In our view, the Fed is far from pulling the trigger on more QE and we maintain our long term bullish outlook on the USD. 1Q core PCE jumped to 2.1% from the prior 1.3%, and though we agree with the bank's view that the labor market is still not functioning normally, the unemployment rate continues to drop.
Bank of Japan underwhelms
As expected, the Bank of Japan (BOJ) expanded is Asset Purchase Program (APP) and extended the maturity of its holdings from a maximum of 2 years to 3. The yen strengthened following the moves, as other measures by the bank were taken to offset the impact of the expanded stimulus. It was announced that the APP will be expanded by ¥10 trillion, however this will be funded by a ¥5T reduction in the Credit Loan Program. The net effect is an increase in total asset purchases of ¥5T to ¥70T from ¥65T. Moreover, the length of the program was extended.
So is this considered “powerful easing”? With the market clearly underwhelmed as evident by a sharply higher JPY, it appears that there is a discrepancy between the interpretation of the BOJ's idea of powerful easing and what the market expects it to be. Bank of Japan Governor Shirakawa said that the bank has no intention to add stimulus each month, however with the economy falling deeper into deflation as evidenced by this morning's Tokyo core CPI figures dropping to -0.5% y/y in April from the prior -0.3% it appears that more will need to be done.
Technically, USD/JPY fell to test the top of the weekly ichimoku cloud around the 80.40 level and this will be a pivotal point in the near term. A weekly close through here may see towards the bottom of the cloud which is just above the 78.00 figure, however we maintain our bearish outlook to the JPY as our outlook is for the BOJ to continue to pursue easing and for US Treasury yields to move higher in the long term which is another key factor to support the USD/JPY.
RBA likely to cut
On Monday, May 1, the Reserve Bank of Australia (RBA) will meet to announce monetary policy and we expect the bank to ease and cut interest rates by 25bps to 4.00% from 4.25%. At recent meetings, the bank has been increasingly dovish in its rhetoric. The bank stated at its April meeting that it would be prudent to wait until CPI is released before further easing. 1Q CPI was released earlier this week and the decline was greater than anticipated with a drop in yearly CPI growth to 1.6% from the prior 3.1% (cons. 2.2%). The slowdown in CPI growth now puts the inflation rate below the RBA's target range which is between 2%-3% and effectively opens the door for an interest rate reduction at next week's meeting.
With external concerns such as the debt crisis in Europe and slowing economic activity in China weighing on the outlook in Australia (the previous two monthly trade balance figures posted deficits), we expect the bank to provide more accommodation with lower policy rates. The tone of the statement will be important to determine if the RBA plans to continue in an easing cycle or if they will shift back to a “wait-and-see” stance to monitor economic conditions. With a rate cut mostly priced into the AUD, the risk is for an even greater reduction of 50bps or a very dovish statement.
As the Aussie has held up relatively well against the USD as the Fed continues to keep all options on the table, we prefer to play AUD downside against another of the commodity currencies, the Canadian dollar. The Bank of Canada has stepped up rhetoric of late to a hawkish tone with Carney stating on many occasions that higher Canada rates may become appropriate. As a result of the diverging policy stances, we prefer to be sellers of AUD/CAD on strength. The pair has been trending lower over the past couple of months and the recent rebound towards the top of the bear channel and 21-day SMA may provide a short opportunity. A sustained break above the 1.03 figure may see towards the 200-day SMA around 1.04 and a move above that would negate our bearish view.
The SNB talks tough on the Swissie
The new head of the Swiss National Bank Thomas Jordan last week gave one of the biggest hints since he was confirmed as the SNB President that the Bank could take further measures to stem Swissie strength when he said that the Swissie was still overvalued with EURCHF at 1.20. He also added that should the economic outlook and threat of deflation require it, the Bank would “at any time” take further measures to weaken the franc. However, Jordan didn't elaborate on the type of measures the bank could take.
Jordan, speaking at the SNB shareholder meeting, said that the Swiss economic outlook remained challenging and that debt turmoil in Europe is the biggest risk. He referenced the EURCHF dip below the 1.20 floor earlier this month, but said it was due to market idiosyncrasies.
Although the leading economic indicator for Switzerland, known as the KOF, rose in April, it remains well below its historic average. We continue to believe that the weak inflation outlook is what could spur the SNB to action. It already expects inflation to decline 0.6% this year, so any further deterioration could spur action.
Traditionally the Swissie has been the ultimate safe haven and EURCHF would be expected to be bid during the Eurozone debt crisis, but the SNB floor has halted this. Now the safe haven of choice is the yen, and USDJPY managed to weaken on the back of the Spanish credit rating downgrade even though the Bank of Japan added another 10 trillion yen to the economy as part of its Asset Purchase Programme. Thus, if the SNB fails to react to stem Swissie strength going forward we could see a sharp weakening in EURCHF.
Is the UK economy really that weak?
The UK slipped back into recession in the first quarter of this year; however the big news was that the markets barely blinked. The economy shrank by 0.2%; the market had been looking for a 0.1% expansion. However, after a slight wobble the pound recovered well and continues to look comfortable above 1.60 versus the dollar. Likewise, Gilt yields also remain low.
So why was the market reaction so muted? One possibility is that the GDP figures don't reflect the underlying strength of the UK economy. Thus, headlines that the UK was returning to the gloom of the 1970's could be misleading. The GDP data diverged from recent PMI surveys, which pointed to expansion in both the manufacturing and services sectors. Added to this retail sales in March were also given a boost by warm weather.
The GDP number for Q1 was dragged lower by a 3% contraction in the construction sector, however equally worrying was the measly 0.1% rise in the services sector over the first three months of the year, which makes up 70% of our economy. It is certainly possible that GDP figures could be revised higher, especially for the construction sector; however, in recent years GDP revisions have more often been revised lower rather than higher and tend to be in the direction of the economic cycle.
Thus, we wouldn't expect any surge higher in the GDP data from revisions alone, even though the first reading was only made up of 40% of the market data. The UK economy is still extremely fragile. The construction sector tends to do badly when people are worried about the economic outlook and fiscal austerity combined with the Eurozone debt crisis could still weigh on growth going forward. Looking ahead to this week, the key data releases will be the PMI surveys. The result for the construction sector is expected to moderate but remain in expansion territory this month at 54.5, while the manufacturing sector is expected to come in at 51.5, which suggests that the economy has strengthened in recent months after a weak start to the year.
The question we have to ask now is will the weak growth data be enough to change the Bank of England's recent shift to a more neutral stance on monetary policy? Earlier this month Adam Posen, a long-term dove on the Committee, failed to vote for more QE, suggesting that the dovish camp was weakening. This helped sterling to rally strongly and it broke above the key 1.60 level versus the dollar. Thus, going forward, any sign that the Bank is starting to get concerned that the UK economy is weakening could weigh heavily on the pound. We will have to wait until next month when the Bank meets and when it releases its next Inflation Report that will include growth and inflation forecasts to find out just how worried the BOE is. Until then we believe the pound will continue to trade with a fairly bullish bias especially versus the euro and the dollar.
The Eurozone's growth pact
It was an eventful week for Europe after the Socialist candidate Hollande beat incumbent Sarkozy in the first round of the French Presidential election, the Dutch government collapsed and Spain's sovereign credit rating was downgraded. There was a common theme that linked all of these events -the European Union's Fiscal Pact.
Hollande campaigned on an anti-austerity, anti-Fiscal Pact ticket, likewise, the Dutch government collapsed because the various parties within the coalition could not agree on how to reduce the fiscal deficit to 3% of GDP next year. Spain was downgraded from A to BBB+ with a negative outlook in part because of the significant risks to Spain's growth outlook. ECB President Mario Draghi suggested that there should be a growth pact that runs alongside the Fiscal Pact in a meeting last week, and the events of recent days suggest action is urgently needed otherwise the Eurozone could tear itself apart.
There is already a deadline for Europe to come up with a roadmap to boost competitiveness and implement structural reform, which is the 18-19 June at the G20 meeting in Mexico. However, the risk is that this type of “growth pact” won't deliver the goods. Reform does need to take place, but it takes years to be effective and countries like Spain, where the unemployment rate surged to 24.44% in the first quarter of the year, is running out of time and needs to see growth in a matter of months or risk needing a bailout.
An effective growth pact, in our view, would include some sort of transfer from the rich north to the south. For example, this could be a transfer of interest rates. If the ECB stepped in and bought peripheral sovereign debt it should reduce pressure on Spanish bond yields, while reducing the attractiveness of German Bunds as a safe haven causing German yields to rise. The second would be to reverse some of the trade flows from the North to the South, so that companies in Spain were incentivized to produce goods that Europe's financially strong member states want. The last thing would be to aid the movement of labor around the currency bloc, so unemployed people in Spain could find jobs in Germany which has a strong labor market. This growth pact is idealistic, but imbalance within the Eurozone has been a major cause of this crisis and unless it is addressed the currency bloc may not survive.
The sticking point is that Angela Merkel is unlikely to sign up to a growth pact that requires sacrifices from Germany. So if she wants to shape what the currency bloc's growth strategy looks like then there could be more years of pain and austerity to come for Europe's weakest states.
The ECB meeting along with PMI data and retail sales are the main things to watch out for next week. Spain is also selling 3 and 5-year debt on the 3rd May, which is likely to attract attention especially since 10-year bond yields have been hovering above the 6% level in recent weeks.
The ECB meeting could add to any data disappointments as we don't expect the Bank to announce any fresh measures to ease sovereign tensions when the meeting takes place next Thursday. This could weigh on the euro, which traded well at the end of last week versus the dollar. However, above 1.3250 we tend to think that 1.33 may be the high for this pair.