WEEKLY OUTLOOK - Week of March 27, 2011

Highlights
Risk appetite stays resilient
Rate expectations driving the euro amid a deteriorating periphery
Storm clouds gather on the UK’s economic horizon
Is AUD strength here to stay?
Key data and events to watch next week
Risk appetite stays resilient

Despite the global tumult from Japan, Libya, Portugal and elsewhere, investors seem to be embracing risk on the basis that the global recovery is on-going, as we suggested in last week’s update. The S&P 500 stock index in the US has regained about ¾ of the decline since Feb. while the Nikkei 225 in Japan has recouped just over half its post-tsunami collapse. The CRB commodities index has also regained about ¾ of recent declines. And the drop in US Treasury yields has now reversed sharply over the past week, with 10-year yields now up around 30 bps from recent 3.15% lows reflecting both reduced safe haven buying and increasing talk from Fed officials that QE3 is not on the table. We expect other Fed speakers to echo this sentiment and so we reckon with a further back-up in US rates.

Normally, a risk-on environment is frequently USD-negative, but against the backdrop of rising US rates, the buck may fare a bit better. In particular, we look for JPY-cross strength to re-emerge in the weeks ahead, barring any other unforeseen global calamities. Higher JPY-crosses, like AUD/JPY, CAD/JPY and EUR/JPY, could result from USD weakness against all but the JPY, with higher US rates supporting a higher USD/JPY. We will keep an eye on recent range highs in those JPY-crosses and a break above them will be a signal to us additional gains are in store.

Next week’s action will be dominated by month-end liquidity and asset manager reallocations, so the price action could remain extremely choppy in the USD pairs, so we suggest paying extra attention to the JPY-crosses, which may display more of a trending pattern. Next week concludes with March US employment data and we expect the report to be generally positive for risk sentiment in that job creation has reached more supportive levels, though still not enough to seriously dent the unemployment rate.

Rate expectations driving the euro amid a deteriorating periphery

This past week, the euro shrugged off seemingly negative developments and continued its ascent despite ratings downgrades in the periphery and a delay in concrete policies regarding the short term EFSF. The longer term ESM will still accumulate 80B euro in paid-in capital, however the payments have been stretched to 16B euro per year over 5 years. S&P downgraded Portugal’s rating which came after a downgrade by Fitch and the downgrade of 30 Spanish banks on Thursday did little to weigh on the common currency.

The rejection of the Portuguese austerity plan not only raises uncertainty about the government with the resignation of Prime Minister Socrates but greatly increases the likelihood that the nation will require a bailout. The EU’s Juncker stated, “the uncertainties concerning Portugal aren’t unknown uncertainties,” and noted “if ever the Portuguese government decided to ask for European aid, the instruments are now at hand to help Portugal”. Talk of austerity and contracting GDP in the periphery did little to change investors’ views on monetary policy as the debt concerns appear to be compartmentalized.

Several ECB officials have recently stated that the bank maintains a clear separation between its monetary policy and unconventional liquidity measures. As such, the market remained focus on inflation and ECB rate expectations which continued to drive the euro higher. A rate hike at the next ECB meeting in April is largely priced in and as such the risks are to the downside. Following the April ECB decision, slower overall growth or lower levels of inflation may deter the bank from starting a tightening cycle and may be met with euro selling.

The market is currently anticipating about 100bps in rate increases over the next 12 months. Technically, the 1.4250/80 area is the highs of November ’10 and March ’11and remains the key resistance level to the upside. A sustained break above here is needed to see further upside potential. The daily Tenkan line currently comes in around 1.4050 and may provide support ahead of the psychological 1.4000 figure. Below here may see a deeper correction towards the Kijun line which is currently around the 1.3885 area.

Storm clouds gather on the UK’s economic horizon

It’s a quieter week for the UK after last week’s Bank of England minutes, a Budget and retail sales dominated the headlines. All three weighed on the pound, which is set to drop more than 1 per cent on a broad based basis at the week’s close.

Two things are dragging the pound lower: firstly, a deterioration in the economic outlook and secondly, a narrowing of the UK’s interest rate differential as investors start to price out the chance of near-term rate hikes from the Bank of England. For example, the market now expects the first hike in August, previously this had been May.

The growth outlook included in Wednesday’s Budget was revised lower for this year to 1.7 per cent, but the risks are to the downside. Fiscal consolidation and the harshest public spending cuts since World War Two don’t get going with a real gusto until this year, yet growth is already starting to falter. Retail sales fell by 1 per cent in February, dragging the annualized rate to a meager 1.2 per cent. This is lackluster at best and extremely worrying for an economy that relies on consumption for 70 per cent of its growth.

From April everyone who works in the UK will be subject to a higher rate of social security and the 40 per cent tax rate also kicks in earlier at GBP35, 000, compared with GBP37, 400. This is going to add to the squeeze on household incomes and further dents the growth outlook.

Added to this, although the Budget figures suggest that the UK will reach its long-term fiscal targets to virtually eliminate the deficit by 2015/16, because of the UK’s elevated headline inflation rate borrowing will be higher next year. The problem with the UK’s inflation is that it isn’t feeding into wage growth, so income tax revenue has not been increasing as one expects during periods of high inflation, yet social welfare payments and pensions are all indexed to consumer prices, which is aggravating the weak public finances.

Chancellor Osborne is sticking to his guns and continuing with his ambitious fiscal targets for this parliament. But if a slowdown in growth triggers a delay in the UK’s debt reduction plans the its sovereign credit rating will be threatened, Moody’s the credit rating agency warned last week. Osborne is keen to avoid this, so whichever way you look at it storm clouds are gathering on the UK’s economic horizon.

While Budgets tend to have muted impacts on financial markets, the pound’s decline was initially fuelled by the minutes of the last MPC meeting. Committee members voted 6-3 to keep rates on hold earlier this month, so the hawkish threesome had failed to draw anyone to their side. More interesting was the uncertain tone to the minutes, which suggests that the MPC are firmly in wait-and-see mode until they get a clearer picture for the outlook for growth.

This was reinforced when Spencer Dale, the Bank of England’s chief economist who voted for a rate hike earlier this month, said that he could be persuaded to swing his vote away from a rate hike if the recovery disappoints.

This has weighed on sterling crosses, especially EURGBP. Currently the market is pricing in nearly 100 bp of rate hikes in the Euro-area over the next 12 months, which compares with 75 basis points for the UK, boosting the cross. If we get a weekly close above 0.8810/20 then 0.8900 – the October highs come into focus before 0.9150 – the March 2010 high.

Is AUD strength here to stay?

AUD/USD strengthened to record post-float levels just short of the 1.0300 figure as risk stabilized into the close of the trading week. Subsiding concerns over Japan’s nuclear crisis played a role in broad based commodity upside this week and subsequent AUD strength. However, recent Aussie strength has also been driven by improving risk sentiments on the back of optimistic global growth prospects stemming from declining tightening expectations on a global basis, sans ECB.

Expectations for an RBA hike have been gradually scaled back with some market participants now expecting tightening to begin as late as Q1 2012. At the surface, it seems contradictory that the possibility of a less rapid appreciation in an economy’s target rate would see a concurrent strengthening to its respective currency. However, the situation in Australia and its surrounding region is quite complex. The near term growth outlook in China remains firm while Japan’s near term outlook seems bleak. Japanese Q2 ’11 GDP is likely to suffer directly from production disruptions as a result of the earthquake.

However, medium term Japanese growth may rebound as rebuilding efforts are likely to have an inflating effect on Q4 Japanese GDP. The significance of this potential scenario lies within the realm of coal. 2H 2011 Japanese coal demand is likely to firm due to reconstruction efforts but coal demand on a global basis may benefit further from mounting public and political pressures as a result of the recent nuclear crisis in Japan. As Australia is one of the world’s top coal producers, expectations for firm 1H 2011 coal demand out of China and the potential for even firmer demand in 2H 2011 have also played a role in record AUD strength.

The main risk to extended Aussie strength, however, is Aussie strength itself. Higher coal prices may see Australia’s terms of trade reach record levels and should eventually pressure the RBA to restart a tightening cycle. While developed economies are behind the curve relative to emerging market economies in terms of tightening, higher commodity prices for extended periods is likely to see developed economies eventually play catch up – including the RBA. The likely result of semi-coordinated global tightening direction in response to higher prices may weigh on AUD as rate differentials may remain near current levels but commodity demand may see substantial declines.

We think near term AUD/USD strength may continue considering recent risk stabilization as well as the technical breakout above prior post-float highs. However, we maintain a cautious medium to longer term AUD/USD outlook on the potential for commodity demand deterioration resulting from central bank policy responses to higher prices.

Key data and events to watch next week

Unites States:

Monday – Feb. PCE, Feb. Personal Income & Spending, Feb. Pending Home Sales, Mar. Dallas Fed Manufacturing Activity, Fed’s Lockhart, Evans and Rosengren Speak

Tuesday – Fed’s Bullard Speaks, Jan. S&P/CaseShiller Home Price Index, Mar. Consumer Confidence

Wednesday – Mar. MBA Mortgage Applications, Mar. Challenger Job Cuts, Mar. ADP Employment Change, Weekly DOE U.S. Crude Oil Inventories, Fed’s Bullard, Lacker and Hoenig Speak

Thursday – Weekly Initial Jobless & Continuing Claims, Mar. Chicago PMI, Feb. Factory Orders

Friday – Mar. Employment Report, Fed's Plosser Speaks, Feb. Construction Spending, Mar. ISM Manufacturing & Prices Paid

Euro-zone:

Tuesday – German Apr. GfK Consumer Confidence, ECB’s Mersch Speaks, German Mar. Prelim. CPI

Wednesday – Mar. EZ Consumer, Economic, Industrial and Services Confidence

Thursday – German Mar. Unemployment Rate, Euro-Zone Mar. CPI

Friday – EZ Mar. final PMI Manufacturing, EZ Feb. Unemployment Rate

United Kingdom:

Tuesday – 4Q Final Total Business Investment, 4Q Current Account, 4Q Final GDP, Feb. Net Consumer Credit, Feb. Mortgage Approvals, Feb. M4 Money Supply

Wednesday – Jan. Index of Services, Mar. CBI Reported Sales, Mar. GfK Consumer Confidence

Thursday – Mar. Nationwide House prices

Japan:

Tuesday – Feb. Jobless Rate, Feb. Retail Trade, Feb. Large Retailer Sales, Mar. Small Business Confidence

Wednesday – Feb. prelim. Industrial Production

Thursday – Mar. Manufacturing PMI, Feb. Labor Cash Earnings, Feb. Housing Starts, Feb. Construction Orders

Friday – 1Q Tankan Large All Industry Capex, 1Q Tankan Outlook

Canada:

Monday – BoC’s Boivin Speaks

Wednesday – Feb. Industrial Product Price, Feb. Raw Materials Price Index

Thursday – Jan. GDP

Australia & New Zealand:

Tuesday – NZ Finance Minister English Speaks, NZ Feb. Imports, Exports and Trade Balance

Wednesday – NZ Building Permits, AU Mar. DEWR Skilled Vacancies, AU Feb. HIA New Home Sales, AU Feb. Job Vacancies

Thursday – AU Feb. Building Approvals, AU Feb. Retail Sales, AU Feb. Private Sector Credit, RBNZ Mar. Activity Outlook & Business Confidence

Friday – NZ 4Q Manufacturing Activity, AU Mar. Performance of Mfg Index, Mar. RBA Commodity Price Index

China:

Friday – Mar. PMI Manufacturing

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WEEKLY OUTLOOK - Week of March 13th, 2011

Highlights
EU competitiveness pact may disappoint
Fallout from Japanese earthquake
Spain gets a wakeup call
Central banks expected to maintain policy rates
A mixed picture in China, but further tightening is still needed
Key data and events to watch next week
EU competitiveness pact may disappoint

Without the final details in hand as of late Friday afternoon, we can’t be sure of the ultimate reaction, but price moves ahead of the release of the EU pact suggest markets are going to be underwhelmed. The draft of the pact suggested that no concrete rules will be established and that individual governments will operate on a ‘best efforts’ basis to rein in debts and deficits and stimulate growth. The only enforcement mechanism will be discussions between member states. If the final pact follows these outlines, markets are more likely, in our view, to voice disapproval. Indeed, in the run-up to Friday’s summit, peripheral-EU bond spreads widened to near crisis peaks from last year, suggesting many still expect defaults and restructurings to follow. Alongside threats to the global recovery emanating from MENA and China, and now Japan, we think the downside for the Euro is vulnerable and we will view a break below the 1.3730/50 daily Kijun line/weekly low/21-day mov. avg. as an indication of a Euro likely headed back toward 1.3500/50 in the near-term. Should the pact contain more disciplined measures, then we would expect to see some further recovery in the single currency, but think it should remain below 1.4000, as growing risk aversion limits the upside.

Fallout from Japanese earthquake

The massive earthquake and tsunami in Japan on Friday undermined risk sentiment further and this led to JPY-strength as JPY-shorts were rapidly covered. There has been talk of Japanese repatriation of funds to cover insurance costs, but we think this is likely overstated and that risk aversion is the better explanation. The tragedy there is still unfolding, with additional earthquakes registering through Friday night, and no estimates of damage costs are available at the moment. However, given the largely agricultural nature of the affected region, we don’t think the impact to Japanese GDP will be especially severe, but that’s not saying much as Japanese growth already turned negative in 4Q. While we think the near-term pressure will remain on USD/JPY, we don’t think the pair will test the pivotal 80.00 level and seems most likely to find a base in the 80.50/81.50 area in coming weeks. We think the MOF will seek to avoid a further surge in the JPY which would add fresh burdens to the Japanese recovery. The BOJ is meeting at the start of next week and may announce emergency measures such as additional asset purchases, which could see the JPY weaken sooner. The government will also likely soon pursue a supplementary budget to pay for clean-up and reconstruction, and this may revive fears over the size of Japan’s debt burdens and also cause the JPY to weaken.

Spain gets a wakeup call

There are growing signs that the market is losing patience with the EU authorities who have failed to come up with a credible, long-term solution to the region’s sovereign debt crisis. As EU leaders gathered for a summit in Brussels at the end of last week, the markets had low expectations that an effective solution would be found. Bond yields spiked to euro-era records for Ireland and Portugal; Spain and Italy were not immune either as the risk premium to hold their government debt also increased.

The downgrade of Spain’s sovereign credit rating by Moody’s to Aa2 from Aa1 at the end of last week focused the markets’ attention back on Europe’s troubled banking sector. A third round of bank stress tests is scheduled to be conducted in the next few months. On 18th March the EU authorities will publish the macro economic scenarios and the sample of banks that will undergo the tests. This is key for the market as it will determine whether the tests are strong enough to really give a true snap shot of the bad debts and recapitalization needs of some of Europe’s most troubled lenders, particularly the Spanish Caja banks. More details will follow in April when the stress test methodology is disclosed and then in June when we finally get the results.

There is no doubt that the EU authorities have made a hash of dealing with their financial problems. It has taken three rounds of stress tests to try and make sense of the bad debts still swimming in Europe’s financial system.

Investors will only be happy once they know exactly how bad the problems are. When the US published devastating results of their bank stress tests in 2009 it was greeted warmly by the markets and led to a stock market rally. Investors will only be happy to hold assets from Europe’s periphery if they can accurately calculate the risk of doing so. Right now they are guessing that things are worse than the authorities are saying, hence bond yields are rising to unsustainable levels. If the truth was out there then bond yields may even start to moderate. Until the full extent of the debt crisis is known there can be no remedy. If the results of the tests are published in June, then a solution is unlikely to be found until the end of the year.

By that time Portugal is most likely to have applied for bailout funds, while Spain just about avoids doing so. But there is a lot of pressure on the larger of the two Iberian nations. Although debt issuance in 2011 is only about 80 per cent of what it was in 2010, Spain still has to tap the markets for an enormous EUR600bn or more for the rest of this year. Doing so at the same time as the bank stress tests are taking place could test investors’ patience. If Spain’s banks require significantly more capital than the EUR 20bn the Spanish authorities have disclosed then its debt could be significantly harder to sell to foreign investors who have already been cutting back on their exposure to the weaker Eurozone states.

The euro has brushed off sovereign debt woes in the past, but they are increasingly weighing on the single currency. It fell back to the 1.3800 level versus the dollar at the end of last week, and the key 1.4000 resistance level is unlikely to be broached for the time being. Technically EURUSD is still in an uptrend above 1.3535 – the top of the Ichimoku cloud, but it has fallen sharply and if we don’t get a bounce somewhere between 1.3600 and 1.3700 then we could see a sharper decline over the coming months, especially versus the greenback.

Central banks expected to maintain policy rates

Several central banks will meet to determine policy in the week ahead. The Federal Open Market Committee (FOMC) will meet on Tuesday March 15, the Norges Bank will meet on Wednesday March 16, and the Swiss National Bank (SNB) is scheduled to meet on Thursday. All of these banks are expected to keep policy rates on hold with the Norges Bank the most likely to surprise with a hike, however we do not anticipate a move on rates.

In the U.S., the Fed has maintained the language that the bank will keep rates low for an ‘extended period’ and the large scale asset purchase program of $600B through June has a ‘high hurdle’ before altering the plan. While the unemployment rate has dropped slightly, labor data suggests that the recovery may not yet be self-sustaining. Additionally, the CPI has ticked upwards slightly but remains at comfortable levels last released at 1.6% YoY on the headline reading and 1.0% YoY for the core measure. This evidence suggests no change in policy at the Tuesday meeting.

The Swiss National Bank (SNB), whose primary mandate is to ensure price stability which it defines as inflation below 2% is likely to maintain rates at 0.25%. Recent data indicates February CPI at +0.4% and a drop in the unemployment rate from January’s 3.8% to 3.6% in February. SNB President Philipp Hildebrand recently noted that the strong franc lowers inflationary pressures in the near term however the bank noted the need to fight inflation over the medium and longer term as it sees its price stability threshold being breached in 2013.

The Norges Bank has signaled that it will resume tightening by the middle of 2011. The bank last raised rates in May and has provided guidance through the end of 2014 and expects its benchmark rate to average 2.25% this year and 3.25% next year. This indicates an expected 25bps hike each quarter from June 2011 until the end of 2014. Thursday’s release of February CPI showed a slowing to +1.2% from the prior month’s +2.0% which is supportive of no change in policy at the upcoming meeting.

A mixed picture in China, but further tightening is still needed

The past week of data released out of China has confounded many market participants. On one hand the February data showed elevated risks to inflation – Feb. PPI was 7.2% vs. expected 7.0% yoy and Feb. CPI was 4.9% vs. expected 4.8% yoy, however on the other Feb. Retail sales came in much weaker at 15.8% yoy and Feb. Trade balance turned negative for the first time in 11 months coming in at -7.31B vs. expectations of +4.9B. Finally it appears their efforts to slow the rapid rise in real estate is beginning to have knock-on effects, however a considerable amount of this may also be attributed to a robust Chinese new year.

In the end, China still has been unable to control the more pressing issue, inflation. While food prices remain the main driver of CPI (which have somewhat moderated of late), higher energy and commodity prices continue to remain the underlying concerns to PPI. Moreover, we’ve seen that commodity pricing pressures tend to lead Chinese PPI, and with crude oil and industrial metals near their respective highs, rising inflation looks like it’s a problem unlikely to go away anytime soon. Therefore, we believe the PBoC will continue to remain active over the coming weeks/months, with our central case looking for two further interest rate hikes, in sum 50bps, before the end of June. We also envision additional RRR hikes in order to further withdrawal liquidity from their financial system.

As China tightens to manage liquidity and control inflation, we may see periodic setbacks in risk sentiment as well as dips in commodity prices and the prices of commodity linked currencies (AUD, CAD, and ZAR), however we believe such pullbacks are likely to be relatively short lived and should be viewed as potential buying opportunities.

Key data and events to watch next week

United States: Tuesday- March Empire Manufacturing, Feb. Import Price Index, Jan. Total Net Tic Flows, March, NAHB Housing Market Index, FOMC Rate Decision Wednesday- MBA Mortgage Applications, Feb. Housing Permits, Feb. Building Permits, Feb. Producer Price Index, Q4 Current Account Thursday- Consumer Price Index, Weekly Jobless Claims, Feb. Industrial Production, Feb. Capacity Utilization, Feb. Leading Indicators, March Philadelphia Fed

Eurozone: Monday- Jan. EZ Industrial Production Tuesday- EZ Employment 4Q, EZ March ZEW Economic Sentiment, German March ZEW Surveys (Current Situation & Econ. Sentiment), EU Finance Ministers meet in Brussels Wednesday- EZ 4Q Feb CPI Thursday- EZ Jan. Construction Output Friday- EZ Jan. Current Account, Trade Balance, German Feb. PPI

United Kingdom: Tuesday- DCLG Jan. House Prices Wednesday – Feb. Claimant Count Change, Jan. Avg. Weekly Earnings, Jan ILO Unemployment Rate, Thursday – Feb. Nationwide Consumer Confidence

Japan: Monday- Jan. F Industrial Production, Jan. F Capacity Utilization, Feb. Consumer Confidence, Tuesday- BOJ Target Rate, Feb. F Machine Tool Orders, 1Q BSI Large All Industry, 1Q BSI Large Manufacturing, Wednesday- Feb. Tokyo Condominium, Jan. Tertiary Industry Index Thursday- BOJ Feb.16-17 Board Minutes Friday- Jan. F Coincident & Leading Index.

Canada: Monday- 4Q Capacity Utilization Rate Tuesday- 4Q Labor Productivity Rate Wednesday- Jan. Manufacturing Sales Thursday Jan. Int’l Securities Transactions, Jan. Wholesale Sales, Feb. Consumer Price Index, Feb. Bank Canada CPI Core

Australia & New Zealand: Monday- RBA March Minutes, Feb. New Motor Vehicle Sales, NZ REINZ House Sales (3/14-16) Tuesday Jan. Westpac Leading Index, 4Q Dwelling Starts Thursday: RBA Foreign Exchange Transactions, NZ 1Q Westpac Consumer Confidence

China: March 13-18- Feb. Actual FDI, March 13-15 Feb. New Yuan Loans, Feb. Money Supply (M0,M1,M2) Tuesday- Conference Board China January Leading Economic Index

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