Week of March 2, 2008

Highlights

• Dollar hammered by weak US data; breaks down out of range.
• How high can the EUR go?
• Multiple central banks rate decisions next week.
• Key data and events for next week.

Dollar hammered by weak US data; breaks down out of range.

After trading in a broad consolidation range for just over three months, the greenback plunged to new all time lows against the EUR, breaking above the key psychological/ technical 1.5000 level. Follow-through buying has been abrupt and this is the result of the relative suddenness of the break-a lot of speculative buyers were caught off guard-and the amount of option interest at/above 1.50 generating EUR/USD buying demand. The immediate catalyst on Tuesday was a string of worse-than-forecast US data reports (higher PPI, lower home price, and sharply weaker consumer confidence), but the move really got going after Fed Vice Chair Kohn suggested that the US housing slump had more room to go and that financial market stabilization would be more prolonged. In short, Kohn suggested that the much hoped-for recovery in the second half of 2008 was likely to be postponed. That prospect of light at the end of the tunnel had been helping to support the USD despite overwhelming expectations that the US economy was softening and US rates were headed lower. Once that light went out, the buck went with it. The USD decline, however, has not been evenly distributed against other major currencies and this gives cause to pause in getting universally bearish on the USD at this point. One currency with arguably the brightest prospects among the majors, AUD, with high interest rates, expectations for additional rate hikes and strong growth, both domestically and regionally, has so far managed only minor new highs beyond the 0.9400 high seen last fall. That is most likely due to the relatively high level of long-positioning and wariness over central bank intervention. GBP and CAD also stand out as being well below their earlier highs against the USD. To be sure, the USD is currently suffering through a deluge of weak data, which is likely to get worse before it gets better, but it's important to note that this move is largely concentrated in the EUR. More importantly, the notion that the major economies have de-coupled from the US has yet to bear fruit. The most that can be said is that there is a time lag, but the ongoing slowdown in the US will eventually affect other major industrialized economies. The most vulnerable currencies outside of the USD remain CAD, due to its close trade relationship with the US, and GBP, due to high household debt levels, weakening housing market, and expected rate cuts ahead. I would now add EUR to that list, given its recent sharp appreciation and the expectation that Eurozone growth reports will eventually turn softer in coming weeks and months. In the short-run, though, traders should reckon with further upside potential for the EUR as speculative players who missed the boat pile into the breakout on pullbacks and new highs.

How high can EUR can go?

In the very short-term, over the next couple of weeks, I think EUR/USD has the potential to see to the 1.5250-5300 area before most of the laggard buying interest is satisfied and medium-term selling interest begins to be felt. Fibonacci projections also point to the 1.5300/05 level as a likely point of technical resistance. Beyond the 1.5300 level, market attention is focused on the 1.5500 level as the next major 'round number' objective. The move higher in EUR/USD has been swift and persistent, to put it mildly. As I mentioned earlier, a lot of major speculative players missed the initial break-out move and have been forced to 'go to the market' as pullbacks have been minimal. This has seen fresh buying come in as new highs are made, a pattern which also reflects option books becoming shorter as EUR/USD advances, bringing in still more fresh buying. EUR/USD's upside will remain in play while prices hold above the 1.4950/70 prior high/breakout level and it would take a drop below the 1.4890 level to indicate a failure and reversal. The fundamental underpinnings of the move higher in EUR/USD are somewhat suspect given that much of the weak US data was previously thought to have been priced into the USD. But the decisive factor appears to be the unexpected outperformance of Eurozone data coinciding with a deterioration in US data during the last two weeks. Also, over the last several months, there has been a distinct tendency for the USD to weaken more in the second half of the month, due to the prevalence of US housing data clustering in the latter half, and that has certainly been the case this time around. There are multiple data risks to the USD in the week ahead, most notably the ISM manufacturing and services PMI's, the Beige Book, and Feb. NFP. But data risks exist for other currencies as well, most notably in GBP and CAD. I would also caution that if the US economy is weakening as much as feared, other major industrialized economies will be affected, with timing and degree the only questions. Keep in mind that European stocks remain mired in negative territory of between -12/14% YTD in contrast to US stocks, which are only down around -7% YTD. This suggests not getting too carried away with the current wave of USD weakness and instead looking for opportunities to sell other currencies likely to experience downturns in the near future. In terms of EUR strength, the sharp break higher this week risks bringing a response from Eurozone finance and central bank officials. Eurozone finance ministers will gather for a regular monthly meeting beginning Monday evening European-time. On Thursday the ECB will hold an interest rate setting meeting followed by ECB President Trichet's press conference. Eurozone finance ministers' views on EUR strength are still quite divided, with some (Belgium's Reynders and Luxembourg's Juncker) suggesting EUR strength is becoming a concern, while others (Netherland's Wellink) suggesting the EUR above 1.45 has not been the problem they expected. With opinion divided, a concerted effort to stem EUR strength seems unlikely, but not out of the question. Last fall, when EUR/USD looked poised to move over 1.5000, market surveys of investors indicated a heightened expectation of intervention if EUR/USD approached 1.55, with the risks increasing sharply above that level. At the minimum, look for Eurozone finance ministers to complain about 'excessive volatility' in exchange rates and the speed of the recent EUR increase.

Multiple central bank rate decisions next week

Except for the US and Switzerland, every other major central bank is holding a rate setting meeting next week. Below are my outlooks for the outcomes in order of the announcements. Australia-RBA decision is scheduled for Tuesday afternoon local Canberra time/early morning European time on Tuesday. Markets are nearly unanimous in expectations of a 1/4% rate hike to 7.25% and I agree. RBA rhetoric has been extremely hawkish and incoming data has been solid if not robust. The RBA statement following the decision is also likely to retain a hawkish slant and warn of additional rate hikes, but slower global growth is likely to obviate the need for that. The risk is clearly that the RBA delays, triggering profit-taking selling of AUD. Look for AUD to remains well supported into the decision and after if the statement is hawkish as expected. Canada-BOC is expected to cut rates, but the market is split between 1/4% and 1/2%. Given the alarm bells ringing at the Fed and the implications for the Canadian economy and with core inflation restrained at 1.4% YoY, I think new Gov. Carney is going to err on the side of providing more accommodation rather than less, so I expect the BOC to cut rates 50 bps to 3.50%. I look for CAD to weaken in the run-up to the decision on Tuesday morning, but primarily against non-USD currencies. New Zealand-RBNZ decision is out on Wednesday afternoon NY time/early morning Wellington. The market expects no change to the 8.25% benchmark rate and given recent declines in business sentiment, I'd have to agree. The risk for Kiwi is that Gov. Bollard then indicates that calmed inflation pressures may permit lower rates in 2Q, leading to a dip in NZD. UK-BOE will announce its decision early Thursday morning NY time. The market expectation is for a steady 5.25% rate, but I think ongoing credit market concerns and recent signs of slowing private consumption will push a slim majority of the MPC to cut rates 25 bps to 5.00%. I'm out on a limb with this one since most BOE speakers have gone out of their way to rein in expectations of lower rates in light of the threats from inflation. But inflation dropped sharply in Feb. and faltering growth is the far greater risk to the UK outlook. If the cut does materialize, GBP should get hit pretty hard, especially on the crosses. Eurozone-the ECB also announces on Thursday morning NY time and I expect no change to the ECB's 4.00% refi rate. Recent indicators suggest Eurozone growth is holding up reasonably well, though many forecasts have recently been reduced. Most importantly, ECB Pres. Trichet will again bang the inflation drum, threatening to raise rates to forestall inflation and keeping EUR supported. On the EUR itself, he will undoubtedly be pressed on the ECB's view of EUR strength, and I expect him to decry 'brutal moves' and vent on 'excessive volatility in exchange rates'. It seems unlikely that he will indicate any willingness to intervene to stem the EUR's rise, absent US Treasury support, but should he give such an indication, it's a sign that the rest of the governing council is concerned about EUR strength and the EUR will likely have made a key top. Japan-BOJ decision is due out on Friday afternoon Tokyo time and no change is expected. Japanese growth is stagnant, deflationary pressures persist, and the BOJ has no room to effectively lower rates. This one is a non-event and the JPY will continue to react to risk aversion and market volatility.

More US housing and other key data next week

US data is heavy again next week beginning with the Feb. ISM-manufacturing index, which is expected to slip below the 50 expansion/contraction line again, and Jan. construction spending. Tuesday sees only weekly ABC consumer confidence, which held steady at -37 this past week. Wednesday sees the Feb. ADP employment report, final 4Q non-farm productivity and unit labor costs, and then the key Feb. ISM service sector index and the Fed's Beige Book for the upcoming March 18 FOMC meeting. Thursday sees weekly jobless claims, Jan. pending home sales, and Feb. ICSC chain store sales. Friday sees the Feb. NFP employment report, currently expected to show an increase of 40K and a tick higher in the unemployment rate to 5.0% from 4.9%. Fed speakers are legion: Monday: Plosser and Kroszner; Tuesday: Bernanke, Mishkin and Fisher; Thursday: Pianalto and Rosengren; Friday: Poole, Hoenig, Fisher, Yellen, Mishkin and Kohn. Eurozone data begins with Feb. manufacturing PMI's and Eurozone Feb. CPI estimate. Tuesday sees Jan. Eurozone PPI and second revisions to 4Q GDP. Wednesday sees Feb. Eurozone service sector PMI's and Jan. Eurozone retail sales. Thursday sees Jan. German factory orders and the ECB rate decision. Friday sees Jan. German industrial production and Jan. OECD leading indicators. UK data begins on Monday with the Feb. manufacturing PMI. Tuesdays sees the Feb. construction PMI. Wednesday sees Feb. Nationwide Building Society consumer confidence, Feb. PMI for the service sector, and the Feb. BRC shop price index, a measure of retail price inflation. Thursday sees the BOE rate decision.