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Could the Eurozone be Turning a Corner?
- Could the Eurozone be turning a corner?
- A short lived recovery for the GBP
- RBNZ sticks to its hawkish bias
- Digesting US data
- RBA likely to pause for now
- Could the Eurozone be turning a corner?
As European markets closed on Friday EURUSD surged to close to 1.37 versus the dollar and close to 127.00 versus the yen, the highest level since November 2011. There were a few drivers for the move higher in the euro last week: 1, strong stock markets, which boosted trader sentiment for the risky end of the FX market and 2, some signs of stabilisation in the Eurozone economy.
January manufacturing PMI data was revised higher for the currency bloc as a whole to 47.9 from 47.5, which is the strongest reading since February 2012. The country details showed large increases in manufacturing activity in the periphery including Spain and Italy. Although new orders and the orders to inventory ratio both improved in January, the employment sub-index declined further. However, the employment index is a lagging economic indicator so if we see further increases this year then we could see employment start to pick up in the coming months.
The unemployment rate backed away from a fresh record high and remained steady at 11.7% in December, defying forecasts for a move to 11.9%. There were bright spots in Germany, but more surprisingly was the 39,000 decline in the number of unemployed people in Spain, the first decline since April 2011. Inflation also eased in January falling to 2% from 2.2%, largely due to a sharp decline in energy inflation. This is good news for the consumer in the medium term.
But within this good data there are still some potential obstacles on the road to sovereign recovery and full economic growth. The first of these is France. It is rapidly falling behind the rest of the currency bloc. Its manufacturing PMI reading is one of the lowest in the bloc at 42.9, and its manufacturing output is declining sharply, only just managing to stay above 40.00 at the start of the year. Added to that, unemployment rose by 32,000 in December, pushing the unemployment rate up to 10.6%. In the last three months France has resembled a peripheral economy, but now it looks like it could start to lag behind the likes of Italy and Spain. Since it is the second largest economy in the currency bloc and is thus a major contributor to the bailout fund, its economic demise could de-rail the sovereign recovery.
The second problem area is the banks. Financial conditions in Europe may have improved over the last 6 months, as you can see in peripheral bond markets and in the valuation of the euro, but the banking sector is still struggling. Some of the currency bloc's largest banks had to make large write downs on asset disposals in Q4 2012 including Credit Agricole and Deutsche Bank, a Dutch bank SNS Reaal had to be nationalised and bailed out to the tune of EU3 billion on Friday, and Spanish banks saw their bad loan ratios rise even more in the fourth quarter. Even though banks are still writing down bad loans that linger on their books, some Spanish banks are also repaying their OMT loans, including Spanish lender BBVA, who saw its bad loan ratio rise to more than 5% in Q4, but who repaid two thirds of its LTRO loans to the ECB this month.
A rush to pay back emergency LTRO loans from the ECB could hurt the "green shoots" of recovery we are seeing in the currency bloc. For example, the ECB's bank lending survey for Q4 showed a larger than expected tightening in lending standards for households and firms. The LTRO and OMT programmes were designed to help improve the transmission mechanism of funds from the banks to the real economy. This data shows that the transmission mechanism is far from fixed and could require more loans and monetary support from the ECB down the line.
One of the reasons for the euro's surge in recent weeks is the shrinking ECB balance sheet, which has fallen more than 5% since its peak. This compares with the Fed's balance sheet which hit a record $3 trillion last week. But if the ECB is forced to increase the size of its balance sheet in the coming months then the euro is at risk from a major pullback. We will be watching the ECB meeting closely this week to see if the ECB makes reference to lending standards in the region and if the Bank sounds worried about the pace of LTRO loan repayment.
But while there are many pitfalls for the Eurozone, the euro rally last week was fast and furious after it passed through the 200-week moving average at 1.3485 - a very bullish development for this cross. The dips have been shallow, which suggests to us that the bulls have control for now. Although this cross is starting to look overbought, the weekly close above 1.3650 could see an extension of the EURUSD rally to 1.38 in the medium-term.
A short lived recovery for the GBP
The pound tried to recover last week but unfortunately rumours of an imminent downgrade to the UK's triple A credit rating on Friday put paid to a move above 1.5900. We still believe that GBPUSD could fall back to 1.53 in the medium term - the lows from mid-2012.
Next week sees the Bank of England meeting. We don't expect any change in interest rates or in QE, and we expect the minutes, released later this month, to be more interesting. In terms of economic drivers next week the service sector PMI is the release with the most potential impact on GBP. Although the headline PMI Manufacturing survey fell to 50.8 from 51.2 in December, there were some encouraging details in the report including the output sub index, which rose to 54.2, the highest level since mid-2012. The frustrating thing for the UK's manufacturers is that export orders remain weak. For this sector to really pick up in the coming months we may need to see a sustained fall in the pound to make UK goods more attractive aboard.
Overall, the pound still remains sensitive to the UK's economic outlook, and the next big event risk for sterling could be a ratings downgrade.
Chart 1: GBPUSD - the recovery was fairly shallow and petered out by the end of last week
One of the best performers in the FX space this week was the Kiwi. Since the start of the rally in the euro and stocks the kiwi has easily outpaced its rivals in the commodity bloc of currencies.
The 2% gain in NZDUSD last week was driven by a more hawkish than expected RBNZ. The fact the Bank is sounding relatively hawkish should not be surprising, the New Zealand economy is extremely sensitive to the global economic cycle. Thus, the recent uptick in the fortunes of the global economy is likely to keep the RBNZ on alert for inflationary pressures. Interestingly, the Kiwi could become a victim of its own success, the RBNZ intervened (albeit in a very small amount) at the end of 2012 to try and limit the strength in its currency, added to that at its meeting last week it mentioned the strength of the kiwi as a key risk factor for the economy. With more and more central banks becoming active in controlling their currencies, we are putting the NZD on the watch list for potential action by the central bank in the coming months.
The key event risk for the kiwi next week is Q4 unemployment released late London time on Wednesday 6th February. This is expected to show a 0.2% drop in the unemployment rate to 7.1%, and fairly moderate wage gains. A strong report could push us above 0.8500 - a key resistance zone - in the short term.
Chart 2: NZDUSD daily
This past week saw a slew of top tier data out of the US including GDP, an FOMC meeting and key housing and labor data. While headlines readings may suggest misses when compared to the consensus forecasts, details of the various reports look more encouraging. Earlier this week, headline GDP figures shocked markets with an unexpected contraction of -0.1% q/q annualized in 4Q. This was a far miss from the market consensus of +1.1% and a sharp decline from the prior +3.1% growth in Q3. The negative growth was due to the largest drop in government defense spending since 1972 as well as weakness in inventories. Personal consumption was relatively strong with an increase of 2.2% in 4Q, representing a roughly 1.5% contribution to GDP. Government spending remains a key uncertainty as Congress debates ahead of potential sequestration and weakness in inventories is not likely to persist, in our view. As such, we think that the risk of a US recession is low and anticipate a rebound in activity in Q1.
The January US employment report was released this morning and the headline came in slightly below market expectations of 165K with a print of 157K. The unemployment rate unexpectedly ticked higher to 7.9% to 7.8%. On the surface the figures look uninspiring however a closer look at the data shows upward revisions to the previous 2 months that add a combined 127K. Furthermore, these revisions bring the 3-month average in headline NFP to 200K.
St. Louis Fed President and FOMC voting member Bullard called the jobs report an "encouraging sign" and hinted at a possible change in the Fed's asset purchase program. Bullard said that QE might be tapered to $75B per month from its current pace of $85B and indicated that a jobless rate in the "low 7's" may let the Fed end QE. To be sure, Bullard is known to be hawkish and his comments should be viewed in this light. Also the unemployment rate has been stubbornly high at levels of around 7.8-7.9% since September and "low 7's" may be far off without a sustained pickup in job growth.
However one of the more notable doves on the Committee, NY Fed President Dudley, also had an upbeat outlook to recent market developments. Dudley's commentary focused more on external developments and he indicated that the improving global economy is helping the US outlook. The USD traded softer on the week against all of the G10 currencies except for the GBP and the JPY while equity markets were boosted by positive sentiment. We expect that longer term trends will remain intact but with a slowdown in the US economic calendar next week, consolidation in the greenback may be likely.
RBA likely to pause for now
The Reserve Bank of Australia (RBA) will announce interest rates on Tuesday February 5 and we agree with the consensus that the benchmark rate is likely to remain on hold at 3.00%, for now. Therefore, the tone of the statement will be important and will likely be the main driver of price action. At its last meeting on December 4, the RBA reduced interest rates by 25bps. The Bank noted risks to the outlook for global growth and, in particular, the debt crisis in Europe.
Since the last meeting European financial conditions have improved markedly as tail risks have receded. Chinese economic activity has picked up and the fiscal cliff in the US has been avoided (although uncertainty still remains around the sequestration). Admittedly, Australian domestic data has disappointed. GDP growth has slowed, the trade deficit widened, retail sales declined, and the unemployment rate ticked higher. Consumer prices in 4Q show slowing inflation, but still inflation rates remain within the RBA's target range. Despite the weaker domestic picture the Bank is likely to pause, at least for now, as it monitors the effects of recent easing. As noted by the Bank, "the full effects of earlier measures are yet to be observed" and we think this indicates the RBA's preference to sit on the sidelines for now.
We expect more easing from the RBA in the coming months which is likely to keep upside in the AUD limited. Derivatives markets show that a cumulative 25bps of rate cuts are priced in by the April meeting. Technically, AUD/USD looks vulnerable as it has broken below a long-term rising trend line support. The trend line dates back to the lows of 2012 and the pair broke below the upward trend line towards the end of last week. This week saw a retest of the trend line as resistance and AUD/USD was subsequently rejected. Currently, AUD/USD is testing the 100-day simple moving average (SMA) and a close below could see further downside toward the 200-day SMA around the 1.03 figure. If the tone of the RBA statement hints at the possibility of future rate cuts, AUD could come under renewed pressure, while more of a neutral stance by the Bank could see AUD rebound. The key pivot to the topside is the 1.06 level which is a long term horizontal resistance.
Chart 3: AUDUSD Daily