Dovish Fed and positioning drive strong Euro bounce
30/Jan/2012 • Currency Updates•
The common currency continued last week with the strong short-term bounce that we had been looking for, given the extreme bearish consensus that had developed among traders and commentators worldwide. This week’s move was sparked by the Fed meeting on Tuesday. US monetary policymakers surprised markets with the news that they do not expect rates to rise from near zero until 2015. This cheered markets, as investors poured into carry trades and risky assets and sold the US dollar. All four major central banks, ECB, Fed, Bank of England and Bank of Japan have made it clear that money will remain plentiful and cheap for the foreseeable future. We do not disagree with the move into risky assets, although we expect that the Euro rally will lose steam once the extreme short positioning among investors is cleared out. As of Tuesday, this process hadn’t even got under way, as the Commitment of Traders report from last week, shows yet another record short against the common currency among speculators.
The main macroeconomic news of the week out of the UK, GDP growth, came in a bit lower than expected, showing that the economy had shrank at a 0.8% annualised rate in the fourth quarter. This confirms our view that the UK has already entered recession, though we expect it to be relatively short and shallow. The other important news was the publication of the minutes from the MPC’s January meeting. As expected, the vote on keeping rates unchanged and completing the increase in Gilt purchases to 275 billion pounds was unanimous. However, there was considerable divergence of opinion as to what to do after that. “Some” thought that further QE was likely to be required while “others” were more cautious. We think the negative GDP and unemployment numbers will by now have tipped the balance towards the former, and expect another increase in the Gilt purchase target in February. Sterling did not react greatly to either announcement, and continued to trade as a low-beta version of the Euro, rising a bit over 1% against the dollar and falling roughly the same amount against the common currency.
Everything lined up in favour of the Euro last week. Traders’ positioning, according to the CFTC, rose to yet another record short. The Fed surprised markets with its dovishness. Finally, the PMI business sentiment indices deliver a big upside surprise, as the composite index rose 2.7 points to 50.4. Unsurprisingly, the common currency continued the short-term rebound it had begun the previous week, rising over 2% against the dollar and breaking above 1.32. We think this rally can continue for a while, particularly since the massive short position traders have against EUR had not yet started to clear out as of Tuesday last week. Longer term, we maintain our bearish view. While the PMI are indeed a nice surprise, other data was less positive. Particularly worrisome were news that bank lending plunged by 74 billion in December. This is the largest drop on record, as fallout from the banking and peripheral crisis spread. There were some vague noises out of Germany about focusing on jobs at the next EU summit, but nothing concrete. Austerity policies have already caused the European economy to contract in the last quarter, and policy is set to become even tighter in 2012.
Beyond the Fed meeting referred to above, the most important piece of news out of the US was the mixed advance report on fourth-quarter GDP. While the headline number showed healthy growth at 2.8%, the details were less positive. Inventory accumulation accounted for two thirds of this growth, and domestic demand grew at an anaemic pace of 0.8%, down from the previous quarter 3.2%. The average of the two quarters comes at 2%, which we regard as a decent, though unspectacular pace. The moderate recovery then continues apace, and the absence of fiscal drag for 2012 bodes, if not well, at least not ill for US employment. We therefore see room for USD appreciation as soon as the current bearish consensus around the Euro begins to dissipate.