US fiscal cliff a major danger to the US dollar

The most immediate danger to the US dollar is quite clearly posed by QE3. The US Federal Reserve’s monetary policy outlook should be a little clearer after Bernanke’s speech in Jackson Hole this afternoon. If it is not, then the Fed’s meeting and press conference on September 13^th should yield plenty of clues.

Whilst data over the past month or two suggests that US economic growth is recovering from its slumber in the first half of 2012, there is plenty of uncertainty ahead with the US ‘fiscal cliff’ drawing closer.

What is the fiscal cliff? The end of 2012 will see tax cuts come to an end and spending cuts dramatically, which are expected to weigh on US GDP dramatically. Tax cuts that will expire include a 2% payroll cut for workers and tax breaks for businesses, while tax hikes related to President Obama’s healthcare law will also kick in. The Congressional Budget Office estimates that the effects of all this could be a reduction in US GDP by a staggering 4.0% in 2013, while two million jobs could be lost resulting in a 1.0% rise in unemployment. So with the fiscal cliff capable of plunging the US economy back into recession, the stakes are extremely high.

                                                                                                                              

The US economy is faced with taking the pain and addressing its fiscal position in an early but huge hit, or spreading the pain over a longer period in order to safeguard a still fragile recovery (a familiar debate to followers of the UK political approach to austerity). As last year’s ‘debt ceiling’ debacle demonstrated, deadlock in the US political system can cause huge delays to major policy decisions.

In addition, this fiscal cliff issue comes in the context of an election year, so there will be no decision made on how to approach tax and spending moving forward until the leadership is determined in early November. A stop-gap measure to delay the tax rises may well come before the end of the year but you can be confident that any decision that is made will come right down to the wire.

What are the implications for the US dollar? Well, as ever there are two sides of the coin. The concerns over the US economy and the fears of recession could drive the dollar down in line with its deteriorating economic fundamentals. Contrastingly, the threat to the world’s largest economy could see the market flood back into the safe-haven US dollar. Inevitably, both strategies will be adopted but which truly prevails is uncertain.

Our bet is that the US dollar will be hurt by the fiscal cliff issue. This will likely be the case whether the US ‘goes over the cliff’ or whether delaying tactics are adopted. The can-kicking that has been evident in the eurozone has been a major weight on the euro over the last couple of years and the market response to more of the same from US policymakers will be the same.

However, the fiscal cliff is by no means the sole point of focus for the financial markets in the second half of 2012. Of course, this all comes as the eurozone debt crisis reaches new levels of seriousness. Indeed, we doubt that the fiscal cliff issue will be enough to stop the EUR/USD pair dropping significantly below $1.20 by the end of the year. The fiscal cliff will weigh on the dollar, but not to the same extent that the debt crisis will weigh on the euro.   

Richard Driver

Currency Analyst

Caxton FX

Will Bernanke signal QE3 at Jackson Hole on Friday?

The US Federal Reserve’s annual retreat to Jackson Hole, Wyoming is always a headline-hitter. In 2010, Fed Chairman Ben Bernanke signalled QE2 in his Jackson Hole address and hopes are sky high that he will usher in a third round of quantitative easing tomorrow afternoon. Coupled with the eurozone debt crisis, US monetary policy has been the market’s obsession for a long time now.

The US recovery certainly hasn’t bounced back as expected from the weakness prevalent in the first half of the year. However, US data has been on an uptrend of late. We have seen monthly jobs growth improve for three consecutive months, whilst housing figures and consumer sentiment have also been on the up. In addition, data this week has revealed that the US economy grew at an annualised rate of 1.7% in Q2, rather than the initial estimate of 1.5%. This won’t have gone unnoticed at the Fed.

The minutes from the Fed’s last meeting stoked QE3 earlier bets this month, hinting that Bernanke & Co were preparing to act - “many members judged that additional monetary easing would likely be warranted fairly soon.” However, the wind was soon knocked out of the market’s sails when Fed policymaker Bullard stated that the minutes were “stale,” pointing to the upturn in recent US growth data as good reason for investors not to get ahead of themselves.

Nonetheless, it is probably fair to say that the majority of market participants are expecting Bernanke to signal QE3 tomorrow. It’s without doubt an extremely close call but our bet is that he will fall short of this benchmark, particularly in light of recent data. The Fed has various other policy options at its disposal, such as giving guidance on how long he expects US interest rates to remain “exceptionally low.” The bar has been set high though, only a QE3 signal is like to satisfy the market’s appetite tomorrow.

What will be the market’s response to the absence of a QE3 hint? Well, equities will no doubt take a hit and commodities and precious metals would follow suit. As for the dollar, well it should rally if Bernanke disappoints. Even if Bernanke gives the market what it wants, with QE3 priced in to the extent that it is, there is a good chance that investors will choose to take profit on short-dollar positions, which again would strengthen the greenback. With this in mind, we would prefer to be long of the dollar ahead of Jackson Hole. 

Richard Driver

Currency Analyst

Caxton FX

Sterling firmer as UK data improves

Sterling steady ahead of Q2 GDP revision

Sterling continues to trade comfortably above the €1.27 level, helped by last week’s news from the UK. First, UK inflation came in well above expectations at 2.6%, weakening the case for more QE. Meanwhile, the UK unemployment rate came in at an eleven-month low of 8.0% and almost six thousand less people claimed for unemployment benefits in July. This was largely thanks to the London Olympics but it’s good news nonetheless.

Last week’s minutes from the MPC‘s August meeting were also positive for the pound. They confirmed that an interest rate cut is not on the Bank of England’s agenda. The option of further quantitative easing is certainly not off the agenda, though the vote this month was unanimously against the measure. However, the minutes revealed that several MPC policymakers viewed the decision to be finely balanced.

The final piece of news from the UK economy last week was the monthly retail sales figure from July. Retail sales surprisingly grew by 0.3% in July, which again raised hopes that UK growth is turning the corner and can pick up in the second half of the year.

The week ahead brings the revised UK GDP figure from Q2 and we are expecting the awful initial estimate of -0.7% to be revised up to an improved, though still worryingly poor, -0.5%. Nonetheless, the latest updates from the UK economy give some reason to believe that Q3 may return some positive growth.

No real signs of imminent ECB action but market hopes remain high

There had been some early market positivity relating to weekend reports that the ECB is preparing a plan which includes buying Spanish and Italian bonds if yields breach pre-determined levels. The ECB is certainly planning something but the ECB has today denied the reports and to make matters worse for the single currency, the Bundesbank has reiterated its opposition to ECB bond-purchasing. The market is pretty much in the dark as to what the ECB is planning and this uncertainty has put the euro on the back foot today. However, the euro is finding plenty of support at $1.23 and could well maintain this as investors will not want to bet too aggressively against the euro in the build up to the ECB’s bond market intervention. What is highly likely to hurt the euro, though, is a lack of any detail at September’s ECB meeting. Market patience is by no means unlimited.

In the short-term the euro faces plenty of risks in the shape of Thursday’s growth figures. More of the same is expected, with the data likely to indicate further contraction. This week’s eurozone meetings will also be important, with Greece and Spain the main points of focus. Some concrete progress will be required if the euro is to advance beyond resistance levels up around $1.24.

The dollar remains on the weaker side at present, despite some firmer US economic figures of late. This has helped sterling maintain levels close to or above $1.57 over the past week. With tough resistance having formed at these levels, we continue to anticipate a downside move for the GBP/USD rate. GBP/EUR is also performing a little better, having avoided a return down to €1.25. This pair is now trading at €1.2750, benefiting from plenty of demand at levels half a cent lower. We don’t envisage rapid upside progress for GBP/EUR, though a decent upward revision to the UK GDP figure on Friday could give the pound a nudge higher.

End of week forecast
GBP / EUR 1.2775
GBP / USD 1.5650
EUR / USD 1.2275
GBP/AUD 1.5200

Richard Driver
Analyst – Caxton FX
For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

Caxton FX Weekly Round-up: Dollar poised for rally

Pressure on for revised UK Q2 GDP figure

Last week’s all-important Quarterly Inflation Report from the Bank of England provided sterling with support just when a return to the €1.25 level was looking probable. King seemed to discard the option of another interest rate cut, describing it as potentially “counterproductive” and the likely effects to be “neither here nor there.” There were no real signals that the BoE is poised to introduce further quantitative easing, which again was supportive of the pound. The MPC minutes released on Wednesday should provide further clarity in this regard; we expect a unanimous decision to hold fire on more QE.

In addition to being less dovish than expected on monetary policy, Mervyn King also stuck to his guns in arguing that UK growth is not as weak as headline data has suggested. King’s comments have increased hopes and expectations that the initial -0.7% GDP figure for Q2 will be revised up. This was supported by last week’s better than expected, although still alarmingly weak in the bigger picture, manufacturing and industrial production figures from June. If an improved GDP figure is not forthcoming on Friday 24th August, then sterling could well be hit hard.

ECB has done nothing so far but hopes remain high

Despite the ECB having failed to take any concrete action at its meeting at the start of this month, the euro remains well away from its late-July lows. This is largely thanks to ECB President Draghi’s indications that the central bank is gearing up to resume the purchasing of Spanish and Italian bonds, in an effort to bring down their unsustainably high borrowing costs.

However, while some short-term relief for the euro would likely follow some concrete action from the ECB, it will be no panacea. Bond-purchases will be tied to very strict conditions with respect to economic reforms. Mario Draghi has suggested that ECB bond-purchases would only occur once a country had requested help, but this request may not come if Germany is too strict with the conditions it attaches. At the very least, German demands may could easily delay progress. In any case, bond-purchases took place last year but we are back in panic mode once again, so we find it hard to believe that ECB action will provide anything more than a short-term lift for the single currency.

Despite the positive sentiment that has built towards the euro over the past few weeks, we continue to hold a distinctly bearish view of the single currency over the rest of 2012. While sterling has plenty of its own domestic issues, chief among which are ongoing weak growth and the threat of the UK losing its AAA credit rating, it should be able to climb higher towards €1.30 this year.

GBP/EUR is currently trading at €1.27 and another push higher may prove tricky in the short-term as GBP/USD is looking ripe for another downward correction. Despite ongoing debate within and outside the US Federal Reserve, the central bank is still resisting the urge to announce or even signal QE3. This case has been strengthened most recently by last month’s better than expected US labour market update. The dollar looks well-positioned for a return to strength this month then, which could bring the GBP/USD rate well down from the current $1.57 level.

End of week forecast

GBP / EUR 1.2750
GBP / USD 1.5550
EUR / USD 1.2250
GBP / AUD 1.5000

Richard Driver

Analyst – Caxton FX
For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

Sterling set for a tough month

As has been the case for many months, eurozone concerns dominated market sentiment in July, so much so that the euro hit fresh multi-month lows across the exchange rates. Immediate concerns over the situation in Spain and Greece hurt confidence significantly, with weak economic growth across the globe adding to concerns. However, market sentiment and the euro have picked up considerably in recent sessions.

After the so-called progress that was made at the June EU Summit, there have been no material developments. The peripheral bond markets are always a good indicator of market tensions with regard to the debt crisis and Spanish 10-year bonds have hit fresh euro-era highs above 7.6% in recent weeks, with equivalent Italian debt setting its own record above the 6.5% level. Whilst economic growth throughout the eurozone is contracting sharply, Spain is edging towards a full-blown bailout and Greece could yet fail to secure its next bailout tranche, which is essential if the country is to avoid collapse.

Economic conditions in the US continue to provide plenty of cause for concern. The US economy slowed from a pace of 2.8% in Q4 2011 to a pace of 1.5% in Q2 2012. Poor performance in the world’s largest economy stunted the US dollar’s progress in recent weeks by increasing speculation that the US Federal Reserve is edging towards introducing the much-debated QE3 measure. However, the Fed’s recent meeting produced yet more ‘wait-and-see’ rhetoric, which has taken some weight off the dollar for the time being.

News out of the UK has also been far from comforting. Recent data has indicated that the domestic economy contracted by 0.7%, which is a shockingly poor figure well below expectations. The Bank of England has introduced another round (£50bn worth) of quantitative easing and the government has initiated an interesting new Funding for Lending Scheme to encourage banks to step up lending, but the effects of these are some way from being felt. In the meantime, UK growth is expected to remain very weak indeed. Sterling still holds some safe-haven demand, though this may be insufficient for it to avoid losses against the euro and dollar this month.

GBP/EUR

Having hit near four-year highs up towards €1.29, this pair has since erased its gains and at the current level of €1.26, it is back where it started in July. Whilst we do maintain that the pound will remain on its longer term uptrend, we anticipate some further short-term sterling softness in the coming weeks.

Spain spooked the markets in July, with borrowing costs soaring well above the 7.0% level amid a request from the Spanish regional government of Valencia’s request for financial aid and concerns of similar emergency needs across Spain’s regions. Spain’s banks have already agreed a bailout with international creditors and it has certainly discussed a full-blown sovereign bailout with Germany, which continues to demonstrate growing bailout-fatigue. In terms of austerity and economic reforms, PM Rajoy is doing all he can but investors are still hammering Spain in the bond markets. A sovereign bailout is looking increasingly unavoidable.

Last week’s ECB meeting was the most eagerly-awaited in a very long time but the market was left wondering what could have been. Draghi had a plethora of options available to him and after he stated that he would do “whatever it takes” to preserve the euro, he delayed any action whatsoever. The decision not to cut interest rates was unanimous after June’s 0.25% reduction, despite ECB President Draghi predicting that the eurozone economy is likely to recover only very gradually, whilst noting significant risks to further deterioration. Q2 was an awful one for the eurozone, with weakness in the periphery spreading to core states including Germany. The latest German and French manufacturing figures reveal a sharp contraction and eurozone unemployment remains a major issue, having recently reached a fresh record high of 11.2%.

Draghi disappointed the markets by suggesting that the European Stability Mechanism will not be granted a banking license, which had been previously indicated by an ECB policymaker and would have greatly increased the bailout funds’ firepower. Importantly, Draghi indicated that the ECB may move to buy up peripheral debt to ease pressure in the bond markets, but his comments fell short of a pre-commitment, never mind concrete action. German resistance to ECB bond-buying and demands for fiscal restraints represent a key obstacle to ECB emergency action.

Whilst alarm bells ring in the eurozone, the UK economy is also in a very weak state, which is best demonstrated by the recent-0.7% GDP figure from Q2, leaving the UK economy firmly in recession. Initial signs have not been positive for Q3 either; the UK manufacturing sector posted its worst figure in three years and the UK services sector gave its worst showing in eighteen months in July.

The Bank of England is clearly concerned with economic conditions in the UK, having introduced another round of quantitative easing in July to support the economy. The MPC voted 7-2 in favour of the £50bn top-up and there were suspicions that another dose would be approved at its recent August meeting in response to the latest shock GDP figure, though sterling has been spared this development. The government has also taken its own action to try to drag the UK out of recession in the form of its Funding for Lending initiative, designed to incentivise UK banks to increase lending, something that the Project Merlin initiative failed to do.

It needn’t be all pessimism towards the UK economy; there remains some fairly strong scepticism over the reliability of the awful initial Q2 UK GDP figure and in combination with the improved weather conditions, hopes for a significantly stronger second half of the year are not misplaced. The effects of the additional round of QE, the Funding for Lending programme should help the UK return to growth, though this may have to wait until Q4. Unfortunately though, initial expectations that the London Olympics will add 0.5% to UK GDP this year are receding.

The sharper than expected recession has highlighted the question marks over the UK’s treasured AAA credit rating. Rating agency Moody’s has retained its negative outlook for the UK’s credit rating, though fears have been quelled somewhat by Standard & Poor’s recent reaffirmation of the UK’s top rating with a stable outlook.

Sterling is trading at €1.26 at present, which represents a pretty aggressive decline from its multi-year high of €1.2878. With weak UK growth figures set to flow this month, we expect this rate to retrace further in the coming weeks down to €1.25. There is a risk that this pair will revisit its June lows of €1.2270 but on balance we think this is unlikely.

GBP/USD

Sterling has remained range-bound against the US dollar over the past month, fluctuating between $1.54 and $1.57. The news out of the US economy has broadly been very disappointing; June’s labour figures were alarmingly poor, manufacturing data was shaky and retail sales contracted sharply. In addition, the US economic growth rate of 1.9% (annualised) in Q1 slowed down to 1.5% in Q2 - almost half of the rate we were seeing at the end of last year.

Naturally, weak growth figures saw bets on QE3 ramped up yet again, which has been a thorn in the US dollar’s side for some time now. Ben Bernanke disappointed the market yet again in his July US Federal Reserve Press Conference. There was no QE3 announcement, nor any real signals that a move is imminent. Clearly this is good news for the US dollar, if not for global market confidence.

The recent release of July’s US non-farm payrolls figure should free up the US dollar to make some gains this month. Data revealed that 163 thousand jobs were added to the payrolls in July, which represents the best showing in five months and should ease fears of a sharp slowdown in the US for now. One thing is certain though, QE3 will remain very much on the Fed’s list of options for the foreseeable future. We see the Fed pulling the trigger on QE3 at some point in Q4.

Despite Moody’s recent reaffirmation of the UK’s AAA credit rating, market confidence in the pound appears to be waning thanks to a steady flow of weak UK growth figures. More of the same can be expected this month and to make matters worse, anecdotal evidence suggests the Olympics will fail to provide the economic boost that was initially expected. The Bank of England held off from adding another dose of QE at its July meeting but suspicions of another top-up will grow with every negative piece of UK data.

We hold a negative view of the EUR/USD pair in the coming weeks, based on continued uncertainty on all fronts; sharp contraction in eurozone growth, a possible Spanish bailout, Greek uncertainty and a continued imbalance between talk and genuine action. If EUR/USD heads down towards $1.21 as we expect, then this would almost ensure GBP/USD declines even if UK news is positive. Given that we expect news out of the UK to be negative, we feel this pair’s downturn could be quite aggressive. A move down $1.52 looks realistic in the coming weeks.

Richard Driver

Analyst – Caxton FX
For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.