Waiting for Trichet, but Watching the Yen

By Marc Chandler On May 5, 2011

BBH Currency View

Dollar stronger against most majors, but the yen is the strongest currency today, breaking 80
The ECB is meeting and Trichet’s press conference should be the key news today
BOE leaves rates unchanged as expected

The dollar strengthened into the NY session and global equities gave back some of the early gains, in part due to much lower-than-expected factory orders out of Germany. The USD is over 0.5% stronger against AUD, CAD and NOK, flat against the EUR and GBP and down 0.7% against the JPY. USD/JPY broke below the 80 level, now trading at 79.80. European indices are down nearly 1%, though US futures are only pointing to a 0.3% lower open. Energy prices are also taking a hit with WTI and Brent futures down about 2.5%. Gold is down 1% and silver is selling off once again, falling 3% today to a cumulative loss of 21% since the start of the month.

The highlight for the FX market today is likely to be centered on the ECB meeting and whether the euro can make a convincing break of the $1.495 level en route to $1.50. The market consensus is for the ECB to remain on hold today with the fixed rated tenders extended through Q2, with the risks of a rate hike today remote. Therefore, the focus is likely to be on the accompanying press conference. With peripheral finances still in precarious shape and a festering divergence between economic growth in the core and the periphery, we suspect that the ECB is in no hurry to raise rates. On the other hand, inflation remains headed in the wrong direction and does not show any signs of topping out anytime soon. The headline rate of inflation, 2.7%, remains above the euro zone’s target of 2%, and creates a negative real benchmark rate of about 1.5%. As such, we will be closely monitoring Trichet’s press conference for potential shifts in guidance. Last month, he noted that the “ECB will continue to monitor all developments over the period ahead very closely.” A similar tone at today’s meeting, in our view, is likely to signal a July rate hike, which also seems consistent with the implied probabilities in the OIS market. A shift in language, indicating the need for “strong vigilance” would likely lead to an earlier 25bps hike, at the June meeting, and indeed would be the near term catalyst to push the EUR/USD through $1.50. Altogether, we suspect that the ECB is likely to hold off until July but see the probability of a June hike increasing as well.

The BoE, as expected, remained on hold with the repo rate remaining unchanged at 0.5%. Today’s service sector PMI adds to the batch of softer Q2 data driven in part by large cuts in government spending. The services PMI adds to the sharp slowing seen in the construction PMI and unexpected rate of moderation in the manufacturing figure. House price data, likewise, have also been weak. Thus, domestic conditions are clearly fragile, caused by falling inflation-adjusted household incomes and large government spending cuts. Taken together, the recent disappointing economic data coupled with the sharp decline in trade-weighted sterling suggests that the BoE is unlikely to move before Q4, if at all in 2011. Indeed, the decline in sterling’s trade-weighted sterling rate is likely doing some of the MPC’s heavy lifting to ameliorate financial conditions. Indeed, overnight OIS swaps now imply only a 39bps raise in the overnight rate over the next year.

There have been some weak data releases in recent days, and today provided a weak retail sales figure in Australia and poor factory orders from Germany. Australian March sales were -0.5% vs +0.5% expected, the first drop in 6 months, and German orders were -4.0% m-o-m, while all participants in a Bloomberg survey had expected a positive figure. There has been weak PMI data in the US, China and European non-core countries, weak retail sales data in countries including Germany, and generally weak UK data. While we believe that taken together the data may represent a slowing of growth prospects for Q2, we believe it to temporary and that this does not represent a turning point for growth. Separately, the yen has been strengthening, and at 79.80 is now at the strongest level since intervention on March 18. We do not expect intervention at this point, not because of Japanese holidays, which may have something to do with the move, but because the BOJ is more concerned with the volatility of any move rather than defending a particular level.