UK Forex Reserve Plan could Harm Pound

Yesterday, UK Chancellor George Osborne announced that his government was ready to begin rebuilding its foreign exchange reserves. Depending on when, how, (or even if) this program is implemented, it could have serious implications for the Pound.

Forex reserve watchers (myself included) were excited by the updated US Treasury report on foreign holdings of US Treasury securities. As the Dollar is the world’s de-facto reserve currency and the US Treasury securities are the asset of choice, the report is basically a rough sketch of both the Dollar’s global popularity and the interventions of foreign Central Banks. Personally, I thought the biggest shocker was not that China’s Treasury holdings are $300 Billion greater than previously believed (with $3 Trillion in reserves, that’s really just a rounding error), but rather that the UK’s holdings declined by 50% in 2010, to a mere $260 Billion.

Given that the Bank of England (BoE) injected more than $500 Billion into the UK money supply in 2010, I suppose that shouldn’t have been much of a revelation. After all, selling US Treasury Securities and using the proceeds to buy British Gilts (sovereign debt) and other financial instruments would enable the BoE to achieve its objective without having to resort to wholesale money printing. In addition, if not for this sleight of hand, UK inflation would probably be even higher.

Still, this is little more than a mere accounting trick, and those funds will probably still need to be withdrawn from the money supply at some point anyway. Whether the BoE burns the proceeds or reinvests them back into foreign instruments is certainly worth pondering, but insofar as it won’t impact inflation, it is a matter of economic policy, and not monetary policy.

As Chancellor Osborn indicated, the UK will probably send these funds back abroad. In addition to providing support for the Dollar (as well as another reason not to be nervous about the upcoming end of the Fed’s QE2), this would seriously weaken the Pound, at a time  that it is already near a 30-year low on a trade-weighted basis. After falling off a cliff in 2009, the Pound recovered against the Dollar in 2010, largely due to the BoE’s shuffling of its foreign exchange reserves. To undo this would certainly risk sending the Pound back towards these depths.

On the one hand, the UK is certainly conscious of this and would act accordingly, perhaps even delaying any foreign exchange reserve accumulation until the Pound strengthens. On the other hand, the BoE is under pressure to fight inflation. It is reluctant to raise interest rates because of the impact it would have on the fragile economic recovery. The same can be said for unwinding its asset purchases. However, if it offset this with purchases of US Treasury securities and other foreign currency assets, it could weaken the Pound and maintain some form of economic stimulus. Especially since the UK has run a sizable trade/current account deficit for as long as anyone can remember, the BoE has both the flexibility/justification it needs to coax the exchange rate down a little bit.

Ultimately, we’ll need more information before we can determine how this will impact the Pound. Still, this is an indication that the GBP/USD might not have much more room to appreciate.

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Forex Markets Look to Interest Rates for Guidance

There are a number of forces currently competing for control of forex markets: the ebb and flow of risk appetite, Central Bank currency intervention, comparative economic growth differentials, and numerous technical factors. Soon, traders will have to add one more item to their list of must-watch variables: interest rates.

Interest rates around the world remain at record lows. In many cases, they are locked at 0%, unable to drift any lower. With a couple of minor exceptions, none of the major Central Banks have yet raised their benchmark interest rates. The same applies to most emerging countries. Despite rising inflation and enviable GDP growth, they remain reluctant to hike rates for fear that they will invite further speculative capital inflows and consequent currency appreciation.

Emerging markets countries can only toy with inflation for so long. Over the medium-term, all of them will undoubtedly be forced to raise interest rates. The time horizon for G7 Central Banks is a little longer, due to high unemployment, tepid economic growth, and price stability. At a certain point, however, inflation will compel all of them to act. When they raise rates – and by much – may well dictate the major trends in forex markets over the next couple years.

Australia (4.75%), New Zealand (3%), and Canada (1%) are the only industrialized Central Banks to have lifted their benchmark interest rates. However, the former two must deal with high inflation, while the latter’s benchmark rate is hardly high enough for carry traders to take interest. In addition, the Reserve Bank of Australia has basically stopped tightening, and traders are betting on only one or two 25 basis point hikes in 2011. Besides, higher interest rates have probably already been priced into their respective currencies (which is why they rallied tremendously in 2010), and will have to rise much more before yield-seekers take notice.

China (~6%) and Brazil (11.25%) are leading the way in emerging markets in raising rates. However, their benchmark lending rates belie lower deposit rates and are probably negative when you account for soaring inflation in both countries. The Reserve Bank of India and Bank of Russia have also hiked rates several times over the last year, though again, not yet enough to offset rising prices.

Instead, the real battle will probably be fought primarily amongst the Pound, Euro, Dollar, and Franc. (The Japanese Yen is essentially moot in this debate, and its Central Bank has not even humored the markets about the possibility of higher interest rates down the road). The Bank of England (BoE) will probably be the first to move. “The present ultra-low rates are unsustainable. They would be unsustainable in a period of low inflation but they are especially unsustainable with inflation, however you measure it, approaching 5 per cent,” summarized one columnist. In fact, it is projected to hike rates 3 times over the next year. If/when it unwinds its quantitative easing program, long-term rates will probably follow suit.

The European Central Bank will probably act next. Its mandate is to limit inflation – rather than facilitate economic growth, which means that it probably won’t hesitate to hike rates if inflation remains above its 2% threshold. In addition, the front runner to replace Jean-Claude Trichet as head of the ECB is Axel Webber, who is notoriously hawkish when it comes to monetary policy. Meanwhile, the Swiss National Bank is currently too concerned about the rising Franc to even think about raising rates.

That leaves the Federal Reserve Bank. Traders were previously betting on 2010 rate hikes, but since these have failed to materialized, they have pushed back their expectations to 2012. In fact, there is reason to believe that it will be even longer than that. According to a Bloomberg News analysis, “After the past two U.S. recessions, the Fed didn’t start raising policy rates until joblessness had fallen about three- quarters of the way back to the full-employment level…To satisfy that requirement, the jobless rate would need to be 6.5 percent, compared with today’s 9 percent.” Another commentator argued that the Fed will similarly hold off raising rates in order to further stabilize (aka subsidize) banks and to help the federal government lower the real value of its debt, even if it means tolerating slightly higher inflation.

When you consider that US deposit rates are already negative (when you account for inflation) and that this will probably worsen further, it looks like the US Dollar will probably come out on the losing end of any interest rate battles in the currency markets.

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Fed Paper: Power of Technical Analysis in Forex is Declining

Being a practitioner of fundamental analysis, you could say that I’m always on the lookout for hard evidence that fundamental analysis is superior to technical analysis. Thus, I was delighted to discover a working paper (“Technical Analysis in the Foreign Exchange Market“) by the St. Louis Branch of the Federal Reserve Bank, released just this month. Alas, the paper barely touched upon fundamental analysis, but its conclusions on technical analysis in the currency markets were startling. In short, the effectiveness of technical analysis in the currency markets has declined steadily since the 1970s, such that only the most sophisticated/complicated strategies are currently profitable.

Rather than conduct original research, the report’s authors – Christopher J. Neely, an assistant vice president and economist at the Federal Reserve Bank of St. Louis, and Paul A. Weller, the John F. Murray Professor of Finance at the University of Iowa – performed a meta analysis of the existing research. They cited a litany of studies, covered a variety of topics, sometimes with contradictory conclusions. In order to ensure comprehensiveness, they looked at the profitability of numerous types of technical analysis indicators, across numerous currency pairs, over time, in different types of trading environments, and adjusted for risk.

All of the earlier studies, dating back to the 1960s, established the profitability of technical analysis, even when it was simplistic. Since then, however, most studies have shown steadily declining effectiveness: “TTRs [Technical Trading Rules] ere able to earn genuine risk-adjusted excess returns in foreign exchange markets at least from the mid-1970s until about 1990…and that rule profitability has been declining since the late 1980s.” The same trend has unfolded in the last decade, as traders have relied increasingly on computerized trading strategies: “Kozhan and Salmon (2010), using high frequency data, find that trading rules derived from a genetic algorithm were profitable in 2003 but that this was no longer true in 2008.”

Given that the two authors also concede that the financial markets are undoubtedly inefficient and that currency markets in particular are filled with observable trends, how should we understand this decline in the effectiveness of technical analysis? In one word, the answer is competition. “Profit opportunities will generally exist in financial markets but…learning and competition will gradually erode ["arbitrage away"] these opportunities as they become known.” In addition, there has been a “dramatic rise in the volume of algorithmic trading,” which has given rise to a so-called financial arms race to develop ever-more sophisticated trading strategies.

Indeed, the research shows that “more complex strategies will persist longer than simple ones. And as some strategies decline as they become less profitable, there will be a tendency for other strategies to appear in response to the changing market environment.” In addition, technical analysis that is used to trade exotic (i.e. less liquid) currencies is more likely to be profitable than major currencies, especially the US Dollar.

The report opens the door to further research, by indicating that “Technical trading can be consistently profitable in certain circumstances.” As if it wasn’t already clear, though, the vast majority of technical traders (perhaps all traders for that matter) are destined to be outmaneuvered and will ultimately lose money trading forex. Another way of looking at this, however, is that the the savviest traders – those that can spot complex trends and execute trading strategies quickly – still have a chance at earning consistent profits.

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Swiss Franc Surges to Record High(s)

In the last two weeks, the Swiss Franc rose to record highs against not one, not two, but three major currencies: the US Dollar, Euro, and British Pound. The Franc is now entrenched well above parity against the Dollar, and is closing in on the magical level of 1:1 against the Euro. With market uncertainty projected to run well into 2011, continued strength in the Franc is all but assured.

The Franc’s rise is due entirely to its being perceived as a safe haven currency. Its debt levels are comparable to other industrialized countries, its economy is in mediocre shape, and interest rates are the lowest in the entire world (the overnight lending rate is a paltry .1%). Some analysts have cited the “strong Swiss economic outlook” and “the health of Swiss public finances” as two factors buttressing its strength, but make not mistake: if not for the tide of risk aversion sweeping through the world’s financial markets, the Franc would hardly be attracting any attention.

As I have reported recently, the Dollar and the Yen have also benefited from the spike of risk aversion caused by renewed concerns over the fiscal health of the EU and the prospect of conflict in Korea. Perhaps owning to nothing more than proximity, the Franc has been the primary beneficiary from EU sovereign debt crisis. “It appears that smart money investors are pre-emptively bailing funds out of the eurozone with Switzerland providing a safe port to ride out the eurozone sovereign debt storm that appears to loom on the horizon,” summarized one analyst.

Unfortunately, it looks like the situation in the EU can only become serious. Despite a collective move towards fiscal austerity, all of the problem countries are still running budget deficits. As a result, members of the EU are set to issue no less than €500 Billion of new debt in 2011. To make matters worse, “The onslaught of credit warnings and downgrades of sovereign ratings over the past few days added to worries that borrowing costs in many euro zone nations could rise further.” This could trigger a self-fulfilling descent towards default and further buoy the Franc.

As far as I can tell, the notion that, “Despite the Swiss franc’s recent sharp gains, we still believe there is plenty of room for further upside ahead,” seems to encapsulate current market sentiment. According to the most recent Commitment of Traders Report, investors continue to increase their long positions in the Franc. According to Bloomberg News, “Options traders are more bullish on the franc for the next three months than any major currency except the yen.” Meanwhile, a sample of analysts’ forecasts suggests that the Franc could appreciate another 5% over the next six months.

At this point, the main variable the Swiss National Bank (SNB), which could resume intervention on behalf of the Franc. After spending close to €200 Billion to depress the Franc, the SNB accepted the futility of its efforts and formally renounced intervention in June. However, Swiss National Bank President Philipp Hildebrand recently referred to the Franc’s rise as a “burden,” and warned that the SNB “would take the measures necessary to ensure price stability” in the event of  “renewed financial market tensions.”

As to whether intervention is likely, analysts remain divided. “The timing [for intervention] would certainly be perfect, with liquidity very thin….pre-holiday markets are ideal for springing a surprise,” said one strategist. According to Morgan Stanley, however, the SNB is “unlikely to intervene in the near term to stem the rise in the franc. The previous intervention earlier this year has left a huge overhang of liquidity in the economy and the Swiss National Bank doesn’t want to further boost the money supply.” In addition, the SNB experienced losses of €22 Billion on its forex reserves in the first nine months of this year, and will be reluctant to incur further losses by resuming intervention.

In short, aside from this lone point of uncertainty, all factors point to continued upside.

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Euro Follows Broader Markets as Europe Attempts to Sort Out Problems

EUR/USD

The EUR/USD failed to hold onto earlier gains generated by broader risk appetite as concerns over the European debt crisis and the U.S. economy spark a late sell off. Optimism was high overnight as the Obama administration and the GOP agreed to extend unemployment benefits and extend existing tax cuts the wealthy. Risk appetite remains a main driver of the pair’s price action despite the concern over Ireland, Spain and Portugal, evidence by the 64% correlation between it and the Dow. Meanwhile, U.S. and European yield expectations have started to grow in influence with both explaining 20% of direction. Fed QE has raised concerns over future inflation and has markets starting to price in abrupt tightening. Conversely, an increase in ECB stimulus efforts has dimmed the yield outlook for the single currency. The passing of the new Irish budget failed to help generate bullish sentiment, which will leave us to take our cues from broader trends when trading the euro/dollar.

EUR Interest Rate Expectations

USD Interest Rate Expectations

ECB Interest Rate Expectations

The European Central Bank has aggressively resumed their bond purchases as they look to restore investor confidence in European sovereign debt. Meanwhile, E.U. ministers voted to not provide aid packages for Spain and Portugal as there is confidence that the monetary authority’s actions will negate the need for help. The central bank increasing their additional measures has pushed out the horizon for a rate hike with Overnight Index Swaps now pricing in 32.4 bps in tightening over the next versus 49.6 on November 18th. Discuss this and trading ideas join the EUR/USD forum.

Credit Suisse (OIS) ECB

Source Bloomberg – Prepared by John Rivera

FOMC Interest Rate Expectations

The outlook for U.S. interest rates has remained unchanged for the past month despite a dismal labor report and the ongoing issues in Europe. Talk of additional QE from Ben Bernanke also failed to dim the outlook for a rate hike, as the prospect for more pump priming has only fueled inflation fears. The upcoming economic docket is light but we could see the extension of unemployment benefits add to the prospect for future tightening. However with the FOMC rate decision looming markets may wait ti see what policy makers say before making any new bets.

Source Bloomberg – Prepared by John Rivera

Risk

Stocks ended the day flat following their late selloff after the S&P 500 hit a two year high and the Dow just missed its yearly high. The blue chip index could be settling into a short-term range if we see continued bearish momentum. 11,000 remains a major support barrier and another test of the psychological level could be ahead, which doesn’t bode well for EUR/USD bulls given their strong correlation. Discuss this and other fundamental data in the Economics Forum.

Dow (Daily)

Source Bloomberg – Prepared by John Rivera

To discuss this report or be added to the email list contact John Rivera, Currency Analyst: jrivera@fxcm.com

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FOREX: Euro Hopes for Lifeline as All Eyes Turn to the ECB

By Ilya Spivak, Currency Strategist Thu Dec 02 06:28:00 GMT 2010 Key Overnight Developments

NZ Dollar Outperforms as Stocks Rise on US Reports, ECB Hopes Australian Dollar Misses Risk Rally on Soft Retail Sales, Trade Data Critical Levels

The Euro continued to follow the risky asset complex higher in overnight trade, adding 0.2 percent against the US Dollar. The British Pound yielded a flat result, oscillating in a narrow range above the 1.5600 figure. We remain long the US Dollar against the Euro, Kiwi and Japanese Yen.

Asia Session Highlights

Capital Spending excl Software (3Q)

Trade Balance (Australian dollar) (OCT)

The New Zealand Dollar outperformed once again in overnight trade, adding 0.6 percent on average against its top counterparts as Asian stock exchanges followed Wall Street higher, boosting the risk-correlated currency. The MSCI Asia Pacific regional benchmark index rose 1.5 percent – the most in nearly a month – following an encouraging set of US economic data as well as amid speculation that the European Central Bank may announce new measures to snuff the sovereign debt crisis festering in the Euro Zone at the upcoming monetary policy meeting (see below).

As yesterday, the Australian Dollar failed to share in the risk-driven advance, yielding a largely flat result on the session after October’s Retail Sales report proved disappointing. Receipts fell 1.1 percent, marking the first decline in eight months and the largest since July 2009. The Trade Balance surplus widened, but the outcome failed to excite considering it came courtesy of a drop in imports rather than robust export growth. Inbound shipments fell A$558 million – or 2.5 percent – while overseas sales added A$253 million (1.1 percent).

On balance, it’s no surprise the Kiwi is overtaking its antipodean counterpart as the go-to beneficiary of risk appetite. The Reserve Bank of Australia has turned noticeably timid – with markets are betting on no further rate hikes for the next 12 months – while the RBNZ is tipped to add 58bps to benchmark borrowing costs over the same period according to a Credit Suisse gauge of traders’ priced-in expectations.

Euro Session: What to Expect

French ILO Mainland Unemployment Rate (3Q)

French Mainland Unemployment Change (3Q)

French ILO Unemployment Rate (3Q)

Gross Domestic Product (YoY) (3Q)

Gross Domestic Product (QoQ) (3Q)

Retail Sales (Real) (YoY) (OCT)

Purchasing Manager Index Construction (NOV)

Euro-Zone Gross Domestic Product s.a. (QoQ) (3Q P)

Euro-Zone Gross Domestic Product s.a. (YoY) (3Q P)

Euro-Zone Household Consumption (QoQ) (3Q P)

Euro-Zone Gross Fixed Capital (QoQ) (3Q P)

Euro-Zone Government Expenditure (QoQ) (3Q P)

Euro-Zone Producer Price Index (MoM) (OCT)

Euro-Zone Producer Price Index (YoY) (OCT)

European Central Bank Rate Decision (DEC)

The monetary policy announcement from the European Central Bank takes top billing on a busy calendar of scheduled event risk, with investors hoping for bold action to contain sovereign stress on the edges of the currency bloc after a story in the Financial Times suggested Jean-Claude Trichet and company may increase their purchases of periphery bonds, thereby lowering borrowing costs and boosting liquidity. Furthermore, if the amount of renewed purchases is sufficiently large, this would markets that the ECB is confident enough in Europe’s ability to contain the crisis to risk a sovereign default against itself, an unequivocally bold statement that would likely send the Euro as well as the entire risky asset complex higher.

On balance, such an outcome seems unlikely. The ECB has given no indication that it was prepared to commit to expanding its balance sheet and several of its members (including Axel Weber, the likely candidate to succeed Trichet as the bank’s President next year) have publicly expressed their unease with the modest bond purchases already being undertaken. Furthermore, the ECB is notoriously incremental and slow-moving in its approach to monetary policy, hinting that a smaller step, like pausing the unwinding of its emergency long-term lending facilities (LTROs) for Euro Zone banks, are likely to come first. Indeed, the ECB may opt for a still more cautious approach, whereby LTROs are kept in place for the banks of those countries still under stress while phasing out those for other Euro Zone members as scheduled.

Elsewhere on the docket, the second revision of Euro Zone Gross Domestic Product figures is expected to confirm that output added 0.4 percent in the third quarter. Separately, Swiss GDP is forecast to grow 0.5 percent in the three months to September while the UK Construction PMI report shows the home-building sector slowed for the second consecutive month in November.

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Thu Dec 02 06:28:00 GMT 2010

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FOREX: Euro Threatened as Irish Government Faces Election Loss

Key Overnight Developments

Swiss Franc Underperforms as Korea Conflict Fears Subside Australian Dollar Weaker as Prices Retrace NY Session Gains Japan’s Trade Balance Surplus Widens as Imports Soften Critical Levels

The Euro and the British Pound kept to narrow ranges in Asian trade, with sterling spiking higher only late into the session after the Bank of England’s Andrew Sentence – the standby hawk on the rate-setting MPC committee – said policymakers need to gradually raise interest rates. We remain long the US Dollar against the Euro, Japanese Yen and New Zealand Dollar.

Asia Session Highlights

Corporate Service Price (YoY) (OCT)

Merchandise Trade Balance Total (Yen) (OCT)

Adjusted Merchandise Trade Balance (Yen) (OCT)

Merchandise Trade Exports (YoY) (OCT)

Merchandise Trade Imports (YoY) (OCT)

BOJ’s Nakamura Speaks on Japanese Economy

Private Capital Expenditure (3Q)

Currency markets saw quiet trade in overnight hours, with the Swiss Franc underperforming the majors having surged earlier in the week as geopolitical fears eased amid fading concerns about an escalation of violence between the Koreas. The Australian Dollar also tipped lower, retracing some of its recent gains having followed Wall Street higher in North American trade.

Japan’s Merchandise Trade Balance surplus undershot expectations, printing at 821.9 billion yen in October. While this marks an improvement in the headline reading from the previous month, the outcome seems far from encouraging considering it comes courtesy of the weakest import growth in 10 months as opposed to robust overseas sales. Indeed, exports grew at an annual pace of just 7.8 percent, the weakest since November 2009. Given strongest Yen in over a decade, which ought to boost imports, such dismal figures seem to point to little more than the anemic state of Japanese domestic demand, reinforcing deflationary pressure and keeping the perennial low-yielder’s funding currency status firmly intact for the foreseeable future.

Euro Session: What to Expect

French Consumer Confidence Indicator (NOV)

Italian Business Confidence (NOV)

All eyes are focused on Ireland, with the ruling Fianna Fáil party expected to do poorly in a by-election in Donegal South West. This would reduce the government’s majority in the lower house of parliament (the Dáil) from three to two seats, making the possibility that the current administration will lose support before the budget vote on December 7 more likely. While the markets have arguably priced in the loss already considering it has been well-telegraphed in recent polls, a particularly skewed outcome in favor of the opposition may stoke risk aversion and compound selling pressure on the Euro.

The data docket looks lackluster, with third-quarter Swiss Employment figures amounting to the only bit of notable event risk. Turning to sentiment, stock index futures tracking the major European bourses are ticking higher ahead of the opening bell, hinting risk-correlated currencies may find a bit of support, absent shocking news out of Ireland of course.

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