Investment and Currency Trading

Fed shifts towards neutral…
The minutes from the April FOMC meeting indicated that the Fed believed that the risks to the economic outlook were becoming more balanced. The summary of policy-makers’ discussions opined that the policy easing already undertaken had diminished the threat to growth. Furthermore, the
Committee added that “future policy adjustments would depend on the extent to which economic and financial developments affected the medium-term outlook for growth and inflation”. Some members went so far as to argue that further easing would be inappropriate unless there was “significant weakening in the economic outlook”. Indeed, Kevin Warsh expressed exactly that sentiment in a speech this week regarding the Fed Funds rate, urging that the Fed should resist calls for more rate cuts even in the face of slowing growth because of the rising inflation threat.

… amid balanced, but growing, risks
The Fed’s central tendency forecasts showed markedly worsening shifts in the outlook for growth, unemployment and inflation. The GDP central tendency for 2008 was lowered from 1.3-2.0% as of January to a tepid 0.3-1.2%, which could represent a low since 1991. The unemployment central
tendency was increased from 5.2-5.3% as of January to 5.5- 5.7%, potentially a high since 2003. Finally, the core PCE inflation central tendency was boosted from 2.0-2.2% as of January to 2.2-2.4%, potentially a high since 1994. Subsequent data very tentatively support the Fed’s shift from its dovish
stance. The yoy change in the core PCE deflator unexpectedly ticked up to 2.1% in March. In contrast, the first estimate of Q1 GDP growth came in as-expected at 0.6% saar, but the latest trade data suggest that growth could be revised higher towards 0.9% next week. Furthermore, other data point to
upside risks to the call for Q2 GDP to have fallen at a 1.0% annual rate. As to unemployment, the April report showed a surprise decline to 5.0%. All this, of course, has encouraged the yield curve to flatten.

Treasury supply will weigh on bonds and curve
The Fed has continued its permanent open market operations, and it most recently (May 21) conducted a $5bn outright coupon sale of Treasuries maturing in 2011 and 2012. Furthermore, supply will remain an issue next week, with the Treasury scheduled to auction $30bn of 2yr notes and $20bn
of 5yr notes. The 2yr auction (May 28) will be offset by $22bn of maturing notes, somewhat dampening the negative effect on this sector of the curve, but, the 5yr auction (May 29) is not offset by any maturing debt. The April auctions were roughly similar in size ($8.4bn of net 2yr issuance on Apr 23 and $19bn of 5yr issuance on Apr 24). In that instance, the 2yr auction had little price impact, but the 5yr auction caused yields to rise generally.

Yields, curve trapped in channels – for now
Finally, the price action supports the assessments of the fundamental and supply situations. Yields have been trapped in an upward trending channel since troughing around the time of the Bear Stearns crisis in mid-March, while the yield curve has been following a flattening trend since early March, when the Fed began permanent open market operations. For the 2yr yield, the uptrending channel provides support around 2.34%. Resistance lies at 2.81%, but the yield would first have to break above the recent high of 2.59% (May 14). For the 10yr yield, the up-channel provides support at 3.77%. Resistance from the up-channel lies at 4.02%, although as with the 2yr yield, the 10yr yield would have to break above the May 14 high (3.97%). Regarding the 2s10s curve, resistance currently lies at 146bp. Down-channel support lies at 123bp, although price action would first have to breach support around 135bp (rough double-bottom during May). This price action remains consistent with the view that the economic backdrop will likely improve in coming weeks due to the tax rebates as well.
Eventually, market believe that the economy will sag again under the weight of rising commodity prices, falling house prices and continued banking impairments, but that theme will only develop several weeks, if not months, from now.

• Relative rate dynamics point to GBP/CAD falling further from current 15 years lows.
• In the case of GBP, weakness is likely to be compounded by diminishing policy credibility.
• Rallying back month energy futures (gas as well as oil) add to the case for selective long CAD positions.

Rate dynamics point to GBP/CAD lower

Although this week’s smaller than expected fall in UK April retail sales challenges the expectation of an August MPC cut, rates strategists remain convinced that the next UK rate cut is merely a question of timing.

Policy credibility adds to the case

Beyond simple interest rate spreads, questions over the credibility of UK policy add to downside GBP risks. In particular, GBP has developed an asymmetric relationship with expected interest rate spreads against a range of currencies, including CAD. What was once a stable and predictable relationship between expected short-term interest rates and the GBP/CAD cross seems to have broken down. Since September, the forward rate spread has opened up significantly in GBP’s favour, but GBP/CAD fallen to a 15-year low. In reality, the relationship has not entirely broken down, but rather become asymmetric.

In the period prior to September 2007, the correlation between GBP/CAD and the expected rate spread was 0.90. Post September 2007, the correlation fell to zero. However, if we split the data into episodes of widening and narrowing rate spreads, the most recent sub-period looks rather different. Post September 2007, the correlation between GBP/CAD in periods of widening rate spreads is actually marginally negative (i.e. GBP falls when rates rise), while during periods of narrowing rate spreads the correlation remains as high as 0.50 – diminished, but still significant.

Thus, from the GBP side of this currency pair, lower rate expectations remain negative for GBP, but higher rates have ceased to be positive. This is rational in the sense that UK rate expectations are rising not as a result of a better activity background, but rather despite a worsening activity background and as a result of a growing perception that rising inflation limits the scope for the BoE to do anything about it.

In this context, note the contrasting market reactions to the April inflation data in UK and Canada, both of which were significantly above market expectations. On the 13 May (UK CPI release day), after the briefest of rallies, GBP ended lower against both EUR and USD. CAD, in contrast, rallied strongly after Statcan reported an unexpected acceleration in core inflation this week.

Energy prices reinforce bullish CAD stance
Aside from interest rates, further support for CAD comes from recent commodity market developments. The migration of the oil price rally along the forward crude curve implies an embedded expectation that the spike in prices is moving from transitory to permanent. Two year forward WTI now trades at a USD1.20/bl premium to the spot price, compared to the year to end-April average of a USD7.10/bl discount. Moreover, the rally in long-dated energy prices is not confined to oil. Forward natural gas prices (actually more important than crude for CAD) are also rallying strongly.

During the long-term down-cycle for the USD, the EUR has been the leading currency versus the USD, with some arguing that the EUR may challenge the USD as the world’s reserve currency. While that debate is one that is likely to persist for many years to come, there are signs that cyclical leadership may be shifting to the AUD. During the period of extreme EUR weakness in 2000, EUR/AUD fell to 1.5001, the low since the introduction of the single currency. Strong global growth enabled the AUD to climb toward that high last year, reaching a low of 1.5478 on July 26, just prior to the onset of financial system stress in early August. EUR/AUD retested that low at 1.5500 on November 1, but then jumped over 12% by late March. There are now signs that stability in global growth, particularly in Asia, combined with modest slowing in Euro zone growth is pushing the AUD back to the forefront. EUR/AUD is testing trend-line support at 1.6275, with 61.8% Fibonacci retracement support nearby at 1.6240. A close below these levels would target 76.4% retracement at 1.5950, with an ultimate test of 1.5500 likely during 2H 2008. A close back above the 200-day MA, currently at 1.6494, would suggest the AUD run might be reversing.