Euro Rally And Why We're Concerned

The euro traded sharply higher against the U.S. dollar Tuesday and from a technical perspective, the currency pair's performance has been very good. All the EUR/USD needs to do now is comfortably clear 1.3050 and it could be on its way to this year's high just below 1.35. From a fundamental perspective however, we have plenty of reasons to be concerned about the euro rally. A large part of the optimism in the euro Tuesday was caused by speculation that Spain is getting close to requesting a bailout and the view that Germany is softening its stance on providing additional money to Spain. However all of this is mere speculation fueled by an article written by the staff of the Financial Times who openly pondered what a Spanish bailout would look like. While we believe that a bailout is inevitable for Spain, the Spanish government hasn't grown more willing to accept one. Tuesday morning, two German lawmakers were quoted saying that they are open to the idea of a precautionary credit line for Spain but one later denied it saying that the market "over-interpreted his comments." A line of credit will most likely be discussed at this week's EU Leaders Summit and it is an idea that the Spanish government likes quite a bit because it provides them with a backstop without having the same stigma as a full scale bailout. Yet is not clear whether this the Germans will cooperate or if this will satisfy investors.

Greece's negotiations with the Troika have also hit a snag that could delay the release of bailout funds. Talks were briefly suspended Tuesday when Greek officials asked for time to confer with leaders on labor reforms that involve eliminating automatic wage increases and reducing severance payments. A complete agreement needs to be reached before Greece can receive its next aid payment, something the government has said they need by the end of November to avoid running out of money. This delay means that a deal for Greece won't come this week and as a result, the odds of a euro positive announcement from the EU Leaders Summit are slim. Finally German Chancellor Merkel rejected the proposal for shared debt liability, which is one of the few ways to put an end to the region's debt crisis. Even with an improvement in investor confidence according to the German ZEW survey, a number of challenges lie ahead for Europe -- all of which require political concessions. Until there is a better spirit of cooperation, we will be skeptical of any rallies in the euro.

USD: Mixed Day Despite Stronger Data
Despite another round of positive economic data, the performance of the U.S. dollar was mixed. Safe-haven flows eased out of the U.S. dollar and into the euro, British pound, Swiss Franc and Aussie but the greenback traded higher against the Japanese Yen, Canadian and New Zealand dollars. The latest U.S. economic reports reinforce the notion that the recovery gained momentum in the month of September but one month worth of improvements is not enough to convince the central bank and investors that the worst is over. The varied performance of the U.S. dollar shows that right now, currencies are trading on country-specific factors. Europe is looking forward to the possibility of a bailout while Asia is in the midst of grappling with slower Chinese growth. Based on the latest consumer price report, inflationary pressures in the U.S. are muted, which is important because it gives the Federal Reserve the flexibility to keep monetary policy easy.

Consumer prices rose 0.6% in the month of September, bringing the annualized pace of CPI growth up to 2.0% from 1.7%. However core prices grew at a slightly slower pace of 0.1%, against expectations for a 0.2% rise. Despite a downward revision to the past month's report, industrial production increased 0.4% last month and capacity utilization ticked up from 78% to 78.3%. This shows that not only has manufacturing activity improved but production is also becoming more efficient. According to the Treasury International Capital flow report, foreign demand for U.S. dollars rose to $91.5 billion from $74.0 billion in the month of August. Nearly all of the purchases were for long-term assets with particularly strong demand coming from banking centers such as the U.K., Switzerland and the Caribbean. The increase in demand for dollars is consistent with concerns about Europe and the strong rally in the greenback this summer. Housing starts and building permits are due for release on Wednesday and we expect an increase in both courtesy of low interest rates.

GBP: Bank Of England Minutes To Reveal Odds Of Further Easing
The British pound traded higher against the U.S. dollar ahead of Wednesday's Bank of England minutes and employment report. Of all the economic data that is scheduled for release this week, the BoE minutes and Chinese GDP report are the ones that we are most interested in. The Federal Reserve, European Central Bank, Bank of Japan and Reserve Bank of Australia have recently eased monetary policy and the question now is whether the Bank of England will follow next month. Based on the latest inflation reports that showed annualized consumer price growth easing from 2.5% to 2.2%, there's a decent case for more stimulus. This is especially true since economic data out of the U.K. has been far from desirable with manufacturing and service sector activity contracting at a faster pace last month.

The housing market has also taken a turn for the worse according to Nationwide and Halifax reports that revealed house prices falling in the month of September. However new gas and electricity increases expected to take into effect between October and January means that the drop in CPI could be temporary. Expectations for inflation are what divide the hawks from the doves. We know that at least two (Broadbent and Dale) and possibly three (Weale) members of the MPC are worried about inflation and do not believe that further Quantitative Easing is necessary. The question is where the other six members stand. When the BoE last met, it left the size of its asset-purchase program and interest rates unchanged but the decision may not be unanimous. The minutes won't be the only driver of volatility for sterling tomorrow. Jobless claims are also scheduled for release and based on the drop in the employment component of manufacturing and service PMI, we do not rule out an increase in jobless claims last month.

AUD: RBA Minutes Suggests November Rate Cut Not A Done Deal
The only commodity currency that participated in the risk rally was the Australian dollar. AUD ended Tuesday slightly higher against the greenback while the Canadian and New Zealand dollars fell sharply. The Reserve Bank of Australia's monetary policy meeting minutes provided little elaboration on their decision to ease and plans for the future. The central bank simply attributed its surprise decision to concerns about "international developments" and slightly slower growth in East Asia, including China. While it is clear that concerns about export demand from China pushed the RBA over the edge, those fears are not new. A large part of the statement was also left unchanged and there were some points of optimism. More specifically, the RBA talked about the rise in house prices and the prospect of more mining investments.

For the Australian dollar, the lack of clear dovishness and bias to ease again has led to profit taking on short AUD/USD positions. The market had been pricing in another quarter point rate cut in November and traders will now have to adjust their positioning. Meanwhile the New Zealand dollar was hit hard by softer inflationary pressure. Consumer prices grew by 0.3% in the third quarter, pushing the annualized pace of growth down to 0.8%, the lowest in more than 12 years. The sharp decline in inflation raises the chance of a rate cut from the Reserve Bank of New Zealand. The Canadian dollar on the other hand shrugged off stronger manufacturing sales and traded lower on cautionary comments from Bank of Canada Governor Carney. On Monday night, Carney warned that economic forecasts will be lowered when the Bank of Canada meets next week to reflect the slowing global recovery and the impact of uncertainty. These dovish comments reduce the chance of a rate hike from the BoC and increase the probability of a less hawkish bias next week. Australian leading indicators are scheduled for release Tuesday evening.

JPY: Noda To Take Steps On Economy To Shore Up Confidence
The Japanese Yen continued to trade lower against most of the major currencies. USD/JPY in particular extended its gains for the second consecutive trading day but has so far failed to crack above the key 79.00 level. No Japanese economic reports were released overnight but the current government is trying to boost confidence and promote growth ahead of what could be a very tough election battle. Constitutionally, August 2013 is the deadline for elections but it is widely believed that leadership race could occur as early as January. Regardless of the timing, the Japanese economy is very weak and if Prime Minister Noda wants to hold onto his seat, he will have to take additional steps to shore up the economy. According to Kyodo News, one of Japan's leading newspapers, the Prime Minister is planning to announce a new round of economic stimulus at the end of this month. The plan will include steps to ease the yen's rise, curb deflation, relax regulations on businesses and expand earthquake reconstruction work. On Monday night the Financial Services Agency (FSA) widened its safety net for yen deposits to include foreign banks. Before the change, only deposits at Japanese banks were protected under the insurance system -- now deposits at foreign banks are protected as well but the details need to be worked out including a possible increase in the capital requirements for banks. In the coming weeks and months, the current administration could take additionally steps to stimulate the economy with the goal of winning favor among the people and staying in power next year.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management