Yesterday’s Bank of England (BoE) and European Central Bank (ECB) meetings came to similar conclusions: they left policy unchanged while introducing “forward guidance.”
Rates
Forward guidance means giving the markets clear guidance about what the future course of interest rates is likely to be. Central banks usually control the economy by raising and lowering interest rates on short-term funds. But when short-term rates hit zero, as they have in many major economies recently, then they can’t lower rates any further.
Moreover, there are problems in getting short rates to percolate through the economy. First, officials may want investors to borrow money and buy stocks, bonds or other risky assets, but investors will always worry about getting trapped if there’s a sudden change in monetary policy. If they borrow short-term funds to invest and then rates go up, they may have to sell their stocks to repay their loans. But if everyone tries to sell their stocks at the same time, the price will collapse and they’ll lose money. Secondly, even if the central bank brings short-term rates down to zero, a lot of financial products are priced off of long-term rates, and they can still be higher than what the central bank wants. In particular, mortgage rates are tied to long-term rates, and housing is crucial for the economy.
Forward guidance allows the central bank to overcome both these problems. By making it clear to the market that it will keep interest rates low for a certain period of time, officials are more or less guaranteeing investors that they can borrow short-term funds and invest them in stocks, bonds, real estate or other less liquid investments without having to worry that short-term rates will suddenly rise, forcing them to sell their investments at a loss. As for the second problem, a long-term interest rate is just a series of short-term interest rates rolled over. That means that if the central bank promises that short rates will remain at zero for the next two years, then two-year rates should fall to zero, too. Forward guidance therefore helps the central bank to extend its influence further out the yield curve and thereby to extend its influence over the economy.
Dovish Statements
Both central banks also came out with dovish statements. The BoE, which issued an unusual statement after its meeting (normally it does not issue a statement if it leaves policy unchanged) said that “in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.” In other words, it’s telling the market that short-term rates will not rise as quickly as investors think. As for the ECB, President Draghi said at his press conference that the governing council had an extensive discussion about a possible rate cut, that both the refi rate and the deposit rate (currently at zero) can go lower still, and that rates would remain “at present or lower levels for an extended period of time,” which he later implied was longer than a year. This is a substantial change for a central bank that previously had said it “never pre-commits.”
As a result, both GBP and EUR weakened, with GBP weakening more than EUR. We believe both currencies are likely to weaken further vs USD on a fundamental view as their central banks are now just starting to launch a new round of easing measures, whereas the Fed is starting to exit from its easing measures.
Today the market will focus on the US non-farm payrolls for June. The consensus forecast is for +165k, a bit less of a rise than +175k in May, although some people have revised up their forecasts following yesterday’s better-than-expected ADP report. The standard deviation on the market consensus is 18k so anything between150k-180k should be within the range of expectations. A number below that will probably diminish expectations of “tapering” and be USD-negative, while above that is likely to accelerate expectations and boost the dollar further.
FX Reaction
Looking at the market’s reaction to the data over the last year, EUR/USD has tended to fall more when the NFP misses expectations than when it beats expectations, which is exactly the reverse of what one would expect. In fact EUR/USD has tended to rise in the first couple of days following a beat. It may be because these data come from a time when “risk on = sell USD” and therefore the market reaction was the opposite of what textbooks say would be likely to happen. I’m not sure it proves anything about today’s data or the reaction in today’s frame of reference, given how a) the Fed has made clear its determination to begin “tapering off” in the next few months if the data allow, and b) the ECB has made clear that it will not be tightening for at least the next year.
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The Market
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- EUR/USD was finding resistance at 1.3005 for most of yesterday morning, moving 10 pips higher following the release of the surprise BoE monetary policy statement. Thereafter the euro plunged 130 pips on Draghi’s statement and press conference, which sent the euro crashing versus the USD.
- The day to day sees the much awaited non-farm payrolls, which may indicate how close the Fed is to initiate tapering off of QE. The short-lived rebound from the plunge yesterday found resistance at 1.2920, with trendline resistance being seen today at 1.2920. Key support levels are seen until 1.2855 with a break of this level likely triggering a breakdown to 1.2800. A close below 1.2800 would complete the symmetrical, in terms of shoulder width, head-and-shoulders formation and signal a steeper down move for EUR/USD. A reversal level is found at 1.2750 and key Fibonacci support at 1.2680. Should the US employment report prove disappointing, key resistance comes at 1.3000, with the tested 1.3030 level seeing downward-sloping trendline resistance for the day.
EUR/GBP- There is no doubt that sterling was the biggest loser yesterday as indicated by the EUR/GBP gains, reversing the sterling gains witnessed on Wednesday following the very strong UK services PMI. The break of key resistance at 0.8590 was short-lived as the ECB issued shortly after the BoE a dovish policy statement of its own triggering a retracement.
- The coiling that has been taking place the past couple of months has strong resistance at 0.8590 with notable resistance thereafter at 0.8660 and 0.8715. Trendline support comes at 0.8490.
USD/JPY- USD/JPY is continuing to rebound unabated as seen in the 4-hour chart, having tested trendline support with the Parabolic SAR signalling an uptrend again. The strong gain in equities in Europe, with the FTSE 100 up more than 3% and DAX more than 2% on the accommodative policies by the BoE and the ECB triggering a risk-on environment that is also boosting Asian stocks today, weakening the yen.
- A breakout from current resistance at 100.40 sees tested resistance at 100.80, with further resistance at 101.35 and 101.65. Support comes at 100, with weak support at 99.7 and better tested support in the 99.15 – 99.35 area, which sees the 50-day MA.
- Gold hardly felt the sell-off of pounds and euros, indicated by the tiny $5 trading range it had on the announcement of the BoE and ECB dovish statements. The support rendered to equities by these statements, the generally improved economic outlook in the U.S., Eurozone and the UK and the increases in US Treasury yields on tapering speculation give no substantial backing for gold to strengthen as things stand, and even more so since inflationary pressures in the Eurozone and the US are subdued.
- The overnight break of $1244 on speculation that the US employment report will be substantial evidence for imminent tapering have the gold test support in the $1242 – $1244 area, with a breakdown seeing weak support at $1234 and better-tested support at $1224. Resistance will likely come in the $1256 – $1259 area. Further resistance comes around $1269.
- Oil had a quiet day for a change with Brent unchanged since yesterday morning and WTI losing 0.25%. Support got tested a number of times at 100.69 with an overnight rebound failing to breakout from weak resistance at 101.45.
- Strong US job gains, however, may be the catalyst for a breakout from $101.45 and $102 resistance, with key levels then seen at $102.95 and $103.80. Support below $100.65 comes at $100 and then $99.15.
MARKETS SUMMARY
