Waiting On The RBA And BoC

Within the next 24 hours, both the Reserve Bank of Australia and the Bank of Canada have monetary policy announcements and in anticipation, the Australian and Canadian dollars ended the day unchanged against the greenback. The RBA is expected to cut interest rates for the fourth time this year and after seeing last night's retail sales and manufacturing report, the only question is how much the RBA will ease. Domestic conditions deteriorated significantly since the last monetary policy meeting with consumer spending stagnating in October and manufacturing activity contracting at a faster pace in November. While consumers grew more optimistic, this optimism has not translated into spending. Instead, weaker business confidence and slower job growth held the economy back over the past month. Based on domestic conditions alone, the RBA needs to ease but stabilization in Europe and signs of recovery in China should also ease some of the central bank's concerns and lead them to opt for a smaller 25bp versus 50bp rate cut. Yet with no monetary policy announcement in January, the RBA won't have any choice but to ease tomorrow if only to ensure that the economy receives some additional support over the next two months. Therefore the reaction of the AUD to the RBA decision could hinge less on how much the RBA eases and more on whether they signal plans to ease again in the New Year.

Since the last Bank of Canada monetary policy announcement, we have seen broad based weakness in the Canadian economy. The country's GDP growth fell in August, stagnated in September and grew at a much slower pace in the third quarter. Consumer spending also grinded to a halt as job growth stalled. Under this back drop, the BoC has every reason to drop their hawkish monetary policy stance and shift to neutral but the same was expected in October and yet the central bank still held onto their hawkish bias. With Bank of Canada Governor Carney possibly distracted by prepping for his departure from the BoC and preparing to become the new head of the Bank of England, adjusting their monetary policy stance before seeing how the U.S. Fiscal Cliff talks play out may not be top priority. However if the central bank shifts to neutral, we can expect a sharp sell-off in the CAD. If the RBA cuts interest rates and talks of doing more while the BoC maintains its hawkish bias, AUD/CAD could break below 1.03. Finally the New Zealand dollar edged higher against the greenback despite a sharp decline in their terms of trade in the third quarter.

USD: Deciphering The Fed's Next Steps
Despite the decline in U.S. equities, the U.S. dollar traded lower against most of the major currencies. The only piece of U.S. data released today was ISM Manufacturing and the release provided zero support for equities and currencies. Manufacturing activity across the nation returned to contractionary conditions in the month of November. The ISM index dropped from 51.7 to 49.5, the lowest level since July 2009 and this means more manufacturers reported a dip in activity than an increase. What made the report particularly disconcerting was the fact that ISM survey Chairman Holcomb said he saw only one comment on Hurricane Sandy and therefore some of the effects could be delayed. Throughout this week we expect to see further evidence of the Super Storm Sandy's impact on the U.S. economy. Nonfarm payrolls are due for release on Friday and job growth is expected to be fall significantly as a result of the storm and Fiscal Cliff concerns. While many investors are aware of the possible distortions to NFPs, every one is still trying to get their heads around what the Federal Reserve will do next once Operation Twist comes to an end. According to the FOMC minutes, a few Fed officials believed that additional asset purchases were necessary after Operation Twist ends this year, but comments from Fed Presidents over the weekend and today as well suggests that not everyone is on board. Fed Presidents Dudley, Kocherlakota and Evans, both of whom are voting members of the FOMC this year felt that easier monetary policy was necessary and support the notion of linking interest rates to the unemployment rate. Plosser (who is also a FOMC voter) on the other hand is comfortable with an inflation only mandate and expressed concerns about the eventual consequences of easier monetary policy. Fed President Bullard who is not a voting member of the FOMC this year but a voting member next year believes that it would be mistake to replace Operation Twist with an equal size bond buying program. Nonetheless we believe that the central bank will still announce fresh asset purchases later this month especially since the majority of FOMC members favor easy monetary policy. USD/JPY could give up further gains if U.S. data gives investors reasons to believe that the Fed will combine an increase in asset purchases this month with a target for the unemployment rate.

Euro Breaks 1.30, Powers to One-Month Highs
The best performing currency pair today was the EUR/USD and what made the rally remarkable was the fact that investors bought euros despite weak economic data and a downgrade of the European Stability Mechanism's rating by Moody's after the bell on Friday. In a special report that we released this morning, we outlined all of the reasons why investors are buying Europe. Our primary argument is a reduction in tail risk or the risk of Europe's sovereign troubles wrecking renewed havoc on the financial markets. The more than 10% increase in Greek Government Bond prices sent the EUR/USD soaring to a fresh 1 month high above 1.30. As a prerequisite to receiving its next tranche of aid, Greece launched a program to buy back $13 billion or 10 billion euros worth of bonds from private investors and based upon the rally in the EUR/USD demand is expected to be strong. We won't know the exact level of interest until Friday because bondholders have until that day to register their interest but the Wall Street Journal reports a good chance of Greek state run pension funds participating in the buyback that could end up reducing Greek debt by as much as 20 billion euros. Spain also lodged a formal request for 39.5 billion euros to bail out its banking sector, which is more of a formality than anything else. The downgrade of the ESM and the confirmation of contractionary manufacturing activity in the Euro zone did not faze the euro because after the downgrade of France, an ESM downgrade was widely expected. We don't expect tomorrow's Eurozone PPI report to have much impact on the euro because we already know that producer prices in Germany and France declined in the month of October. Instead EUR/USD traders should keep eyes on European bond yields and the currency pair's 5 month high at 1.3170.

GBP: Stronger Manufacturing Activity Offset By Weaker Housing Data
Better than expected U.K. manufacturing data drove the British pound higher against the U.S. dollar. With monetary policy committee members divided on the need for more stimulus and the Bank of England meeting on Thursday, this week's PMI reports will play a big role in shaping expectations. The PMI manufacturing index rose to 49.1 from 47.3 in the month of November, which is encouraging but with manufacturing activity contracting for the seventh month in a row, the stabilization is not strong enough for investors to overlook weak domestic and external demand. According to Hometrack, house prices continued to decline with prices dropping for the first time this year in London on concerns a new tax on luxury homes costing two million pounds or more. The housing market has received very little support from the government's Funding for Lending Scheme. The Bank of England's initial reports showed lending to households and businesses increasing only marginally in the third quarter. While the BoE argued that it is too early to draw a conclusion about the success of FLS, four key U.K. banks cut lending in Q3. As a result, very little improvement is expected in tomorrow's PMI Construction report. Later this week U.K. Chancellor Osborne will be delivering his Autumn Statement on the economy and government finances. His speech could have a more significant impact on the British pound than the Bank of England's monetary policy meeting.

JPY: Extreme Short Yen Positions Are Not As Big A Deal As Extreme Longs
This may be a light week in terms of Japanese economic data but that has never stopped the Yen from moving. According to the latest Commitment of Traders report, short Yen positions are at their highest level since July 2007. While this data reflects positioning as of last Tuesday, USD/JPY hasn't budget significantly from those levels. When it comes to the Japanese Yen, speculative positioning is important because it is closely watched by the central bank but there's not much the Bank of Japan or Ministry of Finance will do to stand in the way of Yen weakness, as it supports growth. If investors were extremely long Yen, things would be very different as the central bank would be itching to intervene to not only weaken their currency but also get the best bang for their buck by stopping speculative traders out. The only impact that this extreme positioning can have on the Japanese Yen is limit the upside in USD/JPY because the data suggests that those traders who want to be short are already short. Bank of Japan Governor Shirakawa said at an event last night that the central bank should not just look at the markets when making monetary policy but should instead take a long-term view on the economy. LDP Leader Shinzo Abe reiterated his call for the BoJ to aim for a higher 2% inflation target and to achieve that goal by providing unlimited liquidity.

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