Euro holds on to gains, Fed sounds dovish

Last Friday Fitch did some catching up as it downgraded a number of eurozone countries after S&P’s recent mass downgrade; the downgrades were expected and did not have a major effect on the EUR/USD currency pair.

Despite yet another downgrade for Italy the Italian bond auction conducted Monday went on relatively well, Italy managed to auction off the levels of liquidity required and yields (the cost to the Italian government) were lower compared to previous auctions. However bid to cover ratio, measuring demand, tended towards the lower end.

The EU summit last Monday heralded the week, the aim was to finalise the details of the fiscal compact and the introduction of the European Stability Mechanism (ESM). The ESM treaty should be signed in March to come into force in July. With regards to the fiscal compact, both the United Kingdom and the Czech Republic have opted out.

Last week we had two important events from the United States. First there was the Fed’s FOMC interest rate decision and the press conference that followed; then the advanced reading for Q4 GDP was published. The US economy grew at its fastest pace for 2011 during the last quarter, with growth at 2.8 per cent.

The figure was short of the expected three per cent but still better than the third quarter’s 1.8 per cent. So far so good, but the breakdown of the figure showed a strong build up of businesses’ inventories and weaker spending of capital goods – thus raising concerns on the momentum for future growth.

After last week’s FOMC (Federal Open Market Committee) meeting, the Fed unsurprisingly left its policy rate unchanged. Yet the highlight was the dovish tone the Fed maintained and that it remained supportively accommodating to maintain the economic recovery. The Fed also committed itself not to raise interest rates at least until 2014.

The Fed has added decelerating inflation to its focus, apart from employment growth – as it committed to keep personal consumption expenditure at around two per cent.

The Fed’s official outlook for short term rates, a communication tool initiated last week for the first time, also revealed that the majority of the members see rate hikes as not appropriate before 2014.

So despite the recent improving data out of the United States, the implied dovishness and the concerns being raised over momentum of the US economic growth, it seems we should expect a choppy ride.

The USD/JPY declined towards lows last seen at the end of October last year. The currency pair declined to lows of 76.17, after levels of 77.70 prior to the Fed’s commitment last week to maintain cheap liquidity at least until the end of 2014. For the current week we expect the correction lower to continue towards 75.89.

The EUR/USD rose above two per cent throughout last week, buoyed by hopes for a Greek deal with the private investors and the Fed’s dovish tone. So far in the former part of this week the currency pair has traded in the range of 1.3076 – 1.3221; we expect the 1.3334 – 1.3449 region to resist price movements to the upside, while support at 1.2991 – 1.2761 should cap price moves lower.

Throughout this current week we expect the current uptrend to end around the resistance region (mentioned previously) to later head lower towards 1.2991, unless 1.3449 is breached.

Comments by the Greek Prime Minister with regards to the progress of PSI (Private Sector Involvement) talks helped to maintain risk appetite. Lucas Papademos said that progress was being made. The Financial Times also reported that the ECB’s next three year LTRO (Long Term Refinancing Operations) due at the end of this month would continue to help significantly the liquidity situation. The previous three year LTRO is seen by many as having aided significantly the liquidity situation within the eurozone.

Earlier this week, the eurozone’s economic sentiment overall improved despite industrial sentiment registering marginal declines. German retail sales contracted for the month of December, disappointing expectations for an improved figure.

Ahead of us next Friday the United States will be reporting its payrolls and unemployment data. Non-farm payrolls are expected to rise by 150K, while unemployment rate is expected to remain in line with the previous reading at 8.5 per cent.

The EUR/GBP has traded in the range of 0.8345 – 0.8406 in the former part of this week. For the current week we expect the currency pair to find resistance in the region of 0.8446 - 0.8489; while moves lower should be contained in the region of 0.8321 - 0.8239.

Upcoming FX key events:
Today: Eurozone PPI, UK PMI Construction.
Tomorrow: Eurozone Retail Sales, US Unemployment Rate and Non-Farm Payrolls.

Technical key points:
EUR/USD is bearish, target 1.2500, key reversal point 1.3450.
EUR/GBP is bearish, target 0.80, key reversal point 0.8550.
USD/JPY is neutral.
GBP/USD is neutral.
USD/CHF is bullish, target 1.0050, key reversal point 0.8550.
AUD/USD is neutral.
NZD/USD is neutral.

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Mr Muscat is a senior trader at RTFX Ltd.