EURO Locked and Loaded

With the BoE expected to keep policy on hold, the key focus this morning is clearly on the ECB. The market expects an unchanged rate decision. However, it’s the press conference that will gauge the markets reaction. The bias is towards a hawkish stance.

Investors expect Trichet to signal a July rate hike by using the ‘strong vigilance’ language. Dealers have already priced in a 25bp hike next month. Even with a tightening bias, the market does not anticipate the ECB to take steps to reduce liquidity assistance to the peripheral banking systems. The Central Bank will also be releasing updated forecasts for the Euro-zone where markets can expect growth and inflation forecasts to be revised higher. However, do not expect Trichet to communicate anything more beyond July.

The US$ is weaker in the O/N trading session. Currently, it is lower against 11 of the 16 most actively traded currencies in a ‘subdued’ session.

The dollar is lower against the EUR +0.30%, GBP +0.30% and higher against the CHF -0.14% and JPY -0.13%. The commodity currencies are mixed this morning, CAD +0.00% and AUD -0.46%.

With Bernanke worried about the pace of the US recovery, Canada’s largest trading partner, a recovery that warrants sustained monetary stimulus certainly has put the loonie under pressure this week. Only for oil prices pushing higher has allowed the loonie to pare some of this week’s losses.

Growth and risk sensitive currencies have been trading under pressure as global growth becomes more of a concern. The CAD is trading close to its yearly lows due to its strong trade association and proximity to the US. Last week, the BoC kept their key interest rate unchanged (+1%) and said they will raise it ‘eventually’ as the economy recovers. Policy makers indicated that the recovery is ‘proceeding largely as expected’ and that any rate increases would be ‘consistent with achieving the +2% inflation target’. The Canadian bulls who read the BoC’s communiqué as being hawkish should be happy that they are getting better levels to own the currency.

The loonie is being subjected to the pull of either risk or risk aversion trading strategies. Most strategists are waiting for tomorrow’s employment report before committing to longer term trading positions. Investors continue to look for better levels to own the loonie for now (0.9787).

In the O/N session, markets have reacted negatively to the much lower-than-expected Australian employment report (+7.8k) by pushing the Aussie dollar to a ten-day low. Rate dealers have cut their pricing for RBA rate hikes over the next year by 10bp. Digging deeper, the modest gains in the headline print was due to the +29.8k rise in part-time while full-time employment fell for a second consecutive month by-22k. The unemployment rate was broadly stable at +4.9% because the participation rate was little changed at +65.6%.

On the flip side and providing some currency support was that both full-time and part-time hours worked rose last month. This, combined with the acceleration in wage growth, is supportive of consumption growth and reduction in household debt. However, the report has severely reduced the chance of a July RBA rate hike and allows the currency to trade in a modest range until investors can get more clarity about Governor Stevens’s interest rate outlook.

Aussie yields are still the highest in the G10 and always look attractive. The expected mix of trade surpluses and rising capital inflows should provide support for the currency on these much deeper pullbacks for the time being (1.0574).

Crude is higher in the O/N session ($101.27 +0.53c). Oil prices have been well supported after OPEC failed to make a deal to raise supplies in Vienna yesterday. The weekly EIA report, despite a plunging headline print, cancelled out its own bullish contribution with the uptick in gas supplies. The outlier is Saudi Arabia, as it’s they who might unilaterally increase supply and cap the spike in prices before it affect global growth. With no extra supply, it will provide for a tight market.

Yesterday’s EIA report showed that oil inventories decreased by -4.8m barrels. At +369m barrels, crude oil inventories are above the upper limit of the average range for this time of year. On the flip side and negating the bullish headline, gas inventories increased by +2.2m barrels and are in the upper limit of the average range. Distillate fuel inventories increased by +0.8m barrels last week and are in the upper limit of the average range for this time of year. Refineries operated at +87.2% of their operable capacity.

The US is obviously concerned about the effect of oil prices on the economy and is expected to use all avenues at its disposal to deal with it. Do not expect the bid tone to be maintained in the medium term because of the pressures on global growth.

Some gold profit taking yesterday after the metal traded close to its one month high. Year-to-date, the commodity is up +8% in 2011 after climbing the past 10-years. Big picture, the yellow metal remains better bid on speculation that borrowing costs in the US will remain low after economic data signaled that the recovery may be faltering and on the back of Bernanke’s comments that further stimulus is required. This morning we get the ECB rate announcement. If they keep rates on hold as expected then the market should remain better bid as precious metals benefit from a low interest rate environment.

Strong buying recommendations from Goldman and Morgan Stanley have also been good enough reason to drag the commodity higher this month. The yellow metal is being used as a store-of-value and trades like a currency.

The metals bull-run is far from over with speculators continuing to look to buy gold on deeper pullbacks ($1,536 -$1.90c).

The Nikkei closed at 9,467 up+18. The DAX index in Europe was at 7,071 up+12; the FTSE (UK) currently is 5,813 up+4. The early call for the open of key US indices is higher. The US 10-year eased 6bp yesterday (2.95%) and is little changed in the O/N session.

Bernanke’s comments continue to provide fodder for the bulls to push longer dated yields to new yearly lows. The reality, record monetary stimulus is still needed to support US economic recovery. Even with supply coming down the pipeline, it’s not allowing dealers to price in a bigger concession at the auctions. It seems that market consensus has us believing that there’s going to be another dip in economic growth and that will require a QE3 package.

Yesterday’s $21b 10-year auction was well received, stopping +0.5bps back of 2.967%. The auction had a 3.23 bid-to-cover versus an average cover of 3.15 seen in the six prior auctions. Indirect too +50.6%, while directs too +8.3% versus a +7% average.

Even piggybacking record lows and because of Bernanke’s stance investors continue have an appetite for product. However, these low yields remain difficult to absorb longer term. For now, the trend remains your friend.

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