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Monday, December 6, 2010

Currency Market Analysis by

US Dollar Gains On Bernanke Comments

Markets kicked off the week on a cautiously optimistic tone as traders bid up the US dollar after Friday’s losses, while the euro fell sharply as policymakers debated the issuance of common euro-zone bonds to bail out weaker members of the currency union.
The buck recovered slightly over the weekend after CBS News aired a rare interview with a sitting Federal Reserve Chairman. Ben Bernanke said that it was “certainly possible” that the Fed would expand or pare its announced quantitative easing programme, saying “It depends on the efficacy of the program. It depends on inflation. And finally it depends on how the economy looks”. He articulated his belief that the recovery was on track, calling a return to recession “unlikely”, but highlighted unemployment as the primary risk to growth, and said that he expects jobless rolls to slowly fall toward 5% over the next five years. 
Bernanke also expressed “100% confidence” that the central bank would be successful in preventing dangerous levels of inflation, pointing out that “We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time”.
Judging by the market’s reaction since the QE2 set sail, Bernanke does seem to be gaining converts. Bond market expectations have stabilized, with yields suggesting that traders are assuming a return to a relatively stable inflationary path, which is the Federal Reserve’s stated goal. The dollar has reversed its losses earlier in the year, and is up 1.5% on a trade weighted basis for 2010.

Euro Falls On Policymaker Discord:

The euro dropped as the financial press reported that finance ministers across the common currency zone were brawling over future rescue efforts. A broad division has emerged between those countries supporting an increase in the European rescue fund, and those such as Germany, who would prefer to enforce sanctions against countries which fail to maintain fiscal discipline.
The European Central Bank stepped up its purchases of sovereign bonds late last week, stabilizing debt markets and the euro briefly, but made it clear that these purchases were meant to be temporary measures. As a longer term solution, several countries have suggested that the European Union raise rescue funds by issuing bonds backed by the common currency zone. While Luxembourg and Italy have voiced their approval for such a plan, Germany is expected to continue pouring cold water on the idea until fiscal restraint can be enforced on member nations.
In an interview with the Financial Times, German Finance Minister Wolfgang Schauble said “The international markets do not really understand the very specific construction of the euro. We have a common monetary union, but we don’t have a common fiscal policy. We need to convince the international public and international markets that this is a new form, very specific to meeting the demands of the 21st century”.
Few expect the negotiations to be easy, and fewer still expect the markets to quickly gain faith in the common currency project. The euro has dropped almost ten percent this year on a trade weighted basis, and is expected to fall further as the sovereign debt crisis weighs on economic growth into next year.

Canadian Dollar Flirts With Par:

The Canadian dollar is holding onto last week’s gains, trading near par against the greenback after the commodity complex had its best week since October last year. The question now is whether the Canadian dollar will breach par and rally higher. The loonie’s high correlation with oil prices would suggest that this is likely, but it is worth noting that in mid-2008, its momentum eventually faded (in percentage terms) even as crude kept skyrocketing. Par has been a psychologically forbidding barrier for many months, but a sharp move higher in the commodity markets would certainly provide the motivation for decisive (and likely very short term) move above it.   
There is significant anticipation building around tomorrow's statement from the Bank of Canada. While virtually no one expects the Bank to raise rates at this meeting, the bond markets are expecting a hike as early as March next year. This view seems to be at odds with evidence of deteriorating economic activity, but the Bank will also be taking recent strength in the United States into account when considering the economy's future path. Canadian inflation rates are slightly above the Bank's two percent target, but within a comfortable margin of error - particularly as much of the recent gain has been attributable to higher gasoline prices.
Uncertainty in Europe, tightening in China and the fragile nature of the global recovery all represent risks to the Bank's outlook, making it likely that Carney and Company will err on the side of caution, dampening bond market speculation slightly while leaving interest rate hikes on the menu for the first half of 2011.

Commodities Continue Rally:

Crude oil hit a 26 month high over the weekend, touching $89.75 a barrel and sitting just above $89 this morning, on optimism that the global economy will suck in greater quantities next year as the emerging countries scale up their consumption. Several of the large investment banks have thrown their support behind the rally, forecasting a move up to $100 and beyond. Of course, this means that they likely placed their positions at $70, but the odds of a momentum move to the magic $100 mark are growing by the day.
Copper continued its meteoric rise, surging to $8,750 a metric ton as stockpiles fall. The price has moved up more than 30% since early July in spite of relatively stagnant global demand. The London Metal Exchange reported last week that a single trader has amassed somewhere between 50% and 80% of the inventories held by exchange-listed warehouses around the world (more than 177,875 metric tons, equivalent to 1% of the total that will be consumed this year). Clearly, there's a strong possibility that this position is exerting an upward influence on the spot price.
The trader's identity and motives are unclear, but speculators have been bidding up the price since June, when several investment groups disclosed their intentions to launch copper-backed exchange traded funds (ETFs). Buying an investment before an ETF is forced to buy it (known as front running) has become a favourite game of many large traders, and has created odd dynamics in many markets wherein spot prices are substantially higher than future-dated contracts.
Copper was once considered an excellent barometer for global macroeconomic conditions, because of its widespread industrial use - and experienced market operators have long used the price as a fundamental indicator. In an era defined by massive financial investment in the commodity markets, this perception clearly lags reality. 
The impact of a lot of speculative money on a small commodity market can be very significant, and this influence is often transmitted into the Canadian dollar’s value. The road ahead will be paved with the good intentions of commodity market investors, which is to say – it will be very bumpy!

Have an excellent week!
By Karl Schamotta, Market Strategist
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