Calyon FX the Day Ahead - FX takes stock

By Calyon Fixed Income Research

Highlights

* The focus remains on equity markets and Q2 earnings, with
Bank of America and Citigroup due to report today.
* Data calendar is
relatively sparse. US housing starts are expected to decline, partially
reversing May's decline. Headline Canadian CPI expected to turn negative in
June.
* EUR may garner further support as trade data returned to surplus in
May.

FX takes stock

The FX markets should end the week still looking to equities for direction. Wall Street posted another, albeit smaller, gain yesterday with the market boosted by robust results from JP Morgan and positive soundings from IBM. The focus will remain on the banking sector today with the publication of Bank of America and Citigroup Q2 numbers. General Electric will also release its earnings data. So far, the Q2 figures have tended to surprise to the upside. If BoA and Citi follow suit, equities would seem likely to post further gains, adding to downside pressure on the USD and JPY. The risk is, however, that after four consecutive daily gains the market instead prefers to take profits ahead of the weekend. Further, the JP Morgan results indicated that it was investment banking which had boosted profits. The losses made on the consumer credit side suggest that the US economy still remains vulnerable and that a pull away from recession will be gradual. In addition the news of bomb attacks in Indonesia, targeting two hotels in Jakarta, may spur risk aversion.

The economic calendar doesn't look likely to provide much impetus for currencies. US housing starts for June are expected to decline to 520K (-2.3%), but this is payback for the hefty 17.2% rise in May rather than an indication of renewed housing market softness. Building permits are expected to show a little more resilience, increasing slightly on the month. Despite the expected decline in starts, the series is showing clear signs of bottoming out, although this may not signal a swift rebound in the sector.
Fundamental weakness in the housing sector is set to remain a feature for quite a while given the recession's impact on jobs, income, confidence, tight credit conditions, elevated inventories of homes for sale and falling home prices. However, the stabilization of single-family starts in recent months, and some firming in mortgage applications for home purchases are positive signs for an eventual stabilization in housing activity late this year as policies to stabilize housing gain traction. Still, rising foreclosures are expected to keep downward pressure on home prices. Given these factors, it will require a big surprise in the data for it have anything other than a negligible impact on the USD.

The CAD has been a star performer against the USD over the past week, gaining around 4% in spot terms as risk appetite improved and BoC's quarterly business survey showed an improved outlook for the economy, in particular orders. Depending on how equity markets end the CAD may be forced on to the back foot today by possible profit taking after its recent gains and knee jerk reaction to a week inflation report. Headline CPI is expected to turn negative in year on year terms for the first time since the end of 1994. A “deflationary” CPI rate might boost speculation that with rates as low as they can go the Bank may yet move more aggressively in to the credit and quantitative easing. The BoC, however, does not target the headline CPI, but rather the core.
The core rate is expected to fall below its 2% YoY target, but remain
comparatively elevated at 1.7%. Further, whilst that BoC survey suggested that the negative output gap would keep inflation pressures in check for now;
businesses did report an increase in inflationary expectations. In addition, the survey showed that credit conditions in Q2 were loosening, or rather les tight than Q1, signalling that past rate cuts may be working through the system and the negating the need for CAD unfriendly credit/quantitative easing.
Consequently, profit taking and softer commodity prices through the summer months appear the biggest threat to the Loonie, with USD/CAD likely to find very strong resistance at the June 1 low of 1.0785.

An improvement in the risk backdrop has allowed EUR/USD to finally sustainably break above the 1.4000 level again and now comfortably holding above 1.4100. This renewed vigour should more strongly spill over into other crosses. The Single Currency has suffered at the hands of the CAD, AUD, NZD and to a lesser extent the NOK over eth past few days
and hence ample scope to retrace some of these losses. A prime candidate would be gains in EUR/NZD with the Kiwi still reeling from Fitch downgrading its credit outlook, with a move back to yesterday's high around 2.2000 possible.
Equally, the scope profit taking on CAD positions would favour a EURCAD move back to 1.5900. The Eurozone trade data for May should also shore up EUR sentiment. The adjusted surplus is expected to rise after reported improvement from Germany and France. Whilst, the trade data is still being flattered by weak domestic demand curtailing imports, German orders data suggest that the decline in foreign demand hit bottom earlier in the year and whilst any improvement is likely to be gradual, EUR friendly signs of rising exports should continue through to the end of the year.

Stuart Bennett Senior FX Strategist