USD: Vulnerability of Earnings
The risk seeking mode in the financial markets was unaffected by Moody’s decision to downgrade Greece’s government bond ratings to junk levels. Considering that Moody’s was the second and not first big rating agency to cut the country’s debt rating below investment grade, the announcement was not exceptionally newsworthy. Although the dollar turned lower against the Japanese Yen, the euro, British pound, Australian and New Zealand dollars held onto their earlier gains. The U.S. dollar and Japanese Yen traded lower against all of the major currencies which suggest that investors are starting the new trading week less nervous.
Impact of Strong Dollar, Weak euro on Earnings
Since the beginning of the year, the U.S. dollar strengthened approximately 14 percent against the euro. Sharp currency fluctuations can have a strong impact on earnings and in recent weeks, we have seen a number of companies warn about the impact that the strong dollar or a weak euro may have on profitability. For example, this morning, video game manufacturer THQ said that for the first quarter, it now expects to lose between 20 to 30 cents a share compared to a prior estimate that it would breakeven on a per share basis due to a strong dollar and lower than expected sales of its videogame UFC Undisputed. Even as McDonald’s Corp posted strong international sales for May, the fast food giant warned that year over year profits could be hurt by the weakness of the euro because 25 percent of its sales come from the Eurozone. McDonald’s competitor Burger King also expects foreign exchange translation to shave earnings by up to two pennies per share. Technology firms with a big dependence on their international operations and sales such as Google, Priceline and Expedia are all expected to suffer from a strong dollar, which reduces the value of foreign earnings. To explain this further, imagine that McDonalds sells a Big Macs in France for 2 euros at a EUR/USD exchange rate of 1.45. For U.S. based McDonald’s, that would mean revenue of $2.90 per Big Mac. Suppose that the euro weakens 20 percent, bringing the EUR/USD exchange rate down to 1.16. The 2 euros for each Big Mac now equals revenue of only $2.32 instead of $2.90. Compound this by millions of Big Macs sold abroad and you can understand how a strong dollar can hurt companies like McDonald’s. At the same time, a strong dollar also negatively impacts U.S. companies selling products abroad because it reduces their competitiveness. The companies are faced with the difficult of decision of raising prices to keep margins intact or maintain their competiveness by reducing prices and take a hit to profit – either way, it is a losing situation for U.S. exporters and we expect more companies to blame weaker earnings on a strong dollar in the coming weeks.
Is China Still Buying U.S. Dollars?
Tomorrow’s Treasury International Capital flow report will provide the latest details on whether China is still buying U.S. dollars. Washington has continued to pressure China to revalue the Yuan and in protest, China may have bought less U.S. dollars. However there has been a lot of risk in holding euros over the past few months and no significant alternative that can absorb China’s flow than U.S. dollars. Therefore we expect foreign demand for U.S. dollars to remain healthy especially considering that job growth was very strong in March and April, providing foreign investors with hope about a recovery in the U.S. economy. Aside from the TIC data, the Empire State manufacturing survey is also scheduled for release and it will be interesting to see if the strong dollar has taken a toll on manufacturing activity.
EUR: MOODYS DOWNGRADES GREECE
For the fifth trading day in a row, the euro extended its gains against the U.S. dollar, shrugging off Moody’s decision to downgrade Greece’s bond ratings by 4 notches to junk levels. Euro traders shrugged off the announcement because Moody’s is late to the game. Standard & Poor’s downgraded Greece’s ratings to junk back in late April. Fitch said they have no immediate plans to cut Greece’s debt rating to junk although they currently have Greece rated at the lowest investment grade level with a negative outlook which implies the possibility of a downgrade. The Greek government was quick to fire back, saying that “today’s downgrades in no way reflect the progress achieved in recent months.” While Greece has taken steps to shore up its finances, Moody’s may be more concerned about the toll that the austerity measures will have on the nation’s growth and long-term viability. Today we also saw signs that the European Union was considering ‘temporarily’ banning or restricting naked CDS trades, a move that would follow Germany’s example from last month. Restrictions, which may be voted on as soon as tomorrow, will only be considered in case of developments “which constitute a serious threat to financial stability.” Separately, the Eurozone reported that annual Industrial Production posted its strongest gain on record, thanks in part to the weak euro. The ZEW’s economic sentiment reports and Eurozone employment numbers are scheduled for tomorrow.
GBP: OBR REDUCES DEFICIT FORECASTS
Of all the major currencies, the British pound strengthened the most against the U.S. dollar after the Office of Budget Responsibility (OBR) released a lower budget deficit forecast. The OBR is a newly created and independent agency whose aim is to take the responsibility of forecasting out of the Treasury’s hands. The OBR is tasked with providing a nonbiased assessment of U.K. finances. After a thorough review, they came up with lower budget deficit and growth forecasts than the figures projected in March. More specifically, the Office for Budget Responsibility estimated that the public sector net borrowing as a percentage of GDP would fall from 10.5 percent in the 2010-11 financial year to 3.9 percent in 2014-15. The March budget projected borrowing would fall from 11.1 percent of GDP in 2010-11 to 4 percent in 2014-15. The composition of the forecasts also changed with the output gap lowered and the structural component increased. Growth on the other hand is expected to reach 2.6 percent in 2011 compared to the March budget forecast of 3.25 percent. Growth forecasts for 2012-2014 were also revised lower. These forecasts will be used in the Budget next week (also produced by the OBR) and they will help determine the amount of spending cuts needed. If the OBR’s rosier forecasts are reliable, then it reduces the chance of Britain losing its prized AAA rating. Consumer prices are scheduled for release tomorrow and CPI has long been a thorn in the Bank of England’s side because CPI growth above 3 percent has prevented the BoE from raising their asset purchase program to support the economy. Inflationary pressures are expected to ease in the month of May which should validate the central bank’s belief that the high level of inflation is temporary.
NZD/USD: SALES DISAPPOINT, WAS HIKE PREMATURE?
This week’s trading started off with a bang for the commodity currencies; all reached higher levels as investors cast their inhibitions aside. However, with the release of another ratings cut for Greece, the joy was somewhat muted as the Canadian dollar saw its advances mostly dissipate by the end of trading. Nevertheless, the kiwi was among the better performers today even despite what amounted to a horrid Retail Sales report. Sales dropped 0.3%, coming in just under the -0.2% consensus forecasts. Obviously, with wage growth rising at the slowest pace in nearly a decade, it would be unwise for consumers to become spendthrifts. This is particularly concerning considering the Reserve Bank of New Zealand officially kicked off their tightening cycle this month. The question that will be circulating from now on is whether the bank’s first hike in three years was premature. However, since the RBNZ is an inflation targeting bank, it is hard to expect that the sales numbers will have too much of an impact in the short-run. RBNZ Governor Alan Bollard said today that while he recognizes the fact that the trade balance has improved, he is concerned that the “large deficit on the investment income balance” is being exacerbated by the strong kiwi. Though these are not particularly strong comments, it is worth noting Bollard’s distaste for the strong currency. The RBA’s Minutes and Canadian Labour Productivity are on tap for tomorrow.
JPY: BOJ ANNOUNCEMENT TO EARN TRADER FOCUS
USD/JPY was taken lower during late-afternoon trading after earlier rallies failed to materialize on renewed distress emanating from Europe. Meanwhile, stocks rose for a third day as a report showed that Japan’s largest manufacturing companies are more optimistic now than they were last quarter. The report goes a long way to underscore the sectors resilience in the face of what seems to be a storm brewing overseas. Manufacturers polled in the report said that they planned to boost capital spending by 9.7%, and judging by the fact that such investments account for a healthy portion of GDP, we may be in for stronger growth in the country. Perhaps more importantly, the non-manufacturing component of today’s BSI report showed that services companies became optimistic for the first time in nearly a decade. While these reports were promising, it is the BoJ’s monetary policy meeting that traders will be focusing on over the next 24 hours. A change in rates is out of the question, but we are still looking for the announcement of a new plan that will provide capital to banks to shore up credit markets. However, many are worried that any additional plans will be ineffective considering that the BoJ has already done a lot this year to no avail in the fight against deflation.
EUR/GBP: Currency in Play for Next 24 Hours
The EUR/GBP will be the currency pair in play for the next 24 hours. In the Euro-Zone, we expect First Quarter Employment, June ZEW Economic Sentiment, and April Trade Balance figures at 5:00 ET or 9:00 GMT. In the United Kingdom, watch for May Consumer Price Index figures and the monthly DCLG UK House Prices index at 4:30 ET or 8:30 GMT. EUR/GBP is currently trading in the Range-Trading zone, which we determined using Bollinger Bands. The nearest level of support is at the pair’s June low of 0.8210, which is also its lowest level since November of 2008. The closest level of resistance for the EUR/GBP is at 0.8427, a prior low in May which coincides with its 20-Day Simple Moving Average.
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