US Tax Cut Compromise Buoys the Buck

Highlights

• US tax cut compromise buoys the buck
• Europe's leaders shimmy up to a "fiscal harmony"
• Further tightening out of China
• Dovish outlook to weigh on the kiwi
• Key data and events to watch next week

US tax cut compromise buoys the buck

The greenback has bounced back after the announcement of a compromise on extending the Bush tax cuts was reached between the White House and congressional Republicans. First off, we would note that this is not yet a 'done deal' and Democratic opposition could still sink the plan. In the end, though, we think they'll hold their noses and adopt the plan, as the alternative--tax rates rising to start the year--is nearly unthinkable.

The tax compromise has benefitted the USD in two important ways, which hold the keys to the USD outlook ahead. The first is that the tax cuts amount to another dose of fiscal stimulus, which just a week ago seemed an impossibility, and improves the near-term growth outlook for the US economy. Economists are raising 2011 GDP estimates by 0.5-1.0%, looking for somewhere between 3.0-4.0% GDP for the full year. Better growth prospects, in turn, reduce the likelihood that the Fed may need to do the full amount of QE2 and reduces the potential for QE3, removing major dollar negatives for the time being. The second effect was for US yields to rally sharply, providing interest rate support for the USD, again on the back of better prospects for growth and the need for higher rates sooner. We think a fair amount of the back-up in US rates is due to year-end positioning reductions, and we would note that many of the best performing asset classes (e.g. metals and commodities) saw similar set-backs in the past week. (On that note, thinner year-end liquidity conditions are becoming more apparent across all markets.)

We also remain cautious on the prospects for growth to materialize quickly in a way that meaningfully improves the jobs outlook, which is the key to US rates eventually moving higher. As such, we think US rates will eventually begin to drift lower and may have already peaked below key 3.35/3.40% resistance in the 10-year yield. If so, the upside for the USD might be limited in the near-term, especially in USD/JPY where key 84.50/85.00 resistance remains intact. If the US tax cut plan is eventually adopted, we would reckon with a final knee-jerk rally in the USD as political uncertainty is resolved, but after that we would anticipate some give back. If the plan is scuttled by politics, the USD is expected to suffer greatly. We would also note the near complete absence, so far at least, of USD-negative impact from the higher US deficits the tax cuts entail. But we think such concerns will also likely restrain USD strength in the near-term.

While the Fed is likely pleased that additional fiscal stimulus may be forthcoming, they are no doubt unhappy with higher US rates, which is at complete odds to its asset purchase program. At next week's Fed meeting on Tuesday, we expect the Fed to be at great pains to talk down US rates and we think they'll firmly commit to buying however much is needed to keep rates low. Fed assurances that rates will remain low for an extended period should also work against further moves higher in US yields, likely limiting the dollar's upside. The biggest risks to an extended USD rally mostly come from external developments, namely the European debt crisis or excessive Chinese tightening discussed below.

Europe's leaders shimmy up to a "fiscal harmony"

It's been another interesting week for the Eurozone. While pressure has eased a little on the troubled peripheral nations such as Portugal and Spain, a permanent solution to Europe's debt crisis still remains a long way off. One idea that has divided Europe is the issuance of common euro-area bonds. This would tie the borrowing costs of the stronger core nations with the weaker peripheral nations and spread credit risk between all members.

While this would no doubt be beneficial to the weaker economies of Ireland, Greece, Portugal and Spain who would be able to borrow money at cheaper rates, the upside is more limited for the core economies, especially Germany, who would see its borrowing costs rise.

This idea, although touted by Jean-Claude Juncker, President of the EU, was effectively ruled out on Friday when Germany's Angela Merkel and French President Nicolas Sarkozy rejected the idea during a joint press conference saying that it would make governments less fiscally responsible. Instead they called on individual nations to get their fiscal houses in order and restore economic competitiveness. They also said there was no need to top up the European Financial Stability Fund (EFSF), which currently stands at EUR440bn. This stands at odds with the European Central Bank, who has called for leaders to increase the size of the bailout fund as a way to wean weaker European banks off the Central Bank's cheap financing.

However, it was reported on Friday that Ireland's financial sector is still addicted to ECB funding. Irish lenders received EUR136bn in loans from the ECB and the Irish Central Bank up to November 26 - just after it applied for the emergency funds. Until the bailout loan is actually in the bag (currently Irish lawmakers are still voting on the 2011 Budget, which needs to get passed before the funds will be released) and there is more clarity on the banking sector's restructuring plans then Irish lenders are likely to have to continue to resort to the ECB in order to meet their financing needs.

One interesting development from Friday's Franco-German summit was the commitment from Merkel and Sarkozy to converge their tax policies to the peripheral nations to help them become more competitive. They also said that next year they would present structural proposals to bring greater economic coordination to the euro area. Although far from fiscal union, it is a stab at fiscal harmony, which many believe is necessary to ensure the survival of the Euro area project.

The details of greater economic coordination were not elaborated on, and we don't expect to hear anything too interesting at next week's EU Summit on 16-17 December. However, Europe's authorities are making slow but sure progress toward understanding that the market won't accept a piecemeal approach to this sovereign debt crisis, and instead a comprehensive solution needs to be found.

Europe's problems are far from resolved, and we don't expect there to be any great break through at next week's summit. EURUSD could dip to 1.3105 before it finds support at its 200-day simple moving average. However, any positive signals from the summit that Europe's leaders are willing to do what it takes to resolve this crisis and get the Eurozone on a more sustainable footing could provide a temporary boost to sentiment. But EURUSD is unlikely to rise above 1.3420 - the recent high, and in our view the grind lower in EURUSD is set to continue.

Further tightening out of China

China represents a sizeable portion of the global growth outlook. Today's Chinese trade data came in stronger than expected (exports rose 34.9% YoY vs. 22.9% in October and imports gained 37.7% YoY vs. 25.3%) and further underpins the global economic recovery. However, China now faces a more pressing issue with the task of controlling inflation and an overheated real estate market. In response, earlier today the People's Bank of China raised their reserve requirement ratio (RRR) by 50 basis points in efforts to further address these issues. 

Nevertheless, without firmer measures to try to cool growth, such as meaningful interest rate hikes and more flexibility to allow the yuan to appreciate, then markets are unlikely to conclude that China's growth will slow anytime soon. This weekend the November CPI (a measurement of inflation) is expected to rise to 4.7% from 4.4% in October and economists are anxiously awaiting news on a possible interest rate hike in response. In this instance, we think there would be little harm in raising interest rates from their current low levels as it would be consistent with the PBoC's desire to "normalize" policy.

As China tightens to manage liquidity and control inflation, we may see periodic setbacks in risk sentiment as well as dips in commodity prices and the prices of commodity-linked currencies (Gold, Silver, AUD, CAD and equities). Any such pullbacks are likely to be short lived and in our opinion should be viewed as potential buying opportunities.

Dovish outlook to weigh on the kiwi

We expect the kiwi (NZD) to underperform after a dovish shift in the Reserve Bank of New Zealand's (RBNZ) monetary policy stance. The Monetary Policy Statement (MPS) issued by the RBNZ was downbeat and noted that the near-term outlook for GDP has softened. This was highlighted by below average investment, weak household spending, and a slowing housing market. The MPS went on to state that "interest rates are likely to increase modestly over the next two years, for now it seems prudent to keep the OCR low until the recovery becomes more robust and underlying inflationary pressures show more obvious signs of increasing." Additionally, the bank stated its concern that a strong New Zealand dollar is negatively impacting exports.

The RBNZ also urged the government to eliminate the fiscal deficit to ease current pressures on interest rates and the New Zealand dollar. This is likely in response to the recent move by S&P to revise its outlook on New Zealand from stable to negative as the country has become increasingly reliant on foreign debt. The RBNZ revised down its forecast for the 90-day bank bill rate to provide further evidence of maintaining steady rates. We believe that this, along with the downbeat economic outlook and widening fiscal imbalances is likely to weigh on the New Zealand dollar. As such, we would view NZD strength as sell opportunities with a bias lower. In NZD/USD, the daily Tenkan line is currently around 0.7535/40 to provide immediate resistance. A move above the convergence of the 21 and 55-day simple moving averages which is around 0.7590-0.7600 may see to the daily ichimoku cloud top and prior highs around 0.7675. Key levels to the downside include the 100-day sma which is currently around 0.7400/10, the 0.7350 pivot, and 200-day sma currently around 0.7220.

Key data and events to watch in the week ahead

United States: Tuesday - Nov. Advance Retail Sales, Nov. Producer Price Index, Oct. Business Inventories, FOMC Rate Decision, Dec. 12 ABC Consumer Confidence Wednesday - Dec. 10 MBA Mortgage Applications, Nov. Consumer Price Index, Dec. Empire Manufacturing, Oct. Total Net TIC Flows, Nov. Industrial Production, Nov. Capacity Utilization, Dec. NAHB Housing Market Index, Fed's Lockhart speaks on Atlanta regional economy Thursday - Nov. Housing Starts, Nov. Building Permits, 3Q Current Account Balance, Weekly Jobless Claims, Dec. Philadelphia Fed Business Outlook Survey, Geithner testifies at Congressional Oversight Panel Friday - Nov. 

Leading Indicators

Euro-zone: Monday - German Finance Minister Schaeuble speaks on Berlin Panel , EU Foreign Ministers Meeting Tuesday - EZ Oct. Industrial Production and Dec. ZEW Survey of Economic Sentiment, German Dec. ZEW Surveys of Economic Sentiment and Current Situation, Germany's Ifo Economic Institute Publishes Economic Forecasts Wednesday - EZ 3Q Employment, European Commission Issues Quarterly Report on Euro Area Thursday - EZ Dec. PMI Composite, Manufacturing, and Services, EZ Nov. CPI, German Dec. A Manufacturing and PMI Services, EU Summit Friday - EZ Oct. Construction Output, EZ Oct. Trade Balance, German IFO-Business Climate, Current Assessment, and Expectations, EU Summit, ECB's Weber speaks in Munich on Capital Markets Macroeconomic Perspectives

United Kingdom: Monday - Nov. PPI Input NSA, Nov. RICS House Price Balance Tuesday - Oct. DCLG UK House Prices, Nov. CPI, Nov. Retail Price Index Wednesday - Nov. Claimant Count Change, Nov. Jobless Claims Change, Oct. ILO Unemployment Rate Thursday - Nov. Retail Sales, Nov. Nationwide Consumer Confidence, BOE Releases Inflation Attitudes Survey

Japan: Monday - Oct. F Industrial Production, Oct. F Capacity Utilization, Nov. Tokyo Condominium Sales Tuesday - Oct. Tertiary Industry Index; 4Q Tankan Large Manufacturers, Non-Manufacturing, Large Manufacturing Outlook, Non-Manufacturing Outlook, Large All Industry Capex

Canada: Monday - 3Q Capacity Utilization Rate, BoC's Carney gives speech on 'Reflections on the Economic Outlook' Tuesday - Nov. Leading Indicators, 3Q Labor Productivity Wednesday - Oct. Manufacturing Sales Thursday - Oct. International Securities Transactions

Australia & New Zealand: Sunday - NZ Nov. Food Prices Monday - Australia 3Q Dwelling Starts, Australia Nov. NAB Business Conditions & Confidence, NZ Oct. Retail Sales, NZ Nov. Non Resident Bond Holdings, NZ Nov. REINZ Housing Price Index Tuesday - Australia Dec. Westpac Consumer Confidence, Australia Dec. DEWR Skilled Vacancies, Australia Nov. New Motor Vehicle Sales Wednesday - Australia Dec. Consumer Inflation Expectation, Reserve Bank's Bulletin - Dec. Quarter 2010, NZ Nov. Business PMI, NZ Dec. NBNZ Business Confidence & Activity Outlook Friday - RBA Nov. Foreign Exchange Transaction

China: Friday, Dec. 10 - Nov. Producer Price Index, Consumer Price Index, Retail Sales, Industrial Production, and Fixed Assets Investment Urban Cumulative Dec. 10-12 - China Central Economics Works Conference Dec. 11-15 - Nov. Actual FDI (YoY)

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