EUR/USD correction might reach 1.1097, and even 1.1000

Outlook:

The US has to deliver a steady stream of really good data for the correction to grow legs, starting with factory orders this morning and ending with payrolls on Friday. We have a lot of Fed speakers early in the week, too, but honestly, everyone is tired of these two-handed economists by now. (Today it’s Chicago’s Evans and San Francisco’s Williams). The important thing is to shake off a lousy first quarter and raise expectations for Q2, even with Friday’s iffy PMI and construction data. So far we have a forecast of 225,000 jobs on Friday (Bloomberg), from 126,000 in March. Is that enough? A lot depends on wages, hours worked, participation rate, etc. What might cement September is a number over the 12-month average of 260,000.

We also get the Reserve Bank of Australia (tomorrow) and employment data from Australia, New Zealand and Canada ahead of the US version. For some reason, employment data moves the AUD and CAD, although central bank governor comments on currencies is more powerful. Tomorrow it’s the US service sector PMI. Thursday the ECB meets but nothing much is expected, unless somebody says something about Greece. Analysts note that cutting the Emergency Liquidity available to Greek banks would not be bad news, but good news, since the ECB is continuing its commitment to support the Greek banks.

As noted above, the correction in the euro is likely to reach the 25% Fib retracement level at 1.1097, which coincides with hand-drawn support. At a guess, the euro can go farther, to the 38% level or 1.0998, or 1.1000 to name the round number. We will start being really impressed if we get the 50% retracement at 1.0906, but many analysts say the correction will fizzle before it reaches the 62% level at 1.0815. And let’s not forget that if the correction fizzles, we have to accept a resumption of the euro rally to levels like the Feb high at 1.1535.

The correction is still in a nascent stage. The Commitments of Traders report (for last Tuesday) showed a drop in short euro positions but by only 13,000 contracts and the market remains overwhelmingly short. We have to worry that traders have to get rid of short positions, lifting the euro, before they can sell again. What is going to be tested is the end of deflation—more than the beginnings of cyclical recovery in things like production and trade. The last inflation report—zero, rather than a negative—was influential. But zero is not rising inflation, and until rising inflation is seen, the ECB will be rock-hard about QE. If fact, it may be rock-hard to end-2106 even if inflation does re-emerge, as a credibility issue. In other words, buying euros as a hedge or a quickie trade is not the same thing as buying euros on favorable sentiment.

While everyone is watching the euro correction, let’s not forget that Tokyo was closed and London is closed today for May Day. New Yorkers don’t like to admit it, but London is the bigger market in FX and while UK traders can leave orders to be executed elsewhere, it’s not until we get London back tomorrow that we will see the real action. Even then, the focus could well be on sterling over all others, because of the election on Thursday. So far it looks like the pound is suffering from a crisis of confidence. The Tories promise a referendum on EU membership by 2017, with a departure from the EU something every analyst says would be negative for both the UK and EU. But Labour has its drawbacks, too, despite promises of fiscal prudence.

We wish we could avoid saying anything about the UK election on Thursday and we want to put “No Position Recommended” in sterling in the trading advisories. It seems like the Tories will win, although the pollsters keep saying it’s too close to call, despite Cameron being outed as an upper-class public school twit in Scotland in September. Besides, every once in a while, Miliband impresses (stone tablet engraved with promises), although on the whole, he’s a guy without any charm at all. Bloomberg says Miliband was mocked for the stone tablet, but given the propensity of politicians to forget their promises, we think it’s a splendid idea. The Tories, meanwhile, do what conservatives always do—promise to cut taxes and balance the budget at the same time. Why do voters keep buying it?

Clive Crook has an opinion piece in Bloomberg: “Consider a very plausible outcome. England rejects Labour and elects a Tory majority. Scotland also rejects Labour, and elects the Scottish National Party in a landslide. Thus, the United Kingdom gets a Labour government.

“In this scenario, Labour has a minority in the House of Commons, perhaps with fewer seats than the Tories. But with the SNP's tacit backing (support not amounting to the coalition or ‘deal’ that Ed Miliband, Labour's leader, has promised not to strike with the Scots), Labour can muster more votes for its legislation in the Commons than the Tories and the Liberal Democrats acting together.

“England gets a government it did not want, foisted upon it by the actions of an anomalously over-represented Scotland, evidently intent on breaking up the union. A happier outcome, constitutionally speaking, would be a Labour alliance with the Lib Dems -- maybe representing a majority of both votes and seats in England. Again, though, getting legislation passed would probably require the Scots to go along.

“In either case, the crucial thing in all this would not be Britain's traditional aversion to rule by coalition, powerful as that is. It would be the pivotal role in the U.K. government played by an avowedly anti-U.K. party (commanding, by the way, less than 5 percent of the vote in England, Scotland and Wales, and not much more than 50 percent of the vote even in Scotland). This ridiculous prospect makes an eloquent case for Scottish independence or voting reform -- and maybe both.”

Coalition governments are a bad thing—nothing gets done and whatever does get done is wildly unpopular. A seismic change in the UK? In the end, the UK could be losing Scotland and leaving the European Union. That’s the worst-case scenario in the WSJ, which sees instability ahead. Well, we don’t put much stock in the WSJ’s political analysis capabilities, but one thing is right—sterling is going to be volatile this week, just as it was during the Scottish referendum last fall.

For what it’s worth, we see the pound already getting oversold—see the stochastic in the mini-chart. The GBP can swoon to the 50% retracement (1.5034) and even the 62% retracement (1.4923), because when traders start gunning for sterling, they don’t stop easily. But a corrective bounce is clearly in the cards and possibly soon, by which we mean tomorrow. The FT reports that one-week sterling/US dollar implied volatility is at the highest since the last election in May 2010, up to 17.85%. “The move suggests traders think an indecisive poll on Thursday will trigger much twitchiness in the foreign exchange markets, as horse trading to create a coalition leaves a political vacuum. The three-month sterling implied volatility is considerably lower, however, suggesting traders don't think any instability around the elections will persist.”

Right on. At some point this week, sterling will be a screaming buy. After all, “instability” is a ridiculous charge. Thatcher’s election in 1980 was a far bigger “de-stabilizing” event. Today’s crop of whippersnappers don’t know it, but at the time, Thatcher’s promise to end the last vestige of capital controls—the dollar premium—was universally forecast to spell the death of sterling as capital outflows swamped the trading desks. Didn’t happen. Before that, it was the devaluation of Nov 1967 and let’s not forget the Soros Moment in 1982. The UK has weathered financial storms a lot worse than this.
Remember, this is the country that gave us the Magna Carta, and without getting soppy, it’s the starting point of the liberal democracy that led to the formation of the United States. Traders may play ping-pong with the pound, but let’s not go overboard on any “historic moment” stuff.