Euphoria fades, risk currencies weaker

The euphoria emanating from last week’s eurozone agreement will likely fade into this week as renewed doubts creep in. Details of how the EFSF bailout fund will be leveraged or how the special purpose vehicle will be utilised have yet to emerge while the firewall to protect countries such as Italy and Spain may still be insufficient given that the use of the European Central Bank (ECB) to provide unlimited support has been ruled out.

With more questions than answers markets will be hungry for further details over coming weeks and until then it is difficult to see risk appetite stretching too far. One indication of such concern was the fact that Italy’s borrowing costs climbed to euro-era highs the day after the European Union (EU) plan was agreed. The G20 meeting on 3-4 November will be eyed for further developments as well as further reaction to the EU agreement.

There are plenty of events to digest this week that could add to any market nervousness. In terms of central banks we do not expect to see any change in policy stance from the ECB, Federal Reserve or Reserve Bank of Australia (RBA) this week but the decisions may be close calls. The ECB under the helm of new President Draghi will be under pressure to ease policy as growth momentum has clearly weakened but the Bank will likely hold off for the December meeting when new growth and inflation forecasts will be released.

The RBA may also take some solace from a better global economic and market climate but the market disagrees having priced in a cut this week. The Fed will look to see how ‘Operation Twist” is faring before moving again but recent indications from some Fed officials suggest growing support for purchases of mortgage backed securities.

On the data front eurozone inflation today will be the key number in Europe while the US jobs report at the end of the week will be the main release in the US. Ahead of the payrolls data, clues will be garnered from the ISM manufacturing data and ADP jobs report. The consensus is for a 95k increase in non-farm payrolls and the unemployment to remain at 9.1% maintaining the trend of only gradual improvement in the US jobs market.

Recent data releases have turned less negative, however, and at the least have helped to alleviate renewed recessionary concerns. Overall, I suspect that markets will come back down to the reality of slow growth and unanswered questions this week, with risk assets likely to lose steam over coming days.

European agreement at last

Following a drawn out period of discussions European officials have finally agreed on a haircut or debt write off of around 50% of Greek debt versus 21% agreed in July. In addition the EFSF bailout fund will be leveraged up to about EUR 1.4 trillion, with the new EFSF scheduled to be in place next month. The haircut for Greek debt is aimed at ensuring that Greece’s debt to GDP ratio drops to 120% by 2012.

The reaction of markets was initially favourable with EUR/USD breaching 1.40 and risk / high beta currencies bouncing. I doubt that the upward momentum in EUR can be sustained, however, with plenty of questions on the mechanics of the deal, especially about leveraging the EFSF fund, remaining. I suspect that the EUR may have already priced in some of the good news.

Data releases, especially in the US are offering markets more positive news. Following on from firm readings for US durable goods orders and new home sales, today’s US Q3 GDP expected to reveal an acceleration in growth to a 2.5% annual rate, will help to alleviate recession fears to some extent. The USD may benefit if the data reduces expectations of further Fed quantitative easing especially given the recent comments from some Fed officials indicating that the door is open to more QE.

In Japan attention was firmly fixed on the Bank of Japan policy meeting and the prospects for FX intervention to weaken the JPY. In the event the BoJ kept its overnight rate unchanged at 0.1% as expected and expanded its credit program by JPY 5 trillion and asset purchase fund to JPY 20 trillion.

The measures are aimed to easing deflation pressure but the real focus in the FX market is whether there is any attempt to the weaken the JPY. I am currently in Tokyo and here there is plenty of nervousness about possible FX intervention being imminent. Speculation of such intervention will likely help to prevent USD/JPY sustaining a drop below the 75.00 over coming days.

USD, EUR and JPY Outlook This Week

The USD lost more ground last week extending its drop from the early October. Interestingly its latest drop has occurred despite an uptick in risk aversion suggesting other factors are at work. Mixed US data and earnings have not given the USD much direction with a downbeat Beige Book counterbalanced by a firmer Philly Fed manufacturing survey and housing starts.

The data have not been sufficiently weak to fuel expectations of more Fed quantitative easing but some Fed officials including Yellen, Tarullo, Evans and Rosengren in indicating that further QE could be considered. The USD has therefore been somewhat undermined but will take its cue from data releases and events in Europe this week.

This data slate will be mixed but on balance will not support more Fed QE. In particular, Q3 Real GDP is expected to come in sharply higher than in Q2, with a 2.5% annual rate expected to be revealed. Other indicators will be less positive, with October consumer confidence set to slip further and remain at a recessionary level, while September durable goods orders will decline by around 1%.

Despite an expected increase in new home sales in September the overall picture of the US housing market will remain very weak. Overall, the USD may find some respite from the GDP report but the data will be seen as backward looking, with the jury still out on the issue of more quantitative easing.

The EUR struggled to make any headway last week amid a barrage of rumors about the outcome of Sunday’s EU Summit. In the event the summit failed to deliver concrete details although there appeared to be some progress in key areas. Attention will now turn to Wednesday’s summit but once again the risk of disappointment is high. EUR/USD will only extend gains if markets are satisfied at the result but this is by no means guaranteed.

Data releases will not be supportive for the EUR this week, with a further deterioration in ‘flash’ eurozone purchasing managers indices (PMIs) and European Commission confidence surveys expected in October but hopes of a concrete resolution at Wednesday’s EU Summit will keep the EUR/USD supported early in the week although it will find strong resistance around 1.3915.

The sensitivity of the JPY to risk aversion has actually fallen over the last three months while the influence of bond yield differentials also appears to have slipped. The fact that USD/JPY continues to remain in a very tight range with little inclination to break in either direction despite gyrations in risk and yield differentials almost appears if the currency pair has been pegged.
Obviously this is not the case but a break out of the current range does not look imminent.

Speculative JPY positioning has dropped over recent weeks while equity and bond flows have overall been negative but this has not been reflected in JPY weakness resulting in increased frustration by Japanese officials. We continue to look for the JPY to weaken over coming months but much will depend on a widening in US / Japan yield differentials and easing risk appetite as both will regain their hold on the currency. In the meantime, the currency will continue to offer little to get excited about.

Euro looking rich at current levels

Markets continue to be rumour driven with little concrete news to provide direction. The news that a comprehensive deal by European officials at this Sunday’s EU Summit is now very unlikely has come as a further blow to hopes of a swift resolution to the crisis.

So it seems that Sunday’s meeting will provide a forum to thrash out ideas before a second summit next Wednesday. As a reminder the issues at hand are leveraging the EFSF, banking sector recapitalisation and the extent of private sector participation in Greek debt write downs.

The main disagreement appears to be between Germany and France on method of additional funding the EFSF bailout fund (which has EUR 280billion of firepower left), with Germany and the European Central Bank (ECB) opposed to French demands to utilise the ECB to help back the EFSF with France wanting the facility being turned in a bank. In terms of write downs for Greek bond holders there is a push for at least a 50% reduction compared to the 21% agreed in July.

Separately speculation of the amount of new capital needed for banking sector recapitalisation now revolves around a figure of EUR 80 billion. One spanner in the works is that Chancellor Merkel will have to gain approval from the German parliament before agreeing on further changes to the EFSF, which may delay the process further.

Clearly as this week has gone on the air has continued to seep out of the balloon as the market braces for disappointment. Surprisingly the EUR has held up well and while it has failed to extend gains, hitting a high earlier in the week around 1.3915 but still pricing in some scope for success, at current levels.

Helping the EUR was the fact that the market was very short, and while it could still move higher next week if European officials agree on a plan it still looks like a sell on rallies, with the scope for further gains limited from current rich levels. Good news from Europe next week could see a test of EUR/USD 1.40 but this will prove to be a good selling area further out.

At least there was some good news from Greece for a change as the Prime Minister won a vote to pass further austerity measures to help secure the next tranche (delayed from September) of the bailout despite ongoing protests in the country. The near term focus will be on a meeting of Finance Ministers today ahead of Sunday’s summit.

Plenty of event risk

This week is heavy with event risk, with a lot expected from EU leaders. So far the risk on tone to markets has held up, with for example the VIX fear gauge resting below the key 30.0. The G20 meeting over the weekend set the deadline for action for concrete solutions to the eurozone debt crisis for the October 23 EU Summit.

However, there will be little detail on issues such as banking sector recapitalisation, private sector involvement in any debt restructuring or ‘leveraging’ the EFSF bailout fund until the report on Wednesday night by the Troika on Greece. The reward to EU leaders would be the potential for more aid from the IMF but even now it seems that a German government official has poured cold water of a plan being announced at the EU Summit which will disappoint markets.

There are also plenty of data releases for markets to digest over coming days including inflation releases, manufacturing surveys and industrial production data in the US while in Europe the German IFO and ZEW surveys are scheduled for release. The data will follow on from the better than expected September US retail sales releases at the end of last week continuing to dampen expectations that the global economy is falling in recession though there will be a marked deceleration in European data.

Meanwhile the US Q3 earnings season rolls. The risk on tone will likely continue to weigh on the USD and weigh on bonds but unlike a few weeks ago when a lot of bad news was priced in, the scope for disappointment is becoming increasingly high.

Many currencies remain highly correlated with gyrations in risk and in this respect the improvement in risk appetite is good news for high beta / commodity. AUD, NZD, CAD and JPY are amongst the most sensitive currencies and therefore prone to a bigger reaction as risk improves, with the former three strengthening and the JPY weakening. Asian currencies poised to benefit from firmer risk appetite include INR and KRW, both with relatively high correlations with risk.

EUR/USD has made a solid recovery over recent days from its lows around 1.3146 spurred by hopes of action by European officials. Such hopes may yet be dashed but the EUR looks supported over coming days ahead of the EU summit Speculative positioning also reflects a slight improvement in EUR sentiment as IMM short positions have declined in the last week but its worth noting that this week’s European data are unlikely to be supportive for the EUR.

Strengthening risk appetite hitting the dollar

Strengthening risk appetite is taking its toll on the USD, with the USD index now down around 3.5% from its 4 October peak. Although equity markets probably liked the news the USD was dealt another blow from the FOMC minutes which revealed that some Fed officials were keen on embarking on further large-scale asset purchases after recognizing that the impact of Operation Twist will not be so potent.

Earnings will have some impact on risk and in turn the USD, with Q3 earnings from JP Morgan and Google on tap today. However, risk appetite looks well supported and in a market that became long USDs very quickly, this suggests some scope for squaring long positions in the short term.

What comes next for the EUR? The currency has bounced from its lows and has made considerable ground against the USD over recent sessions. Markets quickly got over Slovakia’s initial rejection of the EFSF’s enhancement as agreement was reached by officials in the country to approve the mechanism in a second vote. However, there is not much news on the progress on issues such as European banking sector recapitalisation, ‘leveraging’ the EFSF or the any change in creditor participation in any Greek debt restructuring.

Although European Commission President Barroso gave some broad outlines of what should be done to recapitalise banks disagreement among officials meant that there was little detail. Perhaps no news is good news and in any case markets will have to wait for the delayed EU Summit for further news, but the longer the wait the greater the scepticism and attendant downside risks to EUR.

The Swiss National Bank must be content with their stance on the CHF. Since the imposition of a ceiling for CHF versus EUR at 1.2000, and after an initial sharp jump higher the currency pair has continued to edge upwards. Meanwhile, speculation that the SNB may even raise the ceiling to 1.30 has grown as domestic complaints such as those from the country’s largest telecoms operator yesterday about the ongoing strength in the currency, continue.

The SNB has not indicated that it favors such a move and may be content with a gradual decline in the CHF as is taking place now, but should the fragile market calm at present disintegrate the SNB may have another battle on their hands as appetite for the currency strengthens anew. On the top side resistance is seen around 1.2469 for EUR/CHF.

Like many other high beta currencies AUD is being influenced less by domestic factors and more by risk aversion. Even more influential to the direction of AUD/USD is the movement in commodity prices and like risk aversion this had a negative influence on AUD as commodity prices dropped sharply over September.

Due to a bounce in both risk and commodities AUD has bounced sharply from its recent lows back above parity with the USD. AUD will have found further support from the firm September jobs report today. It is difficult to go against rising risk appetite at present but there is still a significant risk that hopes of a solution to the eurozone’s woes do not materialise while growth expectations are pared back further. Against this background the AUD will remain susceptible to sharp

High Hopes

EUR/USD has rallied over recent days from a low around 1.3146 last week. Market hopes of a eurozone solution may fall flat but the pressure on officials has ratcheted higher, and the risks of failure are now too significant to jeopardize with half measures. Weekend promises of banking sector recapitalisation by Germany and France have helped but will not be enough should such promises prove empty. Markets will likely give the benefit of the doubt to eurozone officials ahead of the delayed October 23 EU Summit and the November 3 G20 meeting.

Consequently EUR will find some support over coming days and could extend gains as risk appetite improves; having broken above 1.3600 the next big resistance level for EUR/USD is 1.3800. The fact that EUR speculative positioning is very negative (biggest short position since June 2010 according to IMM data) highlights the potential for short covering.

Possible good news in Greece, with an announcement by the Troika (ECB, EU and IMF) on talks over the next tranche of the bailout will likely provide more EUR support. One stumbling block for the EUR could come from the Slovakian vote on EFSF bailout fund enhancement, which is by no means guaranteed to pass.

The JPY remains firm benefitting from higher risk aversion, registering one of the highest correlations with risk over recent months. However, the reason why the JPY is not even stronger is that bond yield differentials (especially 2-year) with the US have widened out in favour of the USD over recent days. If the recent improvement in risk appetite continues, combined with widening yield differentials it could push USD/JPY to finally move higher and sustain a break above 77.00.

GBP/USD has made an impressive bounce over recent days from a low around 1.5272 last week despite the Bank of England’s announcement of more quantitative easing last week and credit ratings downgrades of several UK banks. This resilience is impressive but it appears that GBP is caching onto the coat tails of a firmer EUR rather than benefitting from a domestically led improvement in sentiment. Nonetheless, there is scope for further gains in GBP given that speculative positioning in the currency moved close to its all time low early last week in anticipation of BoE QE.

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