ECB risks, more JPY jawboning, Asian FX supported

Risk assets have given back some of their Draghi inspired gains but expectations of European Central Bank action on Thursday continues to provide a solid underpinning for markets. Although European equities closed higher US equities slipped while the VIX ‘fear gauge’ rose. Ahead of the ECB policy decision attention will be on whether German resistance to a more aggressive ECB stance eases. Given that markets have priced in a positive outcome the risks are asymmetric in the days ahead, with a bigger sell off in risk assets should policy makers disappoint.

One indicator worth highlighting is the Baltic Dry Index which has dropped by over 20% from its high on 9 July and continues to head south, indicating rising global growth risks. Economic data releases including the Eurozone ‘flash’ July Eurozone inflation data, and US July consumer confidence will offer some direction for markets but we suspect that a tone of consolidation will continue ahead of the ECB and Fed meetings and the July US jobs report at the end of the week.

Japan continues to jawbone about the strength of the JPY, with Finance Minister Azumi delivering a further threat of FX intervention. Azumi notes that the advance of the JPY has been one sided, does not reflect fundamentals and that no measures will be ruled out when it comes too FX action when needed. He also hints that any intervention may be supported by other countries. It is doubtful that Azumi is setting the scene for actual intervention although a sustained drop below 78.00 will sharply raise the odds of Japanese official JPY selling.

EUR/USD looks supported above 1.2118 but a drift lower is likely ahead of the ECB meeting. Reports in Der Spiegel that Draghi’s pledge of action has created discord within the ECB while Germany continues to resist action to restart the ECB’s securities market purchase programme. The risk is that Draghi has set the ECB and risk assets up for a fall if agreement cannot be reached ahead of the ECB policy meeting.

Asian currencies look supported going in the near term and its worth noting that equity portfolio flows to the region have pocked up over recent days led by South Korea. The USD will be restrained ahead of the Fed meeting allowing Asian currencies to grind higher. We favour KRW and IDR although gains are likely to be limited ahead of the key central bank policy decisions this week. On that note, a likely unchanged decision from the RBI in India today, may act as further disappointment for the INR.

Hopes run high ahead of major central bank decisions

Expectations are running high that central bankers will deliver on further policy steps at the Federal Reserve, European Central Bank and Bank of England meetings this week. Indeed, following strong hints by ECB President Draghi last week, which provoked a rally in global markets, there are high hopes that the ECB restarts its bond buying programme.

Opposition by Germany’s Bundesbank could result in disappointment, however. A meeting today between Draghi and Bundesbank president Weidmann will shed further light on the issue. Also on the table is the potential for the ESM bailout fund to be given a banking licence though this seems unlikely any time soon. Given the rally in risk assets at the end of last week, any lack of action by policy makers this week will provoke significant disappointment.

Similarly a run of weaker US and UK data has led to growing hopes that the Fed and BoE will also ease policy further on Wednesday and Thursday, respectively. While recent press speculation suggests that the Fed is edging closer to further balance sheet expansion the Fed FOMC may want to wait for further news on the economic front before embarking on more quantitative easing.

Meanwhile, the BoE appears to be edging towards further easing too, but rather than more QE a rate cut is looking like the preferred option. I suspect that such action at this week’s monetary policy committee (MPC) meeting is unlikely, however. Adding to the drama of this week’s events is the US July jobs report at the end of this week and yet another lacklustre report is expected, with consensus forecasts for a 100k increase in jobs.

Currency markets are likely to settle into ranges ahead of the key events above. The USD lost a fair bit of ground over recent sessions but further direction will await the ECB and Fed meetings. EUR/USD looks firmly settled above support around 1.2241 but upside traction will be limited until there is further clarification from the ECB. I suspect that last week’s short squeeze has run its course, with a further drop in peripheral Eurozone bond yields required to drive the EUR higher.

Asian currencies look well supported in the near term ahead of the major policy decisions. The SGD and KRW have led gains over the past week and their high degree of sensitivity to risk suggests that they should continue to outperform. The INR has also edged higher on the back of firming risk appetite but much will depend on the outcome of the RBI meeting tomorrow. According to my quantitative models the PHP and TWD will underperform.

Draghi shakes things up

European Central Bank President Draghi shook things up overnight providing a major backstop for risk assets. Draghi effectively noted that the ECB “is going to do whatever is necessary to preserve the EUR”. The aggressiveness of his comments left no doubt that the ECB chief means business.

Whether this translates into renewed bond buying by the central bank is debatable but this is what the market is now hoping for at next week’s ECB policy meeting. Anything less would provoke disappointment.

At the least Draghi has helped to put a floor under the EUR ahead of the policy meeting. After dropping to a low around 1.2117 the currency bounced sharply but its gains were exhibited mainly against the USD rather than on the crosses. Further short covering could see EUR/USD move up to around the 1.2350 resistance level but much further gains are expected to be limited.

The biggest beneficiaries of Draghi’s comments were equity volatility which dropped sharply and Spanish stocks, which rallied by over 6% yesterday. Gold also rallied in the hope of central bank action next week. In terms of Asian currencies, those most sensitive to risk gyrations including KRW, MYR, INR and IDR will be the biggest beneficiaries.

Attention today will turn to data releases including July German inflation data and Q2 US GDP. A weak US GDP may put a bit of a dampener on sentiment especially as it will highlight the sharp slowing in growth over the quarter.

Nonetheless, markets are likely to move into consolidation mode ahead of next week’s ECB and Fed meetings, with risk assets generally supported by expectations / hopes of policy actions by both or either central bank. One index which remains on a downward trajectory is the Baltic Dry Index, which dropped further overnight, highlighting the growing risks to the global economy.

USD bulls restrained

Two events over recent days have managed to inflict a degree of pain to USD bulls over recent days. Firstly the report in the press this week that the Fed is actively considering further policy stimulus steps, which taken together with softer economic data such as the 8.4% drop in new home sales registered in June but more specifically declines in the June ISM manufacturing survey and weaker jobs data, have sharply increased the speculation that the Fed will deliver new policy steps at its FOMC meeting next week.

Secondly the comments overnight from ECB board member Nowotny putting the prospects of giving the ESM bailout fund a banking licence firmly back on the table, has given a lift to the EUR. A banking licence would allow the ESM to leverage the ECB’s balance sheet, massively increasing its firepower. No wonder the markets reacted positively! The only catch is that there is significant opposition from both within the ECB council and from outside especially from Germany, suggesting that it would not be an easy step to take.

However, in a market that is extremely short EUR any slight positive news will act as a balm on the Eurozone’s wounds. Nowotny’s comments managed to overpower the impact of further drop in the German IFO survey in July which in fairness still remains at a relatively high level. The positive impact on the EUR is set to be short lived especially as a license for the ESM is a long way off while the ESM itself has yet to formally take over from the temporary bailout fund (EFSF).

Nonetheless, downside risks to the EUR will be limited ahead of the FOMC meeting next week and risks that a fresh round of Fed quantitative easing could weigh on the USD. Another complication is that there is also an ECB Council meeting next week, another factor that will play into a tone of consolidation for markets over coming days. EUR/USD is likely to face firm resistance around the 1.2181 level while downside is likely to be capped around 1.2040 in the near term. Assuming no major Fed action next week, EUR/USD remained destined for a drop below 1.2000.

EUR/USD edging towards 1.20

There hasn’t been much of a respite before Eurozone concerns have resurfaced. Spain and Greece are once again in the spotlight, with the formal approval of a bank bailout for the former providing little solace as speculation of a full scale sovereign bailout grows. The fact that two Spanish regions have asked for government help, with more likely in the pipeline, has only acted to reinforce such concerns.

As for Greece, the halting of a bailout tranche due to failure to meet targets, the European Central Bank (ECB) decision not to accept Greek debt as collateral and the visit of the Troika (EC, ECB. IMF) will keep markets nervous as default fears intensify. Unsurprisingly Eurozone peripheral bond yield have come under renewed pressure while core Eurozone yields have turned negative in some cases.

Spanish yields have moved above the critical 7% threshold while the EUR has tanked versus USD and on the crosses as it increasingly takes on a funding currency role and makes its way towards the 1.20 level versus USD that I expect it to test soon.

Hopes of further monetary stimulus, especially in the US and China have provided some support to markets recently but the provision of drugs will not cure the patient this time around. Even relatively decent US corporate earnings, with around 2/3 of S&P earnings released beating admittedly lowered expectations so far, have failed to stop the rout.

Big cap defensive and high dividend companies have fared well, giving a degree of resilience to US equities which are up over 8% (S&P 500) this year, but with around 171 companies set to deliver results this week it is not clear that this will continue.

Weakening US data, with a deceleration in US Q2 GDP set to be revealed this week will provide more evidence that US economic momentum is slowing. Nonetheless, as long as US Fed quantitative easing is not an imminent prospect the USD will likely find plenty of support as risk aversion creeps back into the market psyche.

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