Lower range for the JPY, GBP vulnerable

The announcement of the Spanish 2013 budget, German jobs data, and the release of European confidence measures mean that attention will remain focussed on the Eurozone today and the news is unlikely to be good. The request for a Spanish bailout moves ever closer and could eventually provide some relief but prevarication continues to weigh on sentiment.

US data releases will not provide much solace for markets either, with weak durable goods orders and a revision lower to US Q2 GDP expected to be revealed. All in all, another tough session for markets is in store.

Meanwhile, currencies against the USD continue to look vulnerable, with EUR/USD, AUD/USD, USD/CHF in particular, close to breaching their 200 day moving average levels. USD/JPY has closed below the 78.00 level throughout this week suggesting that the currency pair may be moving into a new lower range. So far, there is little sign of potential FX intervention by the Japanese authorities.

Interestingly USD/JPY has dropped despite a general rebound in the USD, suggesting that it is very difficult for the Japanese authorities to blame the move on a weaker USD this time. Nor is the JPY particularly sensitive to risk aversion at present. For a change the move in the JPY cannot be blamed on a narrowing in US versus Japanese bond yield differentials too as the sensitivity of USD/JPY to yield differentials has dropped to an insignificant level while the US yield advantage has actually widened.

Net securities inflows into Japan have been strong recently however, suggesting either or both repatriation into Japanese fiscal half year end or renewed foreign interest in Japanese portfolio assets are helping the JPY. USD/JPY is expected to run into bids around the 77.10 level.

EUR/GBP has tracked the move lower in EUR/USD, while GBP/USD appears to be showing some resilience despite a generally firmer USD. Renewed Eurozone tensions are helping GBP as investors once again look for relative save havens although many would question whether GBP can really be considered as a safe haven.

With little on the data front in the UK today (only the third reading of Q2 GDP) GBP will be left to follow the travails of the EUR. Notably my models show that EUR/GBP divergence from its short term fair value estimate is growing, implying that the drop in the currency pair is unlikely to persist, with GBP resilience likely to give way over coming sessions. My estimate for short term EUR/GBP fair value is 0.8143. This is corroborated by my GBP/USD quantitative model, which also shows downside risks.

US dollar finding some support

Global growth concerns are contributing to undermine commodity prices, with most commodities dropping overnight. Gold was the biggest loser. Risk measures continue to creep higher as a host of worries especially the lack of traction in the Eurozone towards a Spanish agreement on a bailout and inability of Greece to agree on deficit cuts, afflicted markets.

The near term outlook is likely to remain one of caution until some progress in the Eurozone is in evidence. However, growth concerns suggest any improvement in sentiment will be tenuous at best.

On a more positive note, there at least appears to be some movement in the US towards finding a solution towards avoiding the fiscal cliff from taking effect as a bipartisan group of senators have agreed to formulate a deficit reduction plan.

The USD index has rallied over recent days despite expectations for weakness in the wake of the Fed;s announcement of QE3. It almost appears to be a case of sell on rumour, buy on fact. Admittedly the USD usually does weaken following QE with the USD index falling during the full periods of both QE1 and QE2 (-4.6% and -2.9%, respectively).

The counter argument in support of a firmer USD which we believe is supported by the massive deterioration in USD positioning over recent weeks and over 5% drop in the USD since 24 July is that the market has already priced in a lot of QE expectations into the currency.

Another factor that will likely play positive for the USD is the fact that the Fed is not alone in expanding its balance sheet. Many central banks are vying to maintain very easy monetary policy. The implication of this is that there is a battle of the balance sheets in progress that does not necessarily involve the USD being the loser.

EUR/USD has fallen well off its recent highs around 1.3173, with sentiment for the currency souring due to inaction by the authorities in Spain on requesting a bailout and disagreements over how to proceed on various issues including banking supervision. The drop in the September German IFO business climate survey, the fifth in a row, did little to help the EUR, with the survey adding to Eurozone growth worries.

Increasingly it looks as though EUR short covering is running its course and while there may yet be a further bounce in the EUR should the ECB begin its bond purchase programme, the near term outlook is more fragile. Business and consumer confidence surveys in Germany and France today will echo the weakness of the IFO in contrast to a likely firming in September US consumer confidence, contributing to a weaker EUR. A test of support around 1.2848 looms

Reality Check

Markets face a reality check going into this week. The euphoria emanating from recent Fed, ECB and BoJ actions is fading quickly. The reality of weak growth and underlying structural tensions is coming back to haunt markets, suggesting much more limited upside for risk assets over coming weeks.

While there are some positive indications that the growth outlook may not have much further to deteriorate, such as the bounce in the Baltic Dry Index, scepticism about the ability of central banks to reflate economies is growing. In this respect, its worth highlighting that the rally in gold prices failed to extent much further last week although in part this may be due to an options expiry tomorrow.

Renewed tensions are creeping back into the market psyche, especially with regard to Europe. Procrastination from Spain about a formal bailout threatens to weigh on markets in the days ahead as some officials suggest that the EUR 100 billion received for Spanish banks will be sufficient for the country to avoid needing further aid. Bank stress test results, a Moody’s review on Spanish ratings and the country’s 2013 budget will all be scrutinised over coming days.

Meanwhile, disagreement between Germany and France over the timing of introducing banking union and supervision is accentuating tensions in the region. Greece remains in the limelight too, as the government continued to find further budget cuts in order to receive the next tranche of loans. The only good news appeared to come from a German press report that the ESM permanent bailout fund’s firepower will be leveraged up to EUR 2 trillion.

The EUR has lost momentum following its initial surge higher and looks constrained on any move above 1.3000. While EUR short positions have continued to be pared back according to IMM data the scope for short covering is becoming more limited. Developments in Spain and Greece will provide further guidance for the currency, but any upside in EUR/USD will be limited to resistance around 1.3180. It seems more likely that having failed to sustain gains, the EUR will continue to drift lower.

US dollar Fed debasement begins

Unsurprisingly risk appetite improved sharply in the wake of European Central Bank (ECB) and Federal Reserve actions as well as the many other events that have passed without incident. Indeed, the long list of events including German constitutional court decision on the ESM bailout fund, and Dutch elections, did not result in any obstruction to sentiment. Instead markets have been left to digest the impact of monetary policy actions.

The Fed did not disappoint in this respect and the $40 billion per month of Mortgage Backed Securities (MBS) purchases will and already has gone a long way to spurring risk assets, combined with the impact of the ECB bond buying programme. Although there are still plenty of doubts, especially as both Spain and Italy have yet to request a formal bailout, which would enable the ECB’s bond purchases to actually begin, the market tone will be ‘risk on’ over the short term. Indeed, our risk aversion barometer has shifted decisively into risk loving territory.

Data and events this week are unlikely to change this perspective although the risk of profit taking has grown given the pace and magnitude of recent moves. Although Eurozone flash purchasing managers indices (PMI) are likely to remain in contraction territory, the German ZEW investor confidence survey is set to bounce as it reacts to recent events. US housing market data will also look encouraging revealing further signs of recovery, although US manufacturing surveys in the form of the Philly Fed and Empire surveys for September will remain weak.

There will be plenty of scrutiny on the Bank of Japan which will be under a lot pressure for more aggressive policy action to reach the 1% inflation goal, especially following the steps taken by the Fed and ECB. Nonetheless, further easing by the BoJ looks unlikely this week. Meanwhile, in the UK softer inflation data and weaker retail sales will keep the door open to further Bank of England quantitative easing.

The USD will remain on the back foot in the wake of more Fed QE, but the USD index will find some support around the beginning of May low around 78.603. Notably USD short positioning has already increased sharply over recent weeks, suggesting that at least some of the Fed’s QE is in the price. Conversely EUR short positions have been cut sharply and while the momentum in EUR/USD is still to the upside, it will face resistance around the 1.3180. As long as there is not a sharp correction higher in peripheral bond yields, the EUR should remain supported.

JPY firmer ahead of Fed decision

The USD has come under growing pressure ahead of tommorow’s Fed FOMC decision. While by no means a done deal the majority of market participants are looking for the Fed to embark on a fresh round of quantitative easing or QE3. The Fed is also expected to shift its guidance to maintaining highly accommodative monetary policy into 2015 from 2014. There is a non-negligible risk of no action at the FOMC meeting which if correct will result in market disappointment, with an attendant sell off in risks assets.

Heading into the Fed meeting, comments by Republican House speaker Boehner that he was ‘not confident’ about reaching a deal with President Obama on avoiding the fiscal cliff as well as renewed warnings by Moodys ratings on the US AAA credit ratings, dealt the USD a further blow. It seems unlikely that the USD will be able to make much of a recovery if the Fed pulls the trigger for more QE. However, it should be noted that with so much in the price, should the Fed not deliver on expectations, the USD may actually bounce.

One currency that has felt the consequences of a weaker USD has been the JPY, which finally broke through the 78.00 level against the USD yesterday. A stronger JPY was greeted with plenty of disquiet in Japan (I’m in Tokyo this week) at a time when economic indicators are turning south. The fact that both the European Central Bank and the Fed are outpacing the Bank of Japan in terms of balance sheet expansion means that any JPY weakness is likely to be limited, with further upside risks to the currency prevailing.

Much will depend on the impact on US Treasury yields from Fed QE. Currently Japanese investors are disinclined to pour money overseas at a time when the yield advantage of US Treasuries or German bunds versus Japanese JGBs is limited. If US yields remain low, the prospects for further JPY weakness will also be limited while the pressure on the Japanese authorities to act to meet their 1% inflation goal and weaken the JPY will grow.

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