Euro falls, yen rises as risk aversion picks up

The USD index is quickly slipping back to its mid September lows, although downside momentum has been restrained by an overnight jump in risk aversion. The USD had been undermined by a continued improvement in risk appetite as markets expect (hope) that a deal to avert the fiscal cliff can be averted although recent developments have not been encouraging on this front. Additionally, given the relative strong performance of US equities this year there may be an element of profits repatriation out of the US weighing on the USD. A likely upward revision to US Q3 GDP, rise in the Philly Fed survey manufacturing, and existing home sales, will if anything imply firmer risk appetite and consequent USD weakness.

EUR/USD is trading close to multi month highs but dropped from a high of 1.3309 overnight despite a firmer than expected reading for the December German IFO survey on renewed caution over a deal to avert the fiscal cliff. News flow has provided some impetus to the EUR over recent weeks following recent agreements by European leaders on issues such as banking supervision and a positive Greek debt buyback. Such progress has set the background for a firm end to the year for the currency. Nonetheless, as reflected in its drop overnight any increase in risk aversion will limit the ability of the EUR to move higher. Additionally the EUR will be restrained by caution expressed by the Greek finance minister in the FT over the country’s future highlighting that Greece is not out of the woods yet.

The JPY’s slide has continued unabated ahead of today’s BoJ policy decision. Markets have already priced in further easing in the form of an increase in asset purchases and any outcome that reveals anything less than JPY 10 trilion in asset purchases will provoke JPY buying in a market that is heavily short. However, the LDP’s strong showing in elections implies that markets will need to take seriously threats of more aggressive policy action over coming months, especially with regard to JPY strength. Indeed, weak export data revealed yesterday, while not solely attributable to JPY strength, will nonetheless, fuel more pressure for a weaker currency. Therefore, any pull back in USD/JPY will prove short lived as investors once again eye the JPY as the favoured short leg of carry trades.

Please note this will be my last blog post for 2012. Thank you for reading econometer.

Seasons Greetings and best wishes for the new year to all econometer.org readers.

ps. if you haven’t checked it out please click on the link below to order my new book, Chronology of a Crisis.

http://www.searchingfinance.com/products/books-econ-politics-finance/chronology-of-a-crisis.html

GBP resilience, SEK vulnerable

Signs of some further flexibility on both sides reveal that negotiations over the US fiscal cliff are progressing, albeit very slowly. Discussions between President Obama and House speaker Boehner yesterday appeared to go relatively well but the chances of a deal by year end remain slim. Against this background US equities posted gains while risk measures improved ignoring the weaker than expected reading for the December Empire manufacturing survey.

There is little else in terms of directional influence today, with highlights including RBA December board minutes, a vote on the Italian 2013 budget, UK inflation data and an interest rate decision in Sweden. The overall tone is likely to continue to be constructive for risk assets.

While I expect GBP to show some resilience over the coming year especially against the EUR, I look for the currency to eventually end the year weaker against the USD. The principal risk to GBP revolves around the UK economy. It seems very likely that the UK economy has contracted in the final quarter of the year. Worryingly, a weaker external environment taken together with the relative resilience of GBP has resulted in a deteriorating trade deficit, which could ultimately inflict pressure on GBP to weaken.

The fact that the UK basic balance (direct investment + portfolio flows + current account) position remains in negative territory also suggests that the underlying support for GBP is weak. Given these soft economic fundamentals it is difficult to see GBP breaking significantly higher over the coming months. Although the relationship is not perfect, my expectation that EUR/USD will drift lower over the course of 2013 will act to drag EUR/GBP lower too, with my forecast at 0.79 by end year.

EUR/SEK has probed higher over recent weeks and look to register further upside. Today’s Riksbank policy meeting will be the next focal point for SEK but with a rate cut largely priced in following recent deterioration in employment data and other signs of slowing growth, the SEK is unlikely to find any support in the near term. Sweden’s industry body and the OECD have highlighted the policy room to lower interest rates, with the OECD also noted the fiscal leeway that Sweden has should economic conditions worsen.

Officials are also targeting the exchange rate given recent comments by Sweden’s finance minister Borg about increasing foreign exchange reserves over the longer term. The implication is that the SEK will suffer as other currencies are bought against it. The weakness in the SEK is consistent with my quantitative models and a break of EUR/SEK 8.80 is looming over the short term.

USD and JPY on the back foot

Running into the end of the year it is clear that the USD is turning into the biggest loser. In part this reflects year end flows but also the dovish Fed stance and uncertainty about a resolution of the fiscal cliff. Indeed, with the Fed FOMC meeting out of the way the lack of progress on averting the fiscal cliff is quite disconcerting. Market confidence of an agreement appears to be slipping judging by the weakness in risk assets at the end of the week.

The USD is unlikely to make up much ground in the days ahead despite some likely positive data releases including yet more data showing housing market recovery, gradually improving manufacturing confidence gauges as well as a revision higher to Q3 GDP.

The EUR is on the verge of ending the year in strong form (too strong for Eurozone economies) as news of agreements on Greece’s loan tranche and banking supervision have given the currency even more support. Much of the rally in the EUR is likely to come from position adjustment into year end and could reverse quickly into new year, however.

Nonetheless, there is no doubt that receding tail risk due in large part due to continued support from expected eventual ECB asset purchases (OMT) activation will limit any downside in the EUR. In the near term the EUR may still take some direction from the German IFO survey on Wednesday but assuming that this survey continues its stabilisation, EUR/USD will likely maintain gains above technical support around 1.2880.

Japan faces a new reality following elections following Shinzo Abe’s Liberal Demoractic Part (LDP) victory in lower house elections. In particular, pressure for more aggressive policy will be sustained given the two thirds majority obtained. Nonetheless, it is not obvious that coalition parties will be as welcoming while some of the rhetoric from LDP leader Abe has already softened.

As the deterioration in the Tankan survey revealed the economic picture is clearly worryingly weak. Trade data over the coming week will be scrutinised to determine the lingering impact of frictions with China as well as the strength of the JPY. On this note, a further increase in asset purchases by the BoJ this week will mean that the JPY is unlikely to retrace its losses very quickly. Nonetheless, USD/JPY will face strong resistance around 84.60.

USD underperforms

The Fed expanded its asset purchases by buying $45 billion in longer dated Treasuries following the end of Operation Twist, with total purchases at USD 85 billion per month. The Fed went a step further by changing the guidance, now anticipating that policy will be maintained at an “exceptionally low range for the Fed Funds rate” as long as the unemployment rate remains above 6 ½ % and inflation no more than ½ % above the Fed 2% goal.

Equity market reaction was limited, with any positive boost dampened by the recognition that the Fed will not be able to offset the blow to the economy from the fiscal cliff. On this front, progress has been limited as the likelihood of a deal by the end of the year is diminishing by the day.

In Europe sentiment is somewhat better as hopes that the EU Council meeting today will yield an agreement on banking union and supervision. Final approval for the delayed Greek loan tranche is likely to be delivered following the completion of Greece’s debt buyback. The better news in Europe will be reflected in a decent reception to the Spanish and Italian bond offerings today.

The USD did not take too kindly to the latest efforts by the Fed to boost the economy although there are clearly diminishing returns as far as FX markets are concerned with regard to Fed QE. Nonetheless, the USD is coming under growing pressure into year end.

Next year assuming that the fiscal cliff in the US is resolved, with a limited fiscal drag on the economy, a relatively positive growth trajectory for the US alongside an expected increase in US bond yields will mean that the USD will still enjoy gains against currencies with weaker growth paths namely the EUR and JPY.

My forecasts for the USD index based on forecasts for its constituents show a gradual strengthening over the course of the next couple of years (82.4 and 85.7 by end-2013 and -2014, respectively) largely due to the USD’s expected appreciation versus EUR and JPY. In reality, this is misleading as improving risk appetite and continued capital inflows to EM and commodity currencies will mean that the USD will underperform.

EUR sell on rallies, weaker CNY

Ahead of several major events over coming days including the Fed FOMC meeting, EU Summit and Japanese elections the market will continue to appear directionless. Indeed, there was little influence overnight, as markets digested news of Italian Prime Minister Monti’s resignation, with the reality that this merely took place earlier than expected limited any damage. Discussions on the fiscal cliff were ongoing but with no sign of breakthrough as officials noted that the lines of communication remain open.

On the data front the German ZEW survey will be the main highlight for Eurozone markets today, with a likely small improvement set to provide marginal relief to the markets. A conference call by the Eurogroup to discuss Greece is also on tap as any news about the progress of Greece’s debt buyback and aid tranche is awaited. In the US a small narrowing in the October trade deficit is expected but small business optimism is likely to have deteriorated in November. The data and events today will leave markets largely unperturbed.

EUR managed to recoup some of its losses after dropping to a low around 1.2880 versus USD which is a strong support level. EUR/USD continues to look like a sell on rallies, with any break above 1.3000 likely to find strong selling interest. A slightly firmer ZEW survey and potentially positive comments about Greece may help limit any pressure, however. USD/JPY continues to look stretched to the topside as indicated by extreme short JPY market positioning although reports that the Bank of Japan are preparing further monetary stimulus at its meeting next week will limit any retracement.

Asian currencies remain supported although the weaker CNY over recent days will likely undermine closely correlated currencies including KRW and TWD. Nonetheless USD/KRW dropped below the psychologically important 1080 level, with the Bank of Korea smoothing rather than stemming any appreciation in KRW. Markets remain wary of more regulations on the KRW while the weaker CNY will also contribute to acting to resist further KRW appreciation in the near term. The IDR was the major underperformer in the region but comments by the central bank governor about guarding the currency will fuel caution about further selling.

Chronology of a Crisis

Chronology of a Crisis
by Mitul Kotecha

Not many would have thought that the global financial crisis stemming from the sub-prime debacle in the US would have spawned such a massive degree of global contagion, the impact of which is being felt to this day. Indeed, it is evident that global markets have had to face crisis after crisis since the sub-prime saga began. It is equally evident that the chances of returning to the definition of normality that we knew prior to the crisis are extremely slim.

Fast forward to late 2012 and one could be forgiven for thinking that markets are still in the midst of crisis. The stark reality is that, despite the massive amount of fiscal and monetary stimulus enacted since 2008, the world economy remains very fragile and while the financial system is arguably in better shape, policy makers have far less ammunition in their pockets than they did at the beginning of the financial crisis. All is not so bad, however, with signs over recent months that the global economy is finally emerging from its quagmire. Even the crisis in the Eurozone is increasingly moving painstakingly towards some form of resolution.

In this book I give a month-by-month analysis of the period following the escalation of the financial crisis, attempting where possible to determine where and how things could have been handled differently. In assessing the market impact, particularly in relation to currency markets, the analysis will hopefully provide some insight into what can be learnt from the crisis and what to expect should a similar situation arise in the future.

Highlights this week

Better than expected Chinese data over the weekend, speculation that Greece is close to reaching its debt buyback target and even some signs of progress in reaching a resolution to avert the fiscal cliff set up risk assets for a generally positive start to the week. Talks between the administration and senior Republicans will continue this week but it appears that some senior Republicans are willing to give up their objections to tax hikes on the very wealthy.

The November US jobs report released at the end of last week which revealed a 146k increase in payrolls and a drop in the unemployment rate to 7.7% is likely to have little influence at the turn of the week. The report was met with a muted reaction. While on the face of it the data was better than expected, downward revisions to past months and a surprising lack of impact from Hurricane Sandy left markets somewhat perplexed.

However, not everything is rosy. Last week’s sharp downward growth revisions to Eurozone growth by the European Central Bank (ECB), a plunge in US consumer sentiment and comments from Italian Prime Minister Monti that he intends to resign will cast a shadow over markets, restraining any upside.

Although activity will likely continue to thin as holidays approach there is still plenty too chew on this week. In the US the Fed is set to continue purchasing USD 85 billion of longer dated securities following the end of Operation Twist but this should come as little surprise to the market and therefore will yield little reaction. There will be some encouraging news on the consumer as retail sales bounce back in November.

Across the pond the European Council meeting beginning on Thursday will be in focus, with banking union and bank recapitalisation among the topics up for discussion. Given the hint of monetary easing by the ECB markets will scrutinise upcoming data for the timing but a likely increase in the German ZEW investor confidence survey in December and stabilisation in the Eurozone composite purchasing manager’s index will not prove compelling enough to warrant an imminent rate cut.

Elsewhere in Japan the upcoming elections will mark the highlight of the calendar over the weekend although the weaker than expected Q3 GDP reading this morning (-0.9% QoQ) and expected deterioration in the Tankan survey later in the week will maintain the pressure for more aggressive policy action and a weaker JPY.

EUR took a hit from the ECB’s dovish stance last week and will not take too kindly to the news of Monti’s intended resignation after the fiscal 2013 budget in Italy. EUR/USD 1.2880 still marks a solid support level for the currency.

USD/JPY continues to probe higher but extreme short market positioning will likely limit the ability of the currency pair to push higher. On the topside 83.15 will market strong resistance for the currency pair.

AUD and NZD look generally well supported, with Chinese data over the weekend giving further support although for AUD/USD 1.0519 will continue to act a tough technical barrier to crack.

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