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.

Euro’s Teflon Coating Wearing Thin

EUR has suffered a setback in the wake some disappointment from the European Union summit at the end of last week and the major defeat of German Chancellor Merkel and her ruling Christian Democratic Union party in yesterday’s election in Baden-Wuerttemberg. The EUR had been fairly resistant to negative news over recent weeks but its Teflon like coating may be starting to wear thin.

The setbacks noted above + others (see previous post) follow credit rating downgrades for Portugal by both S&P and Fitch ratings and growing speculation that the country is an imminent candidate for an EU bailout following the failure of the Portuguese government to pass its austerity measures last week and subsequent resignation of Portugal’s Prime Minister Socrates.

For its part Portugal has stated that it does not need a bailout but looming bond redemptions of around EUR 9 billion on April 15 and June 15 against the background of record high funding costs mean that the pressure for a rescue is intense. Complicating matters is the fact that fresh elections cannot be held earlier than 55 days after being announced, meaning that policy will effectively be in limbo until then. A June vote now appears likely.

After what was perceived to be a positive result of the informal EU leaders summit a couple of weeks ago, the outcome of the final summit last week failed to deliver much anticipated further details whilst more negatively the EU bailout fund’s paid-in capital was scaled back to EUR 16 billion (versus EUR 40 billion agreed on March 21) due to concerns expressed by Germany.

Ireland is also in focus ahead of European bank stress tests results on March 31. Ireland is pushing for increased sharing of bank losses with senior bondholders as part of a “final solution” for financial sector. Meanwhile the new government remains unwilling to increase the country’s relatively low corporation tax in exchange for a renegotiation of terms for the country’s bailout. This point of friction also threatens to undermine the EUR.

The bottom line is that the bad news is building up and the ability of the EUR to shake it off is lessening. Considering the fact that the market long EUR, with positioning well above the three-month average the EUR is vulnerable to position adjustment. After slipping over recent days EUR/USD looks supported above 1.3980 but its upside is looking increasingly restricted against the background of various pieces of bad news.

Edging Towards A Bailout

A confluence of factors have come together to sour market sentiment although there appeared to be some relief, with a soft US inflation reading (core CPI now at 0.6% YoY) and plunge in US October housing starts reinforcing the view that the Fed will remain committed to carry out its full QE2 program, if not more.

However any market relief looks tenuous. Commodity prices remain weak, with the CRB commodities index down 7.4% in just over a week whilst the Baltic Dry Index (a pretty good forward indicator of activity and sentiment) continues to drop, down around 21% since its recent high on 27 October. Moreover, oil prices are also sharply lower. Increasingly the drop in risk assets is taking on the form of a rout and many who were looking for the rally to be sustained into year end are getting their fingers burnt.

Worries about eurozone peripheral countries debt problems remains the main cause of market angst, with plenty of attention on whether Ireland accepts a bailout rumoured to be up EUR 100 billion. Unfortunately Ireland’s reluctance to accept assistance has turned into a wider problem across the eurozone with debt in Portugal, Greece and also Spain suffering. An Irish bailout increasingly has the sense of inevitability about it. When it happens it may offer some short term relief to eurozone markets but Ireland will hardly be inspired by the fact that Greece’s bailout has had little sustainable impact on its debt markets.

Ireland remains the primary focus with discussions being enlarged to include the IMF a well as ECB and EU. What appears to be becoming clearer is that any agreement is likely to involve some form of bank restructuring, with the IMF likely to go over bank’s books during its visit. Irish banks have increasingly relied on ECB funding and a bailout would help reduce this reliance. Notably the UK which didn’t contribute to Greece’s aid package has said that it will back support for Ireland, a likely reaction to potential spillover to UK banks should the Irish situation spiral out of control. Any bailout will likely arrive quite quickly once agreed.

Although accepting a bailout may give Ireland some breathing room its and other peripheral county problems will be far from over. Uncertainties about the cost of recapitalising Ireland’s bank will remain whilst there remains no guarantee that the country’s budget on December 7 (or earlier if speculation proves correct) will be passed. Should Ireland agree to a bailout if may provide the EUR will some temporary relief but FX markets are likely to battle between attention on Fed QE2 and renewed concerns about the eurozone periphery, suggesting some volatile price action in the days and weeks ahead.

Reports of food price controls of and other measures to limit hot money inflows into China as well as prospects for further Chinese monetary tightening, are attacking sentiment from another angle. China’s markets have been hit hard over against the background of such worries, with the Shanghai Composite down around 10% over the past week whilst the impact is also being felt in many China sensitive markets across Asia as well as Australia. For instance the Hang Seng index is down around 7% since its 8 November high.

Exhausted

No the title is not meant to describe how I felt this morning when I woke up but how I feel the market is looking at present in terms of risk trades. Firmer than feared economic data in the US and China and the agreement in Basel on new bank capital ratios boosted risk appetite but the moves are already beginning to fade. It would be easy to jump on the bandwagon but after the sharp gains registered over recent days I would suggest taking a cautious stance on jumping into risk trades at present.

The EUR has played a degree of catch up to risk currencies, rallying sharply against the USD, helped in part by the European Commission which raised its forecasts for the eurozone economy from 0.9% for 2010 to 1.7%. Although the change in forecasts should come as little surprise give that it is now in line with the European Central Bank’s (ECB) expectations the news bolstered the view of economic resilience in the eurozone. Unfortunately as the ECB noted following its last meeting there are plenty of downside risks to growth next year and upcoming data releases will be viewed to determine how sharply growth momentum will slow into next year.

One currency that strengthened was the JPY and this was mainly due the view that Prime Minister Kan will win the contest for leadership of the governing DPJ party in Japan. The race remains very close, with Prime Minister Kan having a slight lead according to Japanese press. The FX market will pay particular attention to the result given that the other contender Ichiro Ozawa has stated his willingness to drive the JPY lower as well as increase fiscal spending. The results of the election will be known shortly and should Ozawa win USD/JPY will likely find support although the bigger influence is likely to be a shift in relative US/Japan bond yields which due to the sell off in US Treasuries over recent days has become more supportive of a higher USD/JPY.

GBP has lagged the move in many risk currencies, failing to take advantage of the weaker USD. There was some relief overnight from an increase in consumer confidence in August according to the Nationwide index, which rose 5 points to 61, from a 14-month low in July. However, any boost to GBP sentiment will have been outweighed by a fall in UK house prices according to RICS, which revealed the sharpest one-month fall in August since June 2004. The data supports the view that the rally in UK house prices could soon be over. Weaker housing activity will also likely limit any further improvement in consumer confidence. Some of this is already priced into GBP however, and over the short-term EUR/GBP may struggle to breach the 0.8400 level.

Another underperformer overnight was the NZD which was hit by disappointing retail sales data for July, which fell 0.4%. Although the drop followed a strong gain in the previous month the data supports the view that the consumer remains cautious in New Zealand, a factor that will likely play into the view that New Zealand’s central bank, the RBNZ will keep policy on hold when they meet tomorrow. NZD slipped off its highs around 0.7347 overnight and also managed to dampen the upside momentum for AUD/USD which will likely struggle to sustain a break through resistance around 0.9350.

Today’s data will provide further direction for the days ahead, with the September German ZEW survey of investor confidence likely to be closely scrutinized. A drop in the economic sentiment gauge to around 10 is expected from 14 in August, highlighting that eurozone growth momentum is beginning to wane. Hard data in the form of eurozone industrial production will also record a weaker performance, likely to drop 0.3% in July. The data will likely cap the EUR today.

In the US the main release is the August retail sales report for which a 0.3% gain in both headline and ex-autos sales is expected. Sales will have been helped by back to school spending although major discounting will have weighed on retailers’ profits. Nonetheless, any gain even if modest will be a welcome development for Q3 growth in the US.

What Stress?

Fed Chairman Bernanke has inadvertently fuelled an increase in risk aversion in the wake of his testimony to the Senate. Although Bernanke noted that he did not see the prospects of a double-dip as a high probability event he stated that the economic outlook is “unusually uncertain”. Nonetheless, although such measures would be implemented if the situation deteriorated further, the Fed was not planning on extending its non-traditional policy options in the near term.
USD benefits as Bernanke does not indicate more quantitative easing.

A combination of caution about growth prospects and disappointment that Bernanke stopped short of indicating that the Fed would embark on further non-conventional policy measures left equities weaker, but the USD was stronger, both due to higher risk aversion as well as less risk of the Fed turning the USD printing press back on again. Bernanke is back at Congress today, with a speech to the House Panel. Although this is effectively a repeat of yesterday’s testimony, the Q&A session may throw up additional clues to Fed thinking and potential for extending quantitative easing but I suspect the USD will retain its firmer tone.

In Europe, most attention remains on the upcoming release of EU bank stress test results. Leaks suggest most banks will likely pass the EU bank stress tests, with the notable exceptions of a few Spanish Cajas and German Landesbanks. Already governments in Germany, France, Greece and Belgium have said their banks are likely to pass. We should all be bracing ourselves for relief to flow through European financial markets, but somehow this does not feel like an environment that will welcome such a result. More likely questions will be asked about why did so few banks fail and why the tests were not rigorous enough?

For example, the test for “sovereign shock” is said to affect only the value of government bonds that banks mark to market, but what about the far larger proportion of government debt that is held in banking books? There are also question marks over the capital hurdle, with the most adverse scenario that banks need to reach a maximum Tier 1 capital ratio of at least 6% by end 2011. Moreover, there have also been reported divisions within European Union (EU) members about how much information to divulge. EUR has also ready lost ground over recent days but the currency could face much more selling pressure into next week if the tests are found to lack credibility.

Please note that econometer.org will take a break until the week of 16th August. Good Luck.

Quantitative easing and the USD

US earnings are coming in ahead of expectations, with Q2 income at the 42 S&P 500 companies reporting so far beating estimates by 11% whilst revenues are 3.3% ahead of forecasts, according to Bloomberg. The overall tone to equities looks positive helped by expectations of an agreement by BP to sell some of its assets and strong earnings reported by Apple after the close of US trade.

Market sentiment was also boosted by speculation that the Fed will embark on fresh monetary stimulus measures. Although there has been no indication that Fed Chairman Bernanke will announce such measures at his semi-annual testimony to the Senate today and to the House tomorrow, speculation of Fed action is rife and there is likely to be some questioning of Bernanke on the issue in the Q&A. If in any way quantitative easing is hinted at by Bernanke, it will act to undermine the USD.

US economic data is helping to compound expectations of further quantitative easing, with yet another weaker than forecast release in the form of a 5.0% drop in June housing starts as hinted at by the bigger than expected drop in homebuilders confidence on the previous day. Separately ABC consumer confidence declined more than expected in the week to July 18, its third consecutive weekly decline, supporting the evidence that consumer confidence is deteriorating once again.

In the absence of major data releases Bernanke’s testimony will be the main driver for markets but earnings from Coca-Cola and Morgan Stanley will also be of interest. Elsewhere the minutes of the Bank of England’s July MPC meeting will be under scrutiny. MPC member Sentance is expected to have voted for a rate hike at the meeting, but any sign that other members joined him, will give GBP a lift. Sentiment for European assets continues to improve, with Greece concluding a well received T-bill auction and Ireland auctioning EUR 1.5bn in 6 and 10-year bonds. Both were heavily oversubscribed although concerns over Hungary continue to linger.

There continue to be various leaks about the European bank stress tests. Banks are expected to detail three scenarios in the results including estimated Tier 1 capital ratios under a benchmark for 2011, an adverse scenario and finally, a “sovereign shock”, according to a document from the Committee of European banking Supervisors. Importantly and perhaps a factor that could hit the credibility of the tests, the sovereign shock scenario is said to not include a scenario of default on sovereign debt.

I continue to see downside risk for the EUR in the wake of the test results, with a “buy on rumour, sell on fact” reaction likely. EUR/USD is vulnerable to a short-term drop to technical support around 1.2763 but much depends on Bernanke’s speech today. Leaks, suggest that around 10-20 banks could fail the bank stress tests, with a total funding requirement in the region of EUR 70-90 billion. Confirmation will have to wait for the official release on Friday ahead of which most currencies are likely to remain range-bound.

EUR strength is overdone

The latest in a long line of disappointing US data was released on Friday. University of Michigan consumer confidence sent an alarming signal about the propensity of the US consumer to contribute to economic recovery. Confidence dropped much more than expected, to its lowest level since August 2009, fuelling yet more angst about a double-dip in growth.

The Fed’s relatively dovish FOMC minutes last week contributed to the malaise and undermined the USD in the process as attention switched from the timing of exit strategies to whether the Fed will expand quantitative easing. Friday’s benign June CPI report left no doubt that the Fed has plenty of room on its hands, with core inflation remaining below 1% and likely to decelerate further over the coming months. Against this background Fed Chairman Bernanke’s semi-annual testimony to the US Congress (Wed/Thu) will be a particular focus, especially if he hints at potential for further QE, a possibility that appears remote, but could harm the USD.

Arguably the biggest event of the week is the European bank stress test results on Friday. Although several European governments have suggested that the banks in their countries will pass the tests there is still a considerable event risk surrounding the announcement. 91 banks are being tested and much will depend on how rigorous the tests are perceived to be. Should they be seen not to be sufficiently thorough, for instance in determining a realistic haircut on sovereign debt holdings, the potential for pressure on the EUR to increase once again will be high. Similarly debt auctions across Europe this week will also garner interest but similar success to last week’s Spanish auction cannot be guaranteed.

The big question in FX markets is whether the EUR can hold onto its recent gains and whether the USD will be punished further amidst growing double-dip worries. Interestingly the USD’s reaction on Friday to the soft consumer confidence data was not as negative as has been the case recently, with higher risk aversion once again outweighing negative cyclical influences. Various risk currencies actually came under pressure against the USD and this is likely to extend into this week. Despite a threat to the USD from any QE hints by Bernanke, speculative positioning has turned net short USD once again suggesting potential for less USD selling.

The bigger risk this week is to the EUR, which could face pressure on any disappointment from the bank stress test results. The EUR was strong against most major currencies last week, suggesting that the strengthening in EUR/USD is less to do with USD weakness, but more related to EUR strength. This strength in the EUR is hard to tally with the worsening economic outlook in the eurozone and the fact that a stronger EUR from an already overvalued level will crimp eurozone growth further. The latest CFTC IMM data has revealed a further covering of short positions, but this is likely to be close to running its course. Technically EUR/USD has broken above its ‘thick’ Ichimoku cloud, and the weekly MACD is turning above its signal line from oversold levels suggesting a period of further strength but its gains are set to be short-lived.

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