Ukraine fallout

So far most of the damage from the escalating crisis in the Ukraine and growing tensions between the West and Russia has been inflicted on Russian markets but global asset markets are also feeling increasing pain from the fallout. The most recent developments highlight that tensions have worsened further.

Equity markets in Europe were next in line for selling pressure, with sharp declines registered while US stock also dropped, but to a lesser degree. Commodity prices have also felt the shock, with European natural gas prices rising sharply and oil also higher. Gold has been a major beneficiary extending gains to around USD 1350.

US Treasury yields settled around 2.6% while the USD bounced as risk aversion spiked. My Risk Aversion Barometer rose over 3% while the VIX “fear gauge” jumped. Asian markets are likely to feel some pressure today although the impact is likely to be much less significant than elsewhere. Nonetheless, the lack of first tier data releases means that most attention will be focussed on developments in Ukraine over today’s trading session.

USD buoyant

After finally returning from a two week trip visiting clients across North America it appears that the USD continues to remain in buoyant mood. I have been highlighting the prospects for a stronger USD against major currencies for some time and this has been borne out by the strong USD performance since early February.

Despite a lackluster performance for US stocks overnight overall sentiment remains largely upbeat as reflected by the fact that my risk barometer has breached its lower threshold and has moved into risk loving territory. Similarly the VIX fear gauge is trading at multi year lows although it did move higher overnight.

The sharp drop in UK industrial production and a warning by the Bundesbank’s Weidmann that the Eurozone crisis was not over added a dose of caution to the market. On a more positive note the Baltic Dry Index is at its highest level so far this year, sending a positive signal for global growth expectations.

While there is still much wrangling in the US over budget proposals, and in Europe, Italian political uncertainty continues, markets remain focused on the positives of improving growth against the background of highly accommodative monetary policies. Nonetheless, the divergence between the US and Europe in terms of growth is set to continue. A likely bigger than forecast increase in US February retail sales in contrast to a bigger than forecast fall in Eurozone industrial production in January will attest to this.

EUR/USD has managed to garner a semblance of stability over recent days, with the currency pair finding it difficult to sustain any decline below the psychologically important 1.3000 level. The drop in EUR/USD over much of February has been more aggressive than implied by the performance of Eurozone peripheral bonds but this is no surprise given that this is not the biggest influence on the currency.

Instead the explanation for the EUR decline is found when viewing the move in US 2 year Treasury yields relative to 2 year bunds. The strong correlation with EUR/USD highlights this relationship, reflecting the impact of lower bund yields and higher Treasury yields. The EUR’s stability over recent days is therefore a function of a slight drop in the US yield advantage.

Given that the trend of firmer US data and weaker Eurozone data is set to continue, this stability is likely to be short lived. Our quantitative model suggests EUR/USD may rally in the short term but we suggest selling into it.

GBP/USD’s decline has continued unabated and there appear to be little to stand in the way of further weakness apart perhaps from the fact that a lot of bad news is priced in. Sentiment for GBP has clearly deteriorated as reflected in the CFTC IMM data revealing four straight weeks of negative positioning. The deviation with the 3 month average positioning has widened significantly, highlighting the pace of the move but also that the drop is beginning to look excessive.

Nonetheless, the bigger than expected drop in January industrial production data revealed yesterday has helped to compound the negativity towards the currency in the wake of deteriorating economic data and in turn heightened expectations of more BoE quantitative easing. Strong technical support around GBP/USD 1.4767 may hold in the short term but momentum indicators are showing no sign of a slowing in GBP selling pressure.

For GBP bulls (if there any left) there may be more value in looking to eventually re-enter long positions against EUR but we would not rush into this trade. .

Euro under growing pressure

A risk off tone has developed in the wake of disappointing economic data (Eurozone April purchasing managers indices, rise in March Eurozone and German unemployment, weaker US ADP jobs report). Additionally the second round of French Presidential elections is helping to keep Eurozone markets nervous. While hitting equities, the weaker market tone is likely to keep the USD buoyed.

The soft ADP report in particular highlights downside risks to the consensus for the April non-farm payrolls data, with analysts set to revise lower their forecasts fuelling concerns about a renewed weakening in the US jobs market. Ahead of this data, markets will contend with the outcome of the European Central Bank (ECB) policy meeting and bond auctions in France and Spain today. Several Fed speakers today will also be on tap.

The EUR will struggle to make any headway in the short term, having suffered in the wake of weak data. An unchanged policy decision from the ECB will give the EUR no assistance leaving EUR/USD vulnerable to a test of strong support around 1.3104. The ECB considers current policy settings as ‘appropriate’ but weaker growth data argue for lower rates.

The reality is that the ECB does not want to give Eurozone governments an excuse to renege on reforms. Should the ECB hint at lower rates in the near future it might actually play well for the EUR helping to alleviate growth concerns, but I suspect such a message is unlikely to emerge.

GBP has lost some ground after hitting a high just above 1.63 at the end of April but the currency looks reasonably well supported, especially against EUR. UK data remains relatively better looking as reflected in stronger readings for the PMI construction index, consumer credit and mortgage approvals.

EUR/GBP has broken its relationship with movements in EUR/USD for the time being, with independent GBP strength being seen. This is been reinforced by the shift in interest rate differentials between the UK and Eurozone, a move which has gone in favour of GBP strength. Indeed my quantitative model for EUR/GBP points to some further downside potential in this currency pair, with a test of technical support around 0.8067 on the cards.

The Devil is in the details

The “partial solution” delivered by European Union (EU) leaders last week has failed to match the high hopes ahead of the EU Summit. Nonetheless, the deliverance of a “fiscal compact”, acceleration of the European Stability Mechanism (ESM) to July 2012 , no forced private sector participation in debt restructuring (outside Greece), and possible boost to the International Monetary Fund (IMF) of up to EUR 200 billion, are steps in the right direction. The fact that UK Prime Minister Cameron threw a spanner in the works to veto a joint proposal to revise the EU Treaty should not detract from the progress made.

Nonetheless, the measures may not be sufficient to allay market concerns, with disappointment at the lack of European Central Bank (ECB) action in terms of stepping up to the plate as lender of the last resort still weighing on sentiment. Data will add to the disappointment this week as “flash” Eurozone purchasing managers indices (PMI) drop further in December.

This week events in the US will garner more attention, including the Federal Reserve FOMC meeting, November inflation and retail sales data plus manufacturing confidence gauges as well as November industrial production on tap. The Fed will not shift its policy stance at this meeting but may sound a little more upbeat on the economy following recent firmer data. Inflation will likely remain subdued while the other data will continue to show gradual recovery.

Overall, the market is likely to thin further as the week progresses and holidays approach, with ranges likely to dominate against the background of little directional impetus. Our call to sell risk assets on rallies remains in place, however. The EUR will likely struggle to make much headway in the current environment, especially given that many details of the EU agreement still need to be ironed out and once again the risk to market confidence lies in implementation or lack of it. A range of EUR/USD 1.3260-1.3550 is likely to hold over the short term.

All Eyes On Europe

EUR looks range bound ahead of key events including the European Central Bank (ECB) meeting, European Union Summit and release of bank stress test results. A senior German official poured cold water over expectations of a concrete outcome from the EU Summit, dampening EUR sentiment as a result.

There will be plenty of attention on the ECB to determine whether they will give a little more ground and provide further assistance to the Eurozone periphery. While a refi policy rate cut is highly likely as well as additional liquidity measures I do not expect any move in the direction of more aggressive action to support peripheral bonds in terms of becoming “lender of the last resort’.

If however, the ECB hints at intensifying its securities market purchases of Eurozone bonds this will likely bode well for the EUR. Indeed, reports overnight suggest that the ECB will announce a set of measures to stimulate bank lending including easing collateral requirements for banks.

More weak UK data in the form a bigger than consensus drop in manufacturing and industrial production in October add to the soft BRC retail sales and house price data, in putting pressure on the Bank of England (BoE) to increase its quantitative easing at today’s policy meeting. While the BoE is set to keep policy unchanged it is only a matter of time before additional asset purchases are announced.

Despite the weaker IP data GBP has held up relatively well against the USD although downside risks appear to be intensifying. If I am correct in the view of no change by the BoE today we expect little change in GBP although there could be a risk of a push higher in EUR/GBP if the ECB delivers some positive news, with resistance seen around 0.8665.

The RBNZ unsurprisingly left policy rates unchanged at 2.5%, sounded less hawkish than the previous meeting and also lowered growth forecasts. The NZD was left unmoved by the rate decision and looks well supported at current levels perhaps due to relief that the statement was not more dovish. The kiwi has been an underperformer over the year but unlike the AUD it has not been particularly influenced by gyrations in risk aversion.

Interest rate futures differentials have seen a renewed widening versus the US over recent weeks. This is significant given that the NZ-US interest rate differentials have a very strong correlation with the performance of NZD/USD. If this widening is sustained it will point to upside potential for the Kiwi.

S&P Spoils The Party

Although stock markets registered gains the rally in risk assets stumbled, with sentiment knocked by news that S&P ratings has placed 15 Eurozone countries on negative watch for a possible downgrade due to “systemic stresses”. Among the 15 were Germany and France. Weaker economic news in the form of service sector purchasing managers indices in China and the US also dented market sentiment.

The Eurozone countries including all six triple A rated governments have a one in two chance of a downgrade within 90 days. Although there has been speculation of a French downgrade the major surprise was the inclusion of Germany in the list. A downgrade of Eurozone countries would hit the ability of the EFSF bailout fund to finance rescue packages for countries give that it is supported by sovereign guarantees from the six AAA rated countries.

Ironically the S&P announcement followed news that German Chancellor Merkel and French President Sarkozy have agreed on treaty changes revealing some progress ahead of the Eurozone summit on 8/9th December. Among the details of the agreement private sector bond holders will not be asked to bear any losses on any future debt restructuring, automatic sanctions for countries that breach the 3% deficit / GDP rule, a “golden rule” on balanced budgets, and an earlier data for the launch of the European Stability Mechanism to 2012.

The “fiscal compact” will be welcomed by the European Central Bank (ECB), with hints by President Draghi that it could be followed by stronger action from the central bank. Although S&P spoiled the party somewhat overnight, markets will go into the EU Summit with high expectations, suggesting that risk assets will find some degree of support. EUR slipped on the S&P news but further losses will be limited ahead of the EU Summit, with markets looking for further concrete actions from Eurozone leaders. EUR/USD will be supported around 1.3260 in the short term.

Sell into Euro rallies

The USD will have found the news that Fitch Ratings lowered its outlook on the US AAA long term ratings to negative unwelcome. Nonetheless, USD sentiment has been recently as reflected in the jump in CFTC IMM USD positioning to multi week highs. The USD will however, face some headwinds from speculation that the Federal Reserve is about to embark on a fresh round of quantitative easing by purchasing mortgage backed securities.

The firm start to the week in terms of risk appetite helped the EUR to recover some ground but the currency remains vulnerable to event risk. High among the event risk is the Eurogroup and Ecofin meetings today, which will decide whether or not to approve Greece’s next loan tranche as well as EFSF leveraging options. Progress on the latter is likely to be limited leaving the EUR vulnerable to disappointment.

Attention will also focus on Italy’s sale of up to EUR 8 billion of BTPs and the likelihood that the country may have to face a yield above the critical 7% threshold. An increase in funding costs will not bode well for EUR sentiment especially following warnings by Moody’s about potential downgrades to sovereign ratings across the region.

EUR/USD failed to follow through on gains overnight but as reflected in the IMM speculative positioning there may be some scope for further short covering given that the net EUR short position reached its highest since June 2010 last week. Nonetheless, upside potential for EUR/USD is likely to be restricted to resistance around 1.3415.

Relatively dovish comments by Bank of England officials and weak data will keep GBP on the back foot over the short term. BoE governor King highlighted the risk of an inflation undershoot while Fisher noted that the BoE expanded QE by a minimum in October and can do more.

The Office for Budget Responsibility is set to cut UK growth forecasts significantly today. Against this background prospects for more BoE QE remain high. In the short term GBP will likely struggle against both the USD and EUR although we expect weakness versus EUR to be short lived, and would sell into any EUR/GBP rally to around 0.8665 support.

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