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.

Extreme Uncertainty

The level of uncertainty enveloping global markets has reached an extreme level. Who would have thought that close to 13 years after its introduction at a time when it has become the second largest reserve currency globally (26.7% of global reserves) as well as the second most traded currency in the world, European leaders would be openly talking about allowing countries to exit the EUR? No less an issue for currency markets is the sustainability of the USD’s role as the foremost reserve currency (60.2% of global reserves). The US debt ceiling debacle and the dramatic expansion of the Fed’s balance sheet have led to many official reserve holders to question their use of the USD. Perhaps unsurprisingly the JPY has been the main beneficiary of such concerns especially as global risk aversion has increased but to the Japanese much of this attention is unwanted and unwelcome.

The immediate focus is the travails of the eurozone periphery. Against the background of severe debt tensions and political uncertainties it is perhaps surprising that the EUR has held up reasonably well. However, this resilience is related more to concerns about the long term viability of the USD rather than a positive view of the EUR, as many official investors continue to diversify away from the USD. I question whether the EUR’s resilience can be sustained given that it may be a long while before the situation in the eurozone stabilises. Moreover, given the now not insignificant risk of one or more countries leaving the eurozone the long term viability of the EUR may also come into question. I believe a break up of the eurozone remains unlikely but such speculation will not be quelled until markets are satisfied that a safety net / firewall for the eurozone periphery is safely in place.

In this environment fundamentals count for little and risk counts for all. If anything, market tensions have intensified and worries about the eurozone have increased since last month. Politics remain at the forefront of market turmoil, and arguably this has led to the worsening in the crisis as lack of agreement between eurozone leaders has led to watered down solutions. Recent changes in leadership in Italy and Greece follow on from government changes in Portugal and Ireland while Spain is widely expected to emerge with a new government following elections. Meanwhile Chancellor Merkel has had to tread a fine line given opposition from within her own coalition in Germany while in France President Sarkozy is expected to have a tough time in elections in April next year. The likelihood of persistent political tensions for months ahead suggests that the EUR and risk currencies will suffer for a while longer.

Eurozone contagion spreading quickly

Contagion from the eurozone debt crisis is spreading quickly, threatening to turn a regional crisis into a global crisis. As highlighted by Fitch ratings further contagion would pose a risk to US banks. Consequently risk assets continue to be sold but interestingly oil prices are climbing. Taken together with comments earlier in the day from the Bank of England that failure to resolve the crisis will lead to “significant adverse effects” on the global economy, it highlights the risks of both economic and financial contagion.

Predominately for some countries this is becoming a crisis of confidence and failure of officials to get to grips with the situation is resulting in an ever worsening spiral of negativity. Although Monti was sworn in as Italian Prime Minister and Papademos won a confidence motion in the Greek parliament the hard work begins now for both leaders in convincing markets of their reform credentials. Given that there is no agreement from eurozone officials forthcoming, sentiment is set to worsen further, with safe haven assets the main beneficiaries.

EUR/USD dropped sharply in yesterday’s session hitting a low around 1.3429. Attempts to rally were sold into, with sellers noted just below 1.3560. Even an intensification of bond purchases by the European Central Bank (ECB) failed to prevent eurozone bond yields moving higher and the EUR from falling.

Against this background and in the absence of key data releases EUR will find direction from the Spanish 10 year bond auction while a French BTAN auction will also be watched carefully given the recent increase in pressure on French bonds. Having broken below 1.3500, EUR/USD will aim for a test of the 10 October low around 1.3346 where some technical support can be expected.

US data releases have been coming in better than expected over recent weeks, acting to dampen expectations of more Fed quantitative easing and in turn helping to remove an impediment to USD appreciation. While the jury is still out on QE, the USD is enjoying some relief from receding expectations that the Fed will forced to purchase more assets. Further USD gains are likely, with data today including October housing starts and the November Philly Fed manufacturing confidence survey unlikely to derail the currency despite a likely drop in starts.

Contagion spreading like wildfire

EUR continues to head lower and is is destined to test support around 1.3484 versus USD where it came close overnight. Contagion in eurozone debt markets is spreading quickly, with various countries’ sovereign spreads widening to record levels against German bunds including Italy, Spain, France, Belgium and Austria. Poor T-bill auctions in Spain and Belgium, speculation of downgrades to French, Italian and Austrian debt, and a weak reading for the November German ZEW investor confidence index added to the pressure.

A bill auction in Portugal today will provide further direction but the precedent so far this week is not good. The fact that markets have settled back into the now usual scepticism over the ability of authorities in Europe to get their act together highlights the continued downside risks to EUR/USD. Although there is likely to be significant buying around the 1.3500 level, one has to question how long the EUR will continue to skate on thin ice.

The Bank of Japan is widely expected to leave policy unchanged today but the bigger focus is on the Japanese authorities’ stance on the JPY. Finance Minister Azumi noted yesterday that there was no change in his stance on fighting JPY speculators. To some extent the fight against speculators is being won given that IMM speculative positions and TFX margin positioning in JPY has dropped back sharply since the last FX intervention to weaken the JPY.

However, this has done little to prevent further JPY appreciation, with USD/JPY continuing to drift lower over recent days having already covered around half the ground lost in the wake of the October 31 intervention. Markets are likely therefore to take Azumi’s threats with a pinch of salt and will only balk at driving the JPY higher if further intervention takes place. Meanwhile, USD/JPY looks set to grind lower.

GBP will take its direction from the Bank of England Quarterly Inflation Report and October jobs data today. There will be particular attention on the willingness of the BoE to implement further quantitative easing. A likely dovish report should by rights play negatively for GBP but the reaction is not so obvious. Since the announcement of GBP 75 billion in asset purchases a month ago GBP has fared well especially against the EUR, with the currency perhaps being rewarded for the proactive stance of the BoE.

Moreover, the simple fact that GBP is not the EUR has given it a quasi safe haven quality, which has helped it to remain relatively resilient. Nonetheless, GBP will find it difficult to avoid detaching from the coat tails of a weaker EUR and in this respect looks set to test strong support around GBP/USD 1.5630 over the short term.

Data releases in focus

For a change the markets may actually concentrate on data releases today rather than political events in the eurozone. The October US retail sales report and November Empire manufacturing survey are likely to paint a less negative economic picture of the US. The data will help to dampen expectations of more quantitative easing in the US but we will be able to hear more on the subject from the Fed’s Bullard and Williams in speeches today.

Overnight the Fed’s Fisher poured more cold water on the prospects of further QE by highlighting that the economy is “poised for growth”. While speculative data in the form of the CTFC IMM data shows a drop in USD sentiment to its lowest in several weeks we do not expect this to persist. The USD will likely benefit from the data today and we see the currency retaining a firmer tone over the short term especially as eurozone concerns creep back in.

The vote by German Chancellor Merkel’s party to approve a measure for a troubled country to leave the EUR opens up a can of worms and will hit EUR sentiment. But rather than politics there are several data releases on tap today that will provide some short term influence on the EUR, including Q3 GDP and the November German ZEW survey. FX markets will likely ignore a positive reading for GDP given that the outlook for Q4 is going to be much worse. The forward looking ZEW survey will record a further drop highlighting the risks to Europe’s biggest economy.

T-bill auctions in Spain and Greece may garner even more attention. Following on from yesterday’s Italian debt sale in which the yield on 5-year bond came in higher than the previous auction but with a stronger bid/cover ratio, markets will look for some encouragement from today’s auctions. Even if the auctions go well, on balance, relatively downbeat data releases will play negatively for the EUR.

When viewing the EUR against what is implied by interest rate differentials it is very evident that the currency is much stronger than it should be at least on this measure. Both short term (interest rate futures) and long term (2 year bond) yield differentials between the eurozone and the US reveal that EUR/USD is destined for a fall.

Europe’s yield advantage has narrowed sharply over recent months yet the EUR has not weakened. Some of this has been due to underlying demand for European portfolio assets and official buying of EUR from central banks but the reality is that the EUR is looking increasingly susceptible to a fall. EUR/USD is poised for a drop below the psychologically important level of 1.35, with support seen around 1.3484 (10 November low).

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