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.

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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.

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.

USD under broad based pressure

There remains a great deal of angst in markets due to the lack of resolution to the US fiscal cliff, which is putting pressure on overall market sentiment as reflected in the multi day rise in the VIX fear gauge over recent days. The fact that both the US administration and senior Republicans are giving little ground in discussions suggests a deal is not in sight although the pressure for compromise will intensify as year end approaches.

The news in Europe is a little better as reflected in the narrowing in peripheral bond yields. There will be little directional influence on markets today, with trading likely to be subdued ahead of the US jobs report on Friday, with any news on the fiscal cliff also closely watched.

The USD continues to come under broad based pressure, with the USD index having lost around 2% of its value since 16 November. The lack of traction in terms of resolving the fiscal cliff and the weaker US data this week, namely the November ISM manufacturing index have weighed on the currency.

How much of the USD move is due to position adjustments as year end approaches fast or renewed confidence in the EUR is debatable but it is clear that the USD looks like it will end the year in a bad state. The ADP jobs report today may give further direction but it seems unlikely that pressure on the USD will abate ahead of the November payrolls data on Friday.

While the EUR’s gains are beginning to look overdone, the momentum for the currency continues to be to the topside as short positions continue to be covered into year end. The EUR’s appreciation is taking place hand in hand with the drop in peripheral bond yields. A positive reception for Greece’s debt buy back as well as Spain’s request for aid for its banking sector has also helped the currency.

Rumours of a German debt downgrade have done little to diminish the EUR’s appeal. An upcoming meeting of EU finance ministers next week ahead of the EU leaders’ summit to try and make some progress towards banking supervision is also hoped to deliver some good news. A test of sentiment will come from a Spanish bond auction today but this is unlikely to be much of an obstacle to the EUR. Near term EUR/USD resistance is seen around 1.3172.

Putting the brakes on the CNY

Markets are becoming increasingly headline driven, with risk appetite gyrating on any fresh lead on fiscal cliff developments. Initially risk assets dropped in the wake of weaker than expected US new home sales data and renewed fiscal cliff concerns but reversed course following more encouraging comments from US House speaker Boehner and President Obama who both indicated that a deal was moving closer to fruition. The comments also sparked a drop in the USD while gold prices came under pressure.

Meanwhile, Eurozone peripheral bond spreads continue to tighten in the wake of the Greek debt deal as tail risks continue to decline. An Italian debt auction may test the market’s new found confidence today. Incidentally the deal will be put to the vote tomorrow in Germany. Data releases are generally taking a back seat to fiscal cliff developments but once again there will be stark contrasts between Europe and the US, with weakening economic sentiment indicators in Europe on the one hand and an upward revision to US Q3 GDP on the other.

Currencies will continue to track the gyrations in risk, but in large part remain in well defined ranges. EUR/USD reversed its losses as fiscal cliff resolution hopes grew but will struggle on the top side. Comments by Moody’s in its credit review on Greece released this morning will also dent EUR sentiment with the ratings agency noting that Greek debt remains unsustainable even after the country’s debt deal. EUR/USD resistance is seen around 1.3023 while support around 1.2870 is expected to hold over the near term.

USD/JPY pushed back above the 80.00 level overnight but I would prefer to sell the currency pair on any run up to 82.50. While weak data such as the bigger than expected decline in October retail sales (-1.2% YoY) highlight the need for more aggressive policy, the “Abe” effect has largely been discounted and markets may wait for elections on December 16 before deliberating on further JPY direction. Ultimately I remain JPY bears but in the near term the up move looks overextended.

China has put the brakes on the CNY as fixings have been less strong over recent days. Given the strong correlation with many other Asian currencies this is resulting in more restraint across the Asian FX spectrum. The most impacted currencies will be the KRW and TWD, as they possess the highest sensitivities to CNY. A slowing in the pace of portfolio inflows, with notably South Korea and Indonesia seeing outflows of equity capital over the month, will also restrain Asian currencies.

Fade gains in the euro

The USD’s drop over recent days has almost wiped out half its rally since October 17. Only the JPY has lost ground over this period. More modest weakness is in prospect for the USD in the short term although I do not look for the currency to drop sharply. Given their strong correlations with the USD index any decline will bode well for EUR, GBP, SEK, CHF, CAD and several emerging market currencies.

Most commentators are ascribing USD weakness to the improving risk appetite but the USD index has maintained a low sensitivity to my risk aversion barometer, suggesting that the relationship is tenuous at present. The reality is that there is probably a bout a profit taking rather than any major shift in USD sentiment and this is set to continue for the time being.

EUR/USD’s impressive resilience over recent weeks highlights the hurdles to anyone wanting to short the currency. Underling EUR support remains firm as reflected in the recent turnaround in the Eurozone basic balance position (direct investment + portfolio flows + current account) while there may also be an element of FX reserves recycling flows providing support of the EUR.

Additionally the market has been giving Eurozone officials the benefit of the doubt with regard to a Greek debt sustainability solution and the lacklustre reaction of the EUR following the Greek deal this morning highlights that much was already priced in. The deal which effectively lowers interest rates that Greece has to pay on its debt while giving it more time to pay the debt paves the way for a EUR 34.4 billion loan tranche in December.

Finally, the threat of ECB Outright Monetary Transactions (OMT) activation continues to threaten to provide a major back stop to any EUR pressure. At current levels the upside for the EUR looks far less compelling. I suggest taking profits / fading the rally on any test of resistance around EUR/USD 1.3030 and EUR/GBP 0.8120.

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