US budget impasse deepens

There has been no sign of agreement between the US administration/Democrats and Republicans over resolving the budget impasse that has caused a partial government shutdown as well as havoc with the timing of government data releases. If anything both sides have become more entrenched in their positions, implying that any agreement on raising the debt ceiling required by October 17 also looks out of reach.

Market reaction so far has been relatively muted in the expectation of an agreement but such hopes may prove optimistic. Following the delay in the US employment report which was originally scheduled for release last Friday markets will also be scrambling for clues as to the impact on the timing of any Fed tapering.

US data releases will not help the market mood or the USD, with consumer confidence set to soften, which will play for further delay in tapering. US September retail sales and August trade data are likely to be delayed although the Federal Reserve FOMC minutes of the last meeting will hopefully provide some clues to the timing of tapering.

Markets are set to become increasingly nervous over coming days suggesting an increase in risk aversion. Consequently pressure on risk assets is likely unless some sign of rapprochement is seen. So far US Treasury yields are holding above 2.6% while the USD index has stabilised around the 80.00 level.

Surprisingly gold has failed to benefit from the lack of budget agreement in the US. The VIX ‘fear gauge’ dropped slightly but none of this will last if Congress does not get its act together. A deal soon would minimise the economic impact but a protracted impasse would be much more negative for growth. Either way the beginning of Fed tapering looks to have been pushed into next year.

USD pressure is set to extend further against most major currencies, with safe havens, in particular JPY and CHF set to be well supported in the days ahead. The drop in US Treasury yields will help yield sensitive currencies especially the likes of the INR but higher risk aversion will counter any positive impact on high beta currencies.

The EUR meanwhile, looks well placed to take advantage of further USD weakness, especially given the prospects of firmer data releases this week including a series of industrial production data.

Swiss franc under pressure

The US debt ceiling continues to garner most attention in markets, with US Treasury Secretary Geithner warning in a letter to Congress about the adverse economic impact of the failure to raise the ceiling. President Obama gave a similar warning, but with current extraordinary measures due to run out between mid February and early March timing is running out.

While Fed Chairman Bernanke echoed this assessment markets found some relief in his speech as it did not repeat the views of some Fed officials in hinting at an early ending of QE. Bernanke qualified his comments by stating that believes that inflation will stay below 2% over the medium term.

EUR/USD could not hold onto highs around 1.3404 but the currency pair does not looks as though it is running out of momentum. As sentiment towards the Eurozone periphery continues to improve and inflows into Eurozone assets increases the EUR is finding itself as a key beneficiary. However, the strength of the currency will only reinforce the weak economic backdrop across the region, which eventually will come back to bite the EUR.

Indeed data today is likely to confirm that the German economy recorded a weak pace of growth over 2012 finishing the year with a contraction in activity over Q4. Our forecast of no growth in the Eurozone this year could face downside risks should the EUR continue to rise. This is unlikely to stem the near term upside for EUR/USD but adverse growth and yield differentials compared to the US will mean that gains in EUR/USD will not be sustained.

The long awaited move higher in EUR/CHF appears to be finally occurring. EUR/CHF is trading at its highest level in over a year and looks set to make further gains. The fading of Eurozone crisis fears, better global economic developments and search for yield, are combining to pressure the CHF versus EUR although USD/CHF is trading near multi month lows.

Additionally improving sentiment outside of Switzerland is not echoed within the country as domestic indicators have worsened recently such as the KoF leading indicator, adding further pressure for a weaker CHF. Recent inflation data revealing a 0.4% YoY in December, the 15th month of annual declines have reinforced the fact that the currency is overly strong. EUR/CHF looks set to move higher, with the December 2011 high of 1.2444 the next target.

USD under pressure, except versus JPY

Following another positive week for risk assets where equities in particular benefitted from substantial capital inflows this week is unlikely to look much different. A host of earnings, especially from financials will help dictate the equity market and in turn risk tone over coming days. There will also be plenty of focus on speeches by various Fed and European Central Bank (ECB) officials including Fed Chairman Bernanke today.

The week will start off in more subdued fashion however, with a Japanese holiday and little fresh news to digest over the weekend. Hope and faith in global economic recovery helped by data releases in the US and China in particular, have helped to calm markets while there is little angst as yet about the looming debt ceiling / spending cut negotiations in the US.

Despite the rush into equities, core bond yields appear to have hit a short term ceiling. Meanwhile, the USD is likely to maintain a weaker tone over the short term except versus JPY where the currency pair has broken through key technical barriers on the top side and is verging on a break of 90.00 helped by more comments over the weekend by Japanese Prime Minister Abe pushing for a 2% inflation target to be implemented.

Data releases this week will maintain the growth recovery story in the US while the Eurozone will continue to show a weaker trajectory. In the US there are plenty of releases to chew on including December retail sales, inflation, industrial production, manufacturing surveys, housing starts, Michigan confidence, and the Fed’s Beige Book. Overall, US releases will help paint a picture of steady and gradual recovery.

In contrast the Eurozone data slate is more limited and what there is (German GDP, Eurozone industrial production) will be less impressive supporting the view of Eurozone economic underperformance over coming months. Admittedly this has yet to affect the EUR which continue to benefit from peripheral bond yield compression and receding crisis fears although EUR/USD will likely run into resistance around 1.3385 which if broken will open the door for a test of 1.3486.

USD firm but running into resistance

Happy New Year!

The consensus view for 2013 favours equities over bonds helped by expectations of a sustained improvement in risk appetite as tail risk diminishes further. Additionally relative valuations support the consensus. So far equities are on track although it may be a mistake to make a strong judgement based on the first week’s trading.

The US December jobs report provided more evidence that the US economy will trundle along this year at a modest pace of growth. Meanwhile, the US fiscal cliff agreement may have played into a tone of firmer risk appetite but the fact that in less than two months there may be even greater tensions on the debt ceiling and spending cuts suggest that a one way bet of improving risk appetite can by no means be guaranteed.

The USD has begun the year in firm shape appearing to break free from the constraint of improving risk appetite at the turn of the year. In part its strength especially against the JPY can be attributed to higher US bond yields which in turn was pushed higher by less dovish than expected Fed December 11-12 FOMC minutes last week. Given that yields are running into technical resistance the USD may find less support from this source over coming days.

A light data week will give little directional impetus to the USD, with highlights including trade data, consumer credit and small business confidence. Instead the USD will take its cue from various Fed speakers who will likely provide more elaboration on their views on an eventual exit from QE. The USD is likely to remain firm in the short term although we would be wary of extrapolating trends based on early year moves.

In contrast to the limited US data schedule there are plenty of data releases and events in Europe to digest this week including the European Central Bank Council meeting. The ECB is unlikely to ease policy at this meeting, with those in the Council against a cut unlikely to have shifted their stance although a rate cut, possibly in March remains on the cards. Data releases will continue to show weakness although importantly sentiment surveys will stabilise rather than drop further.

Sovereign debt issuance may take more importance for the EUR this week, with Austria, Belgium, Italy, Germany, Italy and Spain all scheduled to issue debt. Given the better risk environment a generally favourable reception to the debt issues will give the EUR some solace, likely preventing the currency from sliding further. Strong EUR/USD technical support is set to come just below 1.3000 at 1.2996.

Euro still looks uglier than the dollar

Currency markets continue to vacillate between US debt ceiling concerns and eurozone peripheral debt worries. Despite a lack of agreement to raise the debt ceiling, with House Republicans failing to back a proposal by House speak Boehner, the USD actually strengthened towards the end of the week as eurozone peripheral issues shifted back into focus.

The resilience of the USD to the lack of progress in raising the debt ceiling is impressive and reveals that the EUR looks even uglier than the USD, in many investors’ eyes.

Much in terms of direction for the week ahead will depend on the magnitude of any increase in the debt ceiling and accompanying budget deficit reduction measures. Assuming that a deal is reached ahead of the August 2 deadline it is not obvious that the USD and risk currencies will enjoy a rally unless the debt ceiling deal is a solid and significant one.

Given the limited market follow through following the recent deal to provide Greece with a second bailout, the EUR remains wholly unable to capitalise on the USD’s woes.

A reminder that all is not rosy was the fact that Moody’s ratings agency placed Spain’s credit ratings on review for possible downgrade while reports that the Spanish parliament will be dissolved on September 26 for early elections on November 20 will hardly help sentiment for the EUR. Compounding the Spanish news doubts that the EFSF bailout fund will be ready to lend to Greece by the next tranche deadline in mid-September and whether Spain and Italy will participate, have grown.

Some key data releases and events will also likely to garner FX market attention, with attention likely to revert to central bank decisions including the Bank of Japan, European Central Bank, Bank of England, Reserve Bank of Australia and US July jobs report. None of the central banks are likely to shift policy rates, however.

The risk for the USD this week is not only that there is disappointing result to the debt ceiling discussions, but also that there is a weak outcome to the US July jobs report. An increase of around 100k in payrolls, with the unemployment rate remaining at 9.2%, will fixate market attention on weak growth and if this increases expectations for a fresh round of Fed asset purchases the USD could be left rather vulnerable.

The RBA is highly unlikely to raise interest rates but the tone of the accompanying statement is unlikely to be dovish. The RBA noted the strong emphasis on the Q2 CPI inflation data and in the event it came in higher than expected, a fact that supports my expectation that the Bank will hike policy rates at least once more by the end of this year.

Markets have largely priced out expectations of a rate cut but there is still scope for a more hawkish shift in Australian interest rate markets, which will give the AUD a boost. However, AUD remains vulnerable to developments in the US and Europe as well as overall risk aversion, and a preferable way to play a positive AUD view in the current environment is via the NZD.

Risk Aversion to remain elevated

It remains a tumultuous time for markets, gripped by a cacophony of concerns ranging from the lack of resolution to the Eurozone debt crisis to the failure to reach agreement on raising the US debt ceiling and associated deficit reduction plans. Mingled among these is the growing evidence that economic growth is turning out weaker than expected. Meanwhile Europe’s crisis appears to be shifting from bad to worse, as reflected in a shift in attention towards the hitherto untouched Italy although Italian concerns have eased lately.

The release of the EU bank stress test results at the end of last week have not helped, with plenty of criticism about their severity and rigour following the failure of only 8 banks out of the 90 tested. Expectations centred on several more banks failing, with much more capital required than the EUR 2.5 billion shortfall revealed in the tests. Answering to this criticism officials note that there has already been a significant amount of capital raised over recent months by banks, but this will be insufficient to stem the growing disbelief over the results.

Attention is still very much focussed on Greece and reaching agreement on a second bailout for the country, with further discussions at the special EU summit on July 21. The contentious issue remains the extent of private sector participation in any debt restructuring. The decision to enhance the flexibility of the EFSF bailout fund to embark on debt buybacks has not helped. Consequently contagion risks to other countries in the Eurozone periphery are at a heightened state. Despite all of this the EUR has shown a degree of resilience, having failed to sustain its recent drop below 1.40 versus USD.

One explanation for the EUR’s ability to avoid a steeper decline is that the situation on the other side of the pond does not look much better. Hints of QE3 in the US and the impasse between Republicans and Democrats on budget deficit cutting measures tied to any increase in the debt ceiling are limiting the USD’s ability to benefit from Europe’s woes. Moreover, more weak data including a drop in the Empire manufacturing survey and a drop in the Michigan consumer sentiment index to a two-year low, have added to the worries about US recovery prospects.

Against this background risk aversion will remain elevated, supporting the likes of the CHF and JPY while the EUR and USD will continue to fight it out for the winner of the ugliest currency contest. Assuming that a deal will eventually be cobbled together to raise the US debt ceiling (albeit with less ambitious deficit cutting measures than initially hoped for) and that the Fed does not embark on QE3, the EUR will emerge as the most ugly currency, but there will be plenty of volatility in the meantime.

Data and events this week include more US Q2 earnings, June housing starts and existing home sales. While housing data are set to increase, the overall shape of the housing market remains very weak. In Europe, July business and investor surveys will be in focus, with a sharp fall in the German ZEW investor confidence survey likely and a further softening in July purchasing managers indices across the eurozone. The German IFO business confidence survey is also likely to decline in July but will still point to healthy growth in the country. In the UK Bank of England MPC minutes will confirm no bias for policy rate changes with a 7-2 vote likely, while June retail sales are likely to bounce back.

US dollar on the rise

Risk aversion is on the rise as uncertainties about Greece and worries about weaker economic data weigh on sentiment. A number of key events rather than data will be the main drivers this week. First and foremost amongst these is the vote in the Greek parliament on the country’s budget reform plan, which if passed will pave the way for the way for a disbursement of EUR 12 billion from the European Union / IMF and a new bailout package.

Meanwhile in the US talks on raising the debt ceiling are likely to resume in earnest, with the market likely to become increasingly nervous about the lack of resolution on the issue. Nonetheless, it is Europe that will dominate the headlines and on this front even if the reform plan is passed any market relief is likely to be limited given the ongoing uncertainty about private sector participation in any Greek debt roll over. This suggests that the EUR will remain under pressure over the week despite reassuring comments from Chinese Premier Wen.

Data releases will be relegated to background noise but what there is will not help sentiment. Signs of slowing activity remain evident as revealed in disappointing eurozone manufacturing surveys last week and this will be echoed in the US ISM manufacturing survey at the end of this week. Economic sentiment gauges in Europe are also set to reveal a decline. Given the lack of ammunition and/or unwillingness to risk using further stimulus from the Fed, the sensitivity of markets to weak data will be high, keeping risk aversion elevated.

Indeed, although well flagged the end of the Fed’s QE2 this week will mark a major shift in market dynamics, especially in currency markets where the USD will finally see a massive weight lifted from its shoulders. As indicated by Fed Chairman Bernanke following the FOMC meeting the Fed is not considering a further round of asset purchases, a fact that will help the USD to find firmer support.

Notably the USD index moved has above its 100-day moving average providing a positive technical signal given that it has failed on its last two attempts. The USD index now looks set to break its April high around 76.610.

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