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.

Risk appetite remains fragile

The stabilisation in risk appetite over recent days looks highly fragile and markets will look to upcoming events in Europe and data releases to determine whether a rally in risk assets is justified. Discussions over the weekend between German Chancellor Merkel and French President Sarkozy delivered little in substance apart from a promise that a concrete response to the crisis will be delivered by the end of the month ahead of the 3 November G20 summit.

Both leaders agreed on the need for European banking sector recapitalisation and this issue along with whether or how to leverage the EFSF bailout fund and the extent of private sector participation in any Greek bailout is likely to take growing prominence for markets over coming weeks ahead of the EU summit on 17-18 October. In the meantime, markets may give Eurozone officials the benefit of the doubt but patience will run thin if no progress is made on these fronts.

The US jobs report at the end of last week which revealed a bigger than expected 103k increase in payrolls and upward revisions to previous months will have helped to allay fears about a renewed recession in the US and global economy. Indeed, recent surveys reveal that analysts expected weak US growth rather than recession. This week’s data will help to shore up such expectations with US data including retail sales and consumer confidence likely to outshine European data, including likely declines in industrial production in the region.

Overall, this will help to buoy risk appetite which may leave the USD with less of a safe haven bid but at the same time it will also reduce expectations of more quantitative easing (QE3) in the US, something that will bode well for the USD. Markets are set to begin the week in relatively positive mood but we remain cautious about the ability of risk appetite to be sustained. On balance, firmer risk appetite will play negatively for the USD early in the week but any drop in the USD will be limited by the fragility of risk appetite and potential for risk aversion to intensify again.

Ecofin, ECB, US jobs report in focus

The USD index remains close to its recent highs, maintaining a positive tone amid elevated risk aversion. Data releases have tended to take a back seat to events over recent weeks, but this week the all important US September jobs report may provide the bigger focus for US markets. The consensus expectation is for a 50k increase in payrolls and the unemployment rate remaining at 9.1% an outcome that would do nothing to assuage US growth worries. As usual markets will gauge clues to the jobs data from the ADP jobs data and employment components of the ISM data but an outcome in line with consensus expectations will likely keep risk aversion elevated and the USD supported unless the data is so bad that it results in an increase in expectations for Fed QE3.

There will be plenty of attention on the Ecofin meeting of European finance ministers today especially given that much of the reason for the stability in markets recently is the hope of concrete measures to resolve the crisis in the region. In this respect the scope for disappointment is high, suggesting that the EUR is vulnerable to a further drop if no progress is made at today’s meeting. While the extent of short market positioning has left open some scope for EUR short covering the absence of any good news will mean the impetus for short covering will diminish.

While attention in Europe will predominately remain on finding a resolution to the debt crisis and the saga of Greece’s next loan tranche, the European Central Bank (ECB) meeting will also be in focus this week especially given expectations that the ECB will cut interest rates. While hopes of a 50 basis points rate cut may have taken a knock from the firmer than expected reading for September flash CPI released at the end of last week the EUR could actually react positively to an easing in policy given that it may at least help to allay some of the growing growth concerns about the eurozone economy. However, any EUR will be limited unless officials in the eurozone get their act together and deliver on expectations of some form of resolution to the crisis in the region.

Strong words from Japan’s Finance Minister Azumi failed to have any lasting impact on USD/JPY. Japan will bolster funds to intervene in currency markets by JPY 15 trillion and extend the monitoring of FX positions until the end of December. Japan did not intervene during September but spent around JPY 4.5 trillion in FX intervention in August to little effect. For markets to be convinced about Japan’s conviction to weaken the JPY it will require putting intervention funds to active use, something that doesn’t seem to be forthcoming at present. A factor that may give some potential upside momentum for USD/JPY is the slight widening of US versus Japan bond yield differentials over recent days, which could finally result in a sustained move above 77.00 if it continues into this week.

Euro vulnerable to event risk

The USD is benefitting in the current environment of elevated risk aversion reflected in a jump in USD speculative positioning over recent weeks, with current IMM positioning currently at its highest since June 2010.

Admittedly there is still plenty of scope for risk aversion to intensify but what does this mean for the USD? The USD index is currently trading just over 78 but during the height of the financial crisis it rose to around 89, a further gain from current levels of around of around 14%.

The main obstacle to further USD strength in the event of the current crisis intensifying is if the Fed implements QE3 but as the Fed has indicated this is unlikely to happen anytime soon, as “Operation Twist” gets underway.

Now that the Fed FOMC meeting is out of the way markets will also be less wary of buying USDs as the prospect of more QE has diminished for now. Data this week will likely be USD supportive too, with increases in consumer confidence, durable goods orders, an upward revision to Q2 GDP expected.

The EUR remains highly vulnerable to event risk this week. Various votes in eurozone countries to approve changes to the EFSF bailout fund will garner most attention in FX markets, with the German vote of particular interest although this should pass at the cost of opposition from within Chancellor Merkel’s own party.

The EUR may garner some support if there is some traction on reports of a three pronged approach to help solve the crisis which includes ‘leveraging’ the EFSF fund, large scale European bank recapitalisation and a managed default in Greece, but there has been no confirmation of such measures.

Meanwhile, the potential for negotiations between the Troika (EC, IMF, ECB) and the Greek government to deliver an agreement on the next loan tranche for the country has increased, which could also offer the EUR a boost this week, albeit a short lived one.

Speculation of a potential European Central Bank (ECB) rate cut has increased a factor that could undermine the EUR depending on whether markets see it as growth positive and thus EUR positive or as a factor that reduced the EUR’s yield attraction. There is also more speculation that the ECB will offer more liquidity in the form of a 1-year operation but once again there has been no confirmation.

A likely sharp drop in the German IFO survey today and weakness in business and economic confidence surveys on Thursday will support the case for a rate cut, while helping to maintain the downward pressure on the EUR.

Given the potential for rumours and events to result in sharp shifts in sentiment look for EUR/USD to remain volatile, with support seen around 1.3384 and resistance around 1.3605.

Italy downgrade adds to EUR woes

The USD index remains firm but it remains unlikely that the USD is being bought on its own merits but rather on disappointments in the eurozone. Nonetheless, speculative USD sentiment has turned positive for the first time since June 2010 according to the CFTC IMM data, reflecting a major shift in appetite for the currency. Clearly there are risks to the USD including the potential for more QE3 being announced at this week’s FOMC meeting but this risk is likely to be small.

In contrast, the reversal in speculative sentiment for the EUR has been just as dramatic but in the opposite direction as the net short EUR position has increased over recent weeks, with positioning now at its lowest since June 2010. Sentiment is likely to have soured further overnight following news that Italy’s credit rating was cut by S&P to A from A+ despite the recent passage of an austerity package.

This outweighed any boost to sentiment from what was noted by the Greek Finance Minister as “productive” talks yesterday. Another conference call today is scheduled but the longer markets wait for approval of the next loan tranche the bigger the risk to the EUR. In addition Greek and Spanish T-bill auctions and European Central Bank (ECB) cash operations will be in focus. The EUR remains vulnerable to a test of support around 1.3500.

GBP has continued to slide over recent weeks, having fallen by around 5% since its high just above 1.66 a month ago. However, it has managed to hold its own against the EUR which looks in even more of a sorry state than the pound. The fact that GBP has been unable to capitalise on the EUR’s woes is largely attributable to growing expectations of further UK quantitative easing.

The minutes of the last Bank of England meeting on September 8 to be released on Wednesday will give more clues as to the support within the Monetary Policy Committee for further QE but its likely that the MPC will want to see the next Quarterly Inflation Report in November before committing itself to any further easing. In the meantime, GBP will find it difficult to sustain any recovery, with its drop against the USD likely to extend to around 1.5583 in the short term.

Japan returns from its Respect for the Aged holiday today but local market participants will have missed little action on the JPY, with the currency remaining confined to a very tight range. The inability of USD/JPY to move higher despite the general bounce in the USD index reflects 1) the fact that USD/JPY is very highly correlated with 2 year bond yield differentials and 2) the fact that US yields continue to be compressed relative to Japan. Additionally, risk aversion continues to favour the JPY and combined, these factors suggest little prospect of any drop in the JPY versus USD soon.

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