Volatility Within Ranges

Most investors will likely be happy to see the tail end of May given the sharp losses in many asset classes over the month. At least over the last few days there was a sense of some healing, particularly in risk assets though it is questionable how long this can continue given the still many and varied uncertainties afflicting markets. A reminder of this came late on Friday, with Fitch downgrading Spain’s sovereign credit ratings despite the passage of austerity measures.

The Fitch decision highlights that Spain is rapidly becoming the new epicenter of the crisis; focus on the savings banks or Cajas is intensifying ahead of the June 30 deadline for mergers to qualify for government money, the minority government’s popularity is in further decline, whilst unions are threatening more strikes across the country. Unions in Greece and Italy are also pushing for coordinated strikes, highlighting the difficulties in pushing through austerity measures.

At least economic data is providing some solace to markets. Releases last week in the US highlighted the fact that consensus expectations are underestimating the pace of recovery; consumer confidence, durable goods orders and new home sales all came in above expectations. The same story is likely this week, but there is really only one piece of data that attention will focus on and that’s the May jobs report. The consensus is for a strong 508k increase in non-farm payrolls following a 290k increase in April, though around three-quarters of this will be related to census hiring. The unemployment rate is likely to dip slightly to 9.8%.

Markets are likely to be in limbo, with volatility in ranges likely this week. USD sentiment remains strong as reflected in the CFTC IMM data where net aggregate positioning is at an all time high, but further USD gains may be harder to come by ahead of the US jobs report and G20 meeting this weekend. Stretched USD positioning has proven no barrier to USD strength over recent weeks but the fact that markets are very long USDs could at the least result in a slower pace of further appreciation.

EUR speculative sentiment remains close to all time lows although there are signs of some relative stability over recent weeks. EUR/USD is likely to range between 1.2134 and 1.2475 this week. There was a sharp drop in net short JPY positions over the week (ie short-covering) though this appears at odds with the fall in the JPY. GBP speculative positions showed little improvement, languishing close to all time lows, whilst net longs in commodity currencies were pared back sharply, especially in AUD where net longs were cut by around half though sharp declines in positioning were also registered for NZD and CAD.

GBP could suffer due to worries about the UK government’s plans to reduce its burgeoning budget deficit following the resignation of Treasury Minister David Laws, following an expense scandal. The resignation hits the coalition just three weeks before the emergency budget and could result in complications on the negotiations between the Liberal Democrats and Conservatives on the substance of the deficit cutting measures. GBP/USD is likely to find support around 1.4260 and resistance around 1.4612 this week.


Switching risk on and off

There are several words that can be used to describe current highly risk averse market dynamics including panicked, nervous, fickle, tense, jittery, risky, volatile etc, all of which spark negative thoughts in the minds of investors. Aside from real worries such as renewed banking sector concerns, especially in Europe and in particular with regard to Spanish savings banks, there are also plenty of rumours afflicting market sentiment. In this environment deriving fact from fiction is not particularly easy whilst battling against the heavy weight of negative sentiment.

Although the pull back in risk appetite over recent weeks looks small compared to the peak in risk aversion during the financial crisis, the pace of the drop in markets has been dramatic and the withdrawal of risk seeking capital has been particularly aggressive. For example, in less than one month Asian equity markets have registered an outflow of around half of the total equity capital flows so far this year. Worryingly and despite the backstop in terms of central bank liquidity provision there are signs of renewed tensions in the money markets, with the libor-OIS spread and TED spread widening over recent days.

One of the most interesting observations in the current environment is that risk aversion has been increasing despite encouraging economic data. Not only has economic data been positive but in general has been coming in above consensus, showing that the market has underestimated the bounce in growth in the second quarter. Why is positive data not soliciting a more positive market reaction? Recent data is perhaps being seen as backward looking, and there is growing concern about the likely downdraft on economic activity in H2 2010, especially in Europe as deficit cutting measures bite.

News on the budget front in Europe has been relatively positive too, with Greece registering a sharp decline in its deficit, as well as announcing plans to tighten tax administration procedures. Meanwhile, the Italian cabinet reportedly approved a package of measures to reduce its deficit. On the flip side budget cuts across Europe are leading to growing public opposition, testing the resolve of eurozone governments to pass austerity measures. The public opposition means that the real test is in the implementation and execution of austerity measures. Signs of progress on this front will be key to turn confidence in the EUR around.

The USD remains king in the current environment and any pull back is likely to be bought into though Moody’s ratings agency’s warnings that the US AAA sovereign rating may come under pressure if there was no improvement in the US fiscal position, highlights the risks over the medium term to this currency. The EUR is set to remain under pressure though it is worth noting that the pace of its decline appears to be slowing, leaving open the potential for some consolidation. Near-term technical support for EUR/USD is seen at 1.2142 but a broader range of around 1.18.23-1.2520 is likely to develop over coming weeks.

What To Watch This Week

The end of last week proved to be a calmer affair than the preceding few days. There was some encouraging news on the Greek front, with Germany finally approving its share of the European Union (EU) aid package whilst Greece appeared to be on track with its budget deficit reduction as the country recorded a cash deficit of EUR 6.3billion in the first four months of the year, a 42% reduction compared to a year earlier. EU officials also agreed on tougher sanctions for countries breaching austerity rules.

There were plenty of negatives to offset the good news however, as European business surveys including the German IFO index and flash eurozone purchasing managers indices (PMIs) revealed some loss of momentum in growth as well as increased divergence. European banking sector concerns intensified as the Bank of Spain was forced to take control of CajaSur, a small savings bank holding 0.6% of total Spanish banking assets, which faced difficulties due to distressed real estate exposure. Its woes highlighted the problems faced by many Spanish savings banks due to property market exposure.

US data releases this week will confirm that economic recovery gathered steam in Q2. May consumer confidence data is likely to record a small gain, due in large part to improving job market conditions, whilst the Chicago PMI is set to retrace slightly in May, albeit from a healthy level. Both new and existing home sales are set to record gains in April, the former following a sizeable gain in March although the drop in house prices likely to be revealed by the Case-Shiller index will continue to fuel doubts about the veracity of the turnaround in the US housing market.

In Europe there is not much in terms of first tier releases and highlights include sentiment data such as German Gfk and French consumer confidence indices, and the May French business confidence indicator. The data are likely to be mixed, and as indicated by last week’s surveys will reflect a relatively healthy Q2 2010, but a worsening outlook for the second half of the year.

In the absence of UK data today there will be plenty of attention on the details of plans by Chancellor Osborne to cut GBP 6 billion from the budget deficit. The measures will be small change ahead of the emergency budget package on June 22nd when much bigger cuts are expected. Nonetheless, the first step today will be a crucial test of the new government’s ability to convince ratings agencies and markets that it is serious about reducing the burgeoning fiscal deficit.

Following the massive positioning adjustments of the last week markets will look somewhat calmer over coming days but risk aversion is likely to remain elevated, suggesting little respite for most currencies against the USD. The recent moves have left net aggregate USD positioning registering an all time high according to the CFTC Commitment of Traders data, in the latest week, but after the slight retracement lower in the USD index, it is set to make further gains over coming days.

It was notable that EUR and GBP looked more composed at the tail end of the week whilst attention turned to the liquidation of long positions in CHF, AUD, NOK and SEK. These risk currencies are set to remain under pressure but there will be little respite for EUR which is set to drift lower, albeit a less aggressive pace than over recent weeks and a re-test of EUR/USD technical support around 1.2296 is likely. GBP/USD has showed some resilience over recent days but remains vulnerable to further downside pressure, with 1.4310 immediate support.

Will the ECB intervene to support the Euro? (Part 2)

Click here to read Part 1

The last official intervention by the European Central Bank (ECB) in the currency markets took place in November 2000 and at the time the Bank stated that “the external value of the EUR does not reflect the favourable conditions of the euro area”. The ECB also noted the impact of a weaker EUR on price stability, with inflation at the time running above the ECB’s 2% threshold. This followed intervention a couple of months earlier in September 2000 when the ECB jointly intervened with the US Federal Reserve, Bank of Japan and other central banks in a concerted manner due to “shared concerns about the potential implications of recent movements in the euro exchange rate for the world economy”.

Conditions in the euro area could hardly be described as favourable at present, suggesting that this rationale would be very unlikely to be used to justify intervention. Conversely, a weaker EUR may actually contribute to making conditions in the eurozone more favourable. The rationale used for the September 2000 intervention holds more sway in the current environment. Nonetheless, the move in the EUR is very unlikely to do any serious damage to the world economy even if some Japanese exporters are suffering.

In the past the ECB has given various verbal warnings about the volatility of the EUR being too high, and this could potentially be utilized as rationale for FX intervention. However, implied volatility in EUR/USD is not particularly high when compared to the levels it reached during the recent financial crisis. Currently 3-month implied volatility is at its highest level since June 2009 but well below the peak in volatility recorded in December 2008. Clearly if EUR/USD volatility continues to rise there will be a greater cause for concern but at current levels the ECB is unlikely to even crank up verbal intervention let alone actual FX intervention.

One of the main benefits of the decline in the EUR is the support that it will provide to the eurozone economy. At a time when growth in Europe is slowing EUR weakness will be particularly welcome. Germany and other countries in Northern Europe will be major beneficiaries of EUR weakness given their export dependence. Given such benefits and the currently limited risks to inflation, the ECB is highly unlikely to intervene to strengthen the EUR.

Given the current very negative mood in the market, officials in Europe would do better to rectify some of the structural issues that markets are concerned about. This may provoke a more sustainable rally in the EUR but until there are concrete signs of progress on the fiscal front sentiment towards the EUR will remain negative. Against this background FX intervention to prop up the EUR would face more of a risk of failure, and in turn damage to the credibility of the ECB. This is perhaps as good a reason as any not to expect intervention.

Will the ECB intervene to support the Euro? (Part 1)

The EUR has lost around 23% since it all time high in April 2008 when it traded close to 1.6000. The EUR failed to rally even in the wake of the EUR 750 billion European Union / International Monetary Fund support package, a fact that has highlighted the weight of negative sentiment towards the currency. The latest blow to the currency came from the announcement of unilateral measures from Germany to ban naked short selling on sovereign debt and some financial stocks, actions that only highlighted the lack of policy co-ordination within the eurozone.

The rationale for further EUR/USD weakness is clear and justified partly by growth divergence within the eurozone countries, with Germany on the one extreme and weaker Southern European countries on the other. Moreover, relatively weaker overall growth in the eurozone compared to the US economy, a delay in interest rate hikes by the European Central Bank (ECB) and ongoing concerns about implementation and execution of deficit cutting plans, will also weigh on the EUR.

The EU/IMF support package and in particular ECB interventions in the Eurozone bond market have managed to alleviate some of the strain on European bond markets, but without similar intervention in the FX markets the EUR has become the release valve for Europe’s fiscal and debt problems. As a result the EUR’s fall has accelerated over recent weeks, only showing any sign of stability as fears of currency intervention increased.

The quickening pace of EUR depreciation has led to growing speculation of FX intervention by the ECB and other central banks to support the currency. I believe intervention is highly unlikely and see little reason for panic about the drop in the EUR. Once markets realise that there is indeed little risk of intervention the EUR will resume its downtrend.

One of the main reasons behind this view is that the EUR is not particularly “cheap” at current levels. In fact, “fair value” estimates based on the OECD measure of purchasing power parity (PPP) suggest that EUR/USD is around 5.6% overvalued at current levels, based on an implied PPP rate of around 1.17. Therefore, the drop in the EUR over recent months has only brought it back close to PPP fair value estimates.

Moreover despite the fact that there has been a large nominal depreciation of the EUR its trade weighted exchange rate has declined by much less, around 8.5% since the beginning of the year and around 11.3% since its high in October 2009. Although the trade weighted EUR is around its lowest level since October 2008, taking a longer term view shows that it is slightly above its average over the past 20-years.

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