Double Whammy

Markets were dealt a double whammy resulting in a broad global equity and commodities sell off, and a jump in equity and FX volatility. The risk asset selling began following the news that the Conference Board revised its leading economic indicator for China to reveal a 0.3% gain in April compared to 1.7% increase initially reported earlier.

Given that this indicator has not been a market mover in the past it is difficult to see how it had such a big impact on the market but the fact that the release came at a time when the mood was already downbeat gave a further excuse to sell.

The damage to markets was exacerbated by a much steeper drop than forecast in US consumer confidence, with the index falling to 52.9 in June, almost 10 points lower than the consensus expectation. Consumer confidence remains at a relatively low level in the US, another reason to believe that the US economy will grow at a sub-par pace.

Renewed economic and job market worries were attributable for the fall in confidence, with an in increase in those reporting jobs as “hard to get” supporting the view of a below consensus outcome for June non-farm payrolls on Friday. Further clues will be derived from the June ADP jobs report today for which the consensus is looking for a 60k increase.

A run of weaker than forecast US data releases over recent weeks have resulted in a softening in the Fed’s tone as revealed in the last FOMC statement as well as a fears of a double-dip recession. There will not be any good news today either, with the June Chicago PMI index set to have recorded a slight decline in June, albeit from a high level.

There will also be attention on the release of the US Congressional Budget Office (CBO) 10-year budget outlook, which will put some focus back on burgeoning US fiscal deficit and relative (to Europe) lack of action to rectify it.

European worries remain a key contributor to the market’s angst, with plenty of nervousness about the repayment of EUR 442 billion in 12-month borrowing to the ECB. Demand for 3-month money today will give clues to the extent of funding issues in European banks given that the 12-month cash will not be rolled over.

Elevated risk aversion will keep most risk currencies under pressure, with the likes of the AUD, NZD and CAD also suffering on the back of lower commodity prices. The AUD has failed to gain much traction from a purported deal being offered to miners including various concessions to the mining industry. Much will depend on the reaction of mining companies, and despite the concessions there is importantly no reduction in the 40% rate of the tax.

Equity markets, especially the performance of Chinese stocks will give direction today but a weak performance for Asian equities points to more risk being taken off the table in the European trading session. EUR/USD will now set its sights on a drop to support around 1.2110 ahead of a likely drop towards 1.2045. Having dropped below support around 88.95 USD/JPY will see support coming in around 87.95.

Asian currencies also remain vulnerable to more selling pressure today, with the highly risk sensitive KRW looking most at risk in the short-term, with markets likely to ignore the upbeat economic data released this morning. USD/KRW looks set to target the 11 June high around 1247.80. Other risk sensitive currencies including MYR and IDR also face pressure in the short-term. TWD will be slightly more resilient in the wake of the China/Taiwan trade deal but much of the good news has been priced in, suggesting the currency will not escape the downturn in risk appetite.

The Week Ahead

As last week progressed there was a clear deterioration in sentiment as growth worries crept back into the market psyche. It all started well enough, with a positive reaction to China’s de-pegging of the CNY but the euphoria faded as it became evident that there was still plenty of two-way risk on the CNY. A change in Prime Minister in Australia, which fuelled hopes of a resolution to a controversial mining tax, and an austere budget in the UK, were also key events. However, sentiment took a hit as the Fed sounded more cautious on the US economy in its FOMC statement.

The US Congress finalised a major regulatory reform bill towards the end of the week and markets, especially financial stocks, reacted positively as the bill appeared to give some concessions to banks and was not as severe as feared. However, equity market momentum has clearly faded against the background of renewed growth concerns including sprouting evidence of a double-dip in the US housing market as well as fresh worries about the European banking sector. As if to demonstrate this US Q1 GDP was duly revised lower once again, to a 2.7% annualised rate of growth.

The US Independence Day holiday and World Cup football tournament will likely keep liquidity thin in the run up to month and half year end. However, there is still plenty to digest this week including the all important employment report and consumer confidence data in the US. In Europe economic sentiment gauges, purchasing managers indices and the flash CPI estimate will be in focus. Elsewhere, Japan’s Tankan survey and usual slate of month end Japanese releases, Switzerland’s KoF leading indicator and Australian retail sales will be of interest.

On balance, economic data this week is unlikely to relieve growth concerns, with Eurozone, US and UK consumer and manufacturing confidence indicators likely to post broad based declines due to a host of factors. The data will further indicate a slowing in growth momentum following Q2 2010, with forward looking surveys turning lower, albeit gradually. Whilst a double-dip scenario still seems unlikely there can be no doubt that austerity measures and the waning of fiscal stimulus measures are beginning to weigh on growth prospects even if there is still plenty of optimism for emerging market and particularly Asian growth prospects.

This suggests that Q3 could turn into a period of heightened uncertainty in which equity markets and risk assets will struggle to gain traction. In addition to growth worries, some tensions in money markets remain in place whilst banking sector concerns seem to be coming back to the fore, especially in Europe and these factors will prevent a sustained improvement in risk appetite from taking place over the coming quarter. Some more clarity may come from the results of European stress tests but much will depend on just how stressful the tests are.

In the near term, the main focus of attention will be on the US June jobs report released at the end of the week. Non-farm payrolls are set to record a decline over the month due to a reversal in census hiring, with a consensus expectation of a 110k fall. Private sector hiring is likely to record a positive reading, however, suggesting some improvement in the underlying trend in jobs growth, albeit a very gradual one. Downside risks to consensus suggest plenty of scope for disappointment.

Interestingly, weaker US data of late, has managed to restrain the USD, suggesting that cyclical factors and not just risk aversion are beginning to play into FX movements. Notably the USD was on the back foot against a number of currencies as last week progressed. Even the beleaguered EUR managed to end the week well off its weekly low and close to where it closed the previous week whilst risk currencies such as the AUD and NZD as well as GBP also posted firm performances.

Perhaps some reversal of the optimism towards US recovery prospects give USD bulls some cause for concern, but pressure is likely to prove temporary, especially given that the US economy is still on course to outperform many other major economies. Over the short-term, especially ahead of the US jobs report markets are set to remain cautious with range trading likely to dominate in the week ahead, suggesting that EUR/USD is unlikely to breach the key level of 1.2500. GBP performance has been robust but even this currency is likely to make much headway above GBP/USD 1.5000, where there are likely to be plenty of sellers.

Risk trade rally fizzles out

The risk trade rally spurred by China’s decision to de-peg the CNY fizzled out. The realization that China will only move very gradually on the CNY brought a dose of reality back to markets after the initial euphoria. The fact that unlike in July 2005 China ruled out a one off revaluation adds support to the view that China will move cautiously ahead with CNY reform. In addition, renewed economic worries have crept back in, with particular attention on a potential double dip in the US housing market following a surprise 2% drop in existing home sales in May.

European banking sector woes have not disappeared either with S&P raising the estimate of writedowns on Spanish bank losses, whilst Fitch ratings agency noted that there is an increased chance of the eurozone suffering a double-dip recession. The net impact of all of these factors is to dampen risk appetite and the EUR in particular.

The UK’s announcement of strong belt tightening measures in its emergency budget did not fall far outside of market expectations. The budget outlined a 5-year plan of deficit reduction, from 11% of GDP in 2009-10 to 2.1% of GDP in 2014-15. The main imponderable was the response of ratings agency and so far it appears to have been sufficient not to warrant a downgrade of the UK’s credit ratings. Fitch noted that the “ambitious” plan ensured that the UK would keep its AAA credit rating. The emergency budget and reaction to it has been mildly positive for GBP, which has shown some resilience despite the pull back in risk currencies.

The recent rally in Asian currencies is looking somewhat overdone but direction will come from gyrations in risk appetite and the CNY rather than domestic data or events. Encouragingly equity capital flows into Asia have picked up again over recent weeks, with most countries with the exception of the Philippines registering capital inflows so far this month, led by India and South Korea.

China’s CNY move may attract more capital inflows into the region, suggesting that equity capital flows will continue to strengthen unless there is a relapse in terms of sovereign debt/fiscal concerns in Europe. Nonetheless, central banks in the region will continue to resist strong FX gains via FX interventions, preventing a rapid strengthening in local currencies.

Although India and Korea have registered the most equity inflows this month, both the INR and KRW have had a low correlation with local equity market performance over recent weeks. In fact the most highly sensitive currencies to their respective equity market performance have been the MYR and IDR both of which have reversed some of their gains from yesterday. USD/MYR will likely struggle to break below its 26th April low around 3.1825 whilst USD/IDR will find a break below 9000 a tough nut to crack.

China’s gradual renminbi move

China’s decision to “proceed further with reform” of the CNY exchange rate regime will dictate market activity at the turn of the week. The decision to act now reflects the fact that China is no longer in crisis mode policy. Although the eurozone sovereign crisis may have delayed China’s move, the authorities in China clearly felt that conditions had improved sufficiently enough to act. The decision will pre-empt some of the criticism that China would have faced at the G20 meeting next weekend, leaving attention firmly on Europe.

Before we all get too excited it should be noted that it is unlikely that China’s announcement presages aggressive action on the CNY. Stability appears to be the name of the game, a fact that has already drawn criticism from some in the US Senate who may still push for legislation over China’s exchange rate.

China will likely allow some, albeit gradual appreciation of the CNY. In this respect, it’s worth noting that the CNY appreciated by around 6.6% against the USD during 2007 and around the same amount in 2008 prior to the formal peg with the USD. Appreciation at a similar pace of coming months is unlikely.

The initial impact on the USD was an echo of the July 2005 move but to a far smaller degree. The USD was sold off across the board as market players reacted to the likelihood of the USD playing a less important role in China’s exchange rate mechanism. The USD rallied when China maintained its CNY fixing but lost ground as the CNY appreciated against the fixing.

The fact that net USD speculative positions halved over the past week according to the CFTC IMM data, suggest that the USD is far less vulnerable this week to selling pressure from a positioning perspective. In other words there will be no repeat of the sharp FX moves that were seen post the July 2005 CNY revaluation. Whilst the major currency impact is likely to prove muted, Asian currencies are set to benefit more significantly, with further strengthening likely this week.

China’s announcement will play into the tone of firmer risk appetite at the beginning of the week but the move in some risk currencies, especially the EUR is looking increasingly stretched. The EUR and risk appetite may have benefited from recent positive news flow including the announcement of European bank stress tests and the relatively positive reception to Spain’s bond auction, but speculative positioning (IMM) data reveals that there was already a strong short-covering rally over the past week, which saw net EUR short positions almost halve.

Further EUR/USD gains will be harder to come by, with an immediate obstacle around 1.2500. Perhaps another reason for China to be cautious about the pace of CNY appreciation is the likelihood of further EUR weakness and the impact that this would have on China’s trade with Europe. As it is EUR/CNY has already dropped by over 13% so far this year and China will not want to enact measures that will accelerate the pace of the move in the currency pair.

Stressing About European Stress Tests

Equities and risk appetite were bolstered by the relative success of the Spanish bond auction on Thursday. The results of the auction in which Spain sold EUR 3 billion in 10 year notes helped to stem some of the pressure on eurozone bond spreads, which despite the generalized improvement in market sentiment over recent days, had been continuing to widen.

Another key indicator that has been suggested that all is not well moving in the opposite direction to the improvement in many risk indicators is the Baltic Dry Index which has dropped by around a third since 26th May 2010.

Perhaps more significant in terms of providing sustainable support for markets was the news that the European Union agreed to publish the results of bank stress tests, slated for the second half of July. This could turn out to be a key stepping stone towards increasing the transparency of the eurozone banking sector.

However, doubts will remain until there is some clarity on the terms of the tests such as whether they include details of sovereign debt exposure. Also, if the stress tests reveal shortcomings in the banks in question it is unclear if government funding will be provided for them. Although the publishing of stress test results is a step in the right direction until these and other questions are answered it is difficult to see markets getting too excited.

It’s not all plain sailing for equity markets despite the relatively positive news in Europe as disappointing US data in the form of a surprise jump in weekly jobless claims and a bigger than expected drop in the June Philly Fed survey weighed in on the side of those expecting both a slow and jobless recovery in the US.

The CHF has been a key mover following the Swiss National Bank policy decision. The decision to leave interest rates unchanged was no surprise, but the change in rhetoric towards a less aggressive stance towards CHF strength opens up the floodgates for CHF buyers. will look to test its all time low around 1.3720.

Another central bank that has shown concern about a strengthening currency is the Bank of Japan but unlike the SNB Japan’s central bank has not intervened for several years. The BoJ in the minutes of its May meeting noted that it will “watch if Europe’s crisis strengthens JPY”, indicating some concern about JPY strength.

This sentiment that was echoed by the Japanese government in the release of Economic Growth Strategy aimed at avoiding an excessive rise in the JPY via fiscal and monetary steps to beat deflation. The JPY barely reacted to both the minutes and the growth strategy, with market players likely sceptical until concrete measures are actually implemented.

It still look like an environment of sell on rallies for the EUR and other risk currencies, with their gains likely to run out of steam over coming days. The next key technical level for EUR/USD is around 1.2454, a level that will prove a tough nut to crack.

Euro Rally To Fade

It is not an easy time to forecast currencies. Just as many forecasters fought for the accolade of being the most bearish on the EUR and many others were forced to capitulate or risk falling behind the curve, EUR/USD has started to perk up. Similarly, commodity currencies and many emerging market currencies have bounced.

Perhaps the explanation of these moves is merely position adjustments as traders and investors square positions as they keep one eye on the World Cup or maybe its just fatigue after weeks of selling pressure. Either way, the fact that speculative USD market positioning is at a very high level, suggests there is plenty of scope to take profits on long USD positions.

There are various reasons to expect the calm to give way to renewed tensions, however. Public opposition to austerity plans in Europe, added to the prospects for slowing growth as the plans are implemented, in addition to banking sector concerns, suggest that the outlook for the EUR remains downbeat. These factors also point to the prospects of risk aversion rising over the coming weeks, reversing the recent rally in risk currencies.

Further out, the EUR’s travails will not be over quickly and in the wake of the implementation of austerity plans the EUR will struggle from the impact of relatively slower growth in the eurozone compared to the US and other countries. The EUR will continue to remain under pressure even as risk appetite improves and many risk currencies appreciate.

The interruption of risk as an FX determinant is likely to fade towards the end of the year and investors will then go back to differentiating on the basis of relative growth and interest rate dynamics, which will play well for the USD as US growth strengthens.

Relative growth differentials will also bode well for commodity currencies and there will be scope for plenty of upside in the AUD and NZD as growth strengthens. Both countries have benefited from firm demand in Asia and China in particular and this source of support will likely continue to be beneficial.

Funding currencies including JPY and CHF will likely weaken this year against the USD based on the likely improvement in risk appetite later this year. The outlook for the JPY will be particularly interesting in the wake of the change in Prime Minister in Japan, especially given the new PM’s preference for a weaker JPY and reflationary policies. USD/JPY will likely reach 100 by the end of the year.

GBP should not be seen in the same context as the EUR. Although the UK has got its own share of fiscal problems the new government appears to be moving quickly to mollify both investor and ratings agency concerns. The test will come with the reaction of the emergency budget on June 22nd but I suspect that the downside risk to GBP will be limited.

Unlike the EUR which is trading around “fair value”, GBP is highly undervalued. Arguably past GBP weakness puts the UK economy on a stronger recovery footing. Moreover, problems that Europe will face in implementing multi country austerity plans and widening growth divergence, will not be repeated in the UK. Overall, there is likely to be significant outperformance of GBP versus EUR over coming months

World Cup FX Positioning/Data Highlights

The market tone felt decidedly better over the course of the last week although it was difficult to tell if this was due to position squaring ahead of the World Cup football or a genuine improvement in sentiment. There was no particular event or data release that acted as a catalyst either, with the European Central Bank (ECB) and Bank of England (BoE) meetings passing with little fanfare.

US data ended the week mixed, with retail sales disappointing in May but in contrast June consumer confidence beating expectations. Although questions about the pace of recovery remain, other data such as the Fed’s Beige Book suggest that recovery remains on track, sentiment echoed, albeit cautiously by Fed Chairman Bernanke last week.

Attention this week will centre on inflation data. Expected benign CPI readings will support the view that the Fed will take its time to raise interest rates. Speeches by the Fed’s Bullard, Plosser and Bernanke this week will be eyed for further clues on Fed thinking.

Central banks in Brazil and New Zealand hiked rates last week but this is not likely to be echoed this week. No change is likely from both the Bank of Japan and Swiss National Bank although there will be plenty of attention on the SNB’s comments on the CHF following recent data showing a surge in FX reserves due to currency intervention. The BoJ is unlikely to announce anything new but perhaps some further detail on the loan support plan could be forthcoming.

Manufacturing data will also garner some attention, with the US June Empire and Philly Fed surveys and May industrial production on tap. All three reports will confirm the improving trend in manufacturing activity in the US. Housing data will look weaker, with starts set to pull back in starts in May following the expiry of government tax incentive programmes though permits are set to rise.

In Europe, the June German ZEW (econ sentiment) investor sentiment survey will likely slip slightly due to ongoing fiscal/debt worries but this will be countered by stronger domestic data. In any case the index remains at a high level and a slight drop is unlikely to derail markets.

GBP may find some support form upgrade of UK growth forecasts by the CBI to 1.3% for 2010 and relatively hawkish comments from the BoE’s Sentance in the weekend press warning that inflation is higher than expected, indicating that the Bank may need to hike rates sooner than expected.

Further GBP/USD direction will come from CPI and retail sales data this week as well as public borrowing figures and a report by the new Office of Budget Responsibility on the UK’s fiscal position ahead of the June 22 budget. A break above GBP/USD resistance around 1.4760 is unlikely to materialise.

Despite the many data releases this week, the overall tone is likely to be one of consolidation and reduced volatility in the days ahead. This may allow EUR/USD to gain some ground due to short covering, with the CFTC commitment of traders (IMM) report revealing a further increase in net short speculative positions last week, close to the record set a few weeks back, though we suspect that there will be strong resistance around 1.2227.

The fact that the IMM data revealed that net aggregate net USD long positions reached an all time high last week, highlights the potential for profit taking this week. USD/JPY will look to take out resistance around 92.55 but this looks unlikely unless the BoJ dishes up anything particularly dovish from its meeting.

%d bloggers like this: