Bracing for the worst

There was little progress over the weekend during discussions between US politicians attempting to agree on a budget deal and thus avoiding a partial government shutdown by the end of today. The US Senate is now set to reject a House of Representatives plan to delay President Obama’s Affordable Health Care Act while renewing funding for the government until December 15, leaving an ongoing stalemate in discussions.

Markets are bracing for the worst, with risk aversion rising, US equities and the USD falling. Meanwhile US Treasury yields remain capped having dropped sharply since early September. Political shenanigans in the US threaten to overshadow the US September jobs report at the end of the week. Nonetheless, the data will provide major clues to the timing of Fed tapering regardless of the budget/debt discussions.

It’s not just in the US where politics is fuelling market tensions. In Italy former Prime Minister Berlusconi withdrew his party’s support from the coalition government, leaving current Prime Minister Letta scrambling to form a new parliamentary majority in order to avoid snap elections. The impact will likely be felt on Italian and peripheral bond yields over coming days.

Meanwhile following elections in Germany last week coalition discussions to form a new government are ongoing although no deal is in sight yet and talks could go on for some time yet. Political uncertainties are unlikely to alter the European Central Bank’s (ECB) course this week, with an unchanged policy decision expected although benign inflation and weak credit growth will reinforce the need for an easing bias and forward guidance. Political issues are set to dominate markets over coming days, leaving risk aversion elevated and risk assets under generalised pressure.

The USD index lurched lower in the wake of the uncertainties in the US, extending its drop from early September. The near term prospects for the currency are bleak, with limited potential for any upside unless a budget deal is reached. Safe haven currencies in particular the JPY will be buoyed in this environment. The EUR will not fully be able to take advantage of USD weakness however, given the political tensions within the Eurozone.

In terms of high beta emerging market currencies including Asian currencies, any positive impact from the fact that US yields are capped, with 10 year treasury yields dropping sharply recently (higher US yields have been negative for EM currencies over past weeks so a drop will be positive for them) will be outweighed by rising risk aversion, leaving most Asian currencies vulnerable.


German election results help the euro

St Louis Fed President Bullard put a dampener on the market’s euphoria in the wake of the Fed’s postponed ‘tapering’ announcement. He noted that the Fed’s decision was “borderline”, implying that the Fed was not far from pulling the trigger to the commencement of tapering. Going forward, the timing of tapering will be highly data dependent and obviously recent weaker data releases and possibly the political complications surrounding extending the debt ceiling and agreeing on a budget, played heavily on the Fed’s conscience. However, there are now plenty of questions about the Fed’s communication strategy. There will plenty of Fed speeches over coming days to provide more clarity although Janet Yellen, front runner to succeed Ben Bernanke as Fed Chairman, appears to be keeping conspicuously quiet.

A bounce in China’s September manufacturing confidence revealed this morning as well as a strong outcome in the German elections for Chancellor Merkel (see below) will nonetheless, help to settle some market nerves as the week commences. Merkel’s CDU/CSU party is set to win close to 42% of the vote, which amounts to a very strong mandate. Nonetheless, she will still fall short of an absolute majority while Merkel’s coalition partner the FDP failed to gain enough votes to pass the 5% threshold to win any parliamentary seats means that a new coalition government will need to be formed. The EUR has reacted well to the result, remaining above 1.3500 versus the USD and looks to set consolidate gains over the short term.

Aside from various Fed speakers there will be several data releases to digest over the week. In the US there will be September consumer confidence, August durable goods orders, new home sales, personal income and spending, and revised Q2 GDP data on tap. Overall US data will be reasonably good, with in particular GDP set to be revised higher. In Europe, aside from digesting the German election result there will be a host of business and manufacturing surveys including the German IFO business confidence survey. Consolidation or moderate improvement is expected to be revealed in these surveys, likely giving sufficient support for the EUR to maintain recent gains.

Fed keeps the party going

The party goes on! The Fed decided to play on the side of caution by not acquiescing to market expectations. The FOMC maintained its current USD 85 billion of asset purchases wanting to see more evidence of economic recovery before pulling the trigger. Market expectations centred on a USD 10-15 billion paring back of asset purchases. Clearly worried about a rise in market interest rates Fed Chairman Bernanke strengthened the Fed’s forward guidance by highlighting that the first rate increase may not come until the unemployment rate is “considerably below” 6.5%. A downgrade in the Fed’s economic forecasts will also have helped to justify the inaction by the FOMC.

Clearly risk assets loved what they saw, with equities and commodities rallying and US Treasury yields dropping. Gold prices in particular jumped on the news while the VIX ‘fear gauge’ dropped. The USD was a major casualty losing ground to most currencies, with notably EUR/USD spiking above 1.35 and GBP/USD to above 1.60. High beta emerging market currencies were big winners, given the positive impact of lower US yields and prospects of ongoing capital inflows. While the Fed has merely delayed tapering this will not stop markets from following through on the positive dynamic today. The positive tone will be reinforced across Asian and European markets.

The sharp drop in US Treasury yields hit the USD hard and it is likely to remain under pressure over the short term against a variety of currencies. Although the drop in US yields is likely to prove temporary it is difficult to go against the move in the near term. In order to identify which currencies will benefit the most versus USD I have looked at their sensitivity to US 10 year Treasury yields. The biggest beneficiaries will be Asian currencies given that they register the strongest correlations. The IDR, THB, MYR and INR are at the top of the list in this respect. In any case Asia was already experiencing a resumption of capital inflow as tapering expectations were being priced in and the Fed inaction will reinforce this trend.

GBP bounced following the unanimous vote for no policy shift revealed in the Sep 3-4 Bank of England MPC meeting minutes. Its gains were reinforced by Fed inaction overnight, with GBP/USD breaking through key levels above 1.60. Although the MPC’s 9-0 vote for no change was in line with expectations there was a minority looking for one of two MPC members to have voted for increased asset purchases. Citing upside risks to the growth outlook the BoE appears more confident about the UK’s economy. However, this all but makes a mockery of “forward guidance” and attempts to cap market interest rates. A further test for GBP will come from today’s August retail sales release. There are downside risks to consensus but even this may prove to a temporary stumbling block to a resurgent GBP.

The Swiss National Bank is widely expected to keep policy unchanged today and will make no changes to the CHF ceiling. The desire to keep the ceiling in place remains strong even though the economy is showing signs of recovery, deflationary pressures are receding and capital inflows from the Eurozone have diminished and in fact showing signs of reversing, albeit slowly. Reflecting this SNB reserves growth has slowed while Swiss banks’ foreign liabilities have decreased. The fact that the currency remains overvalued however, means that there is only an extremely slim chance that the ceiling will be removed over coming months. Although the SNB will likely revise upwards its growth forecasts, expect a cautious tone to emerge from the meeting. Accordingly EUR/CHF is set to remains capped around 1.2400 over the near term.

Dollar undermined by outflows, while flows return to Asia

The Lawrence Summers’ effect (ie his withdrawal from the race to be next Fed Chairman) rippled through markets, with risk appetite improving, buoying equities as well as bonds. As noted yesterday he is perceived to be less in favour of quantitative easing compared to the other leading contender Yellen. Commodity prices including gold prices slipped while the USD remained under pressure. Meanwhile, keep an eye on the Baltic dry index which has risen sharply since the beginning of September, indicating a positive bias for global economic activity in the months ahead.

As markets brace for the Fed to announce modest tapering plans tomorrow risk assets are set to remain supported, especially given expectations that the Fed will counter tapering with reinforced forward guidance. Effectively this means that the negative impact on the market from less Fed asset purchases will be offset by more reassurance that policy will not be tightened too quickly. Additionally helping the tone of positive risk sentiment is the expectation that a deal on Syrian chemical weapons is moving ahead.

The USD has been undermined by capital outflows from the US, improving risk appetite and US data disappointments. While we do not expect the USD to slide much further it is likely to remain under pressure over the short term before resuming appreciation later into Q4 and next year. The USD has failed to benefit from the rise in US Treasury yields over recent months due to foreign sales of Treasuries. The Fed FOMC meeting tomorrow is unlikely to offer the USD any support.

Further evidence of Treasury outflows is likely to be revealed in today’s releaser of the August US Treasury TIC flows data. Eventually I expect higher US yields to attract foreign flows, especially from Japan as life insurance companies etc, boost their holdings of US Treasuries, but over the near term the USD will be undermined by capital outflows.

GBP has rallied strongly over recent weeks both against the USD and EUR but the currency faces some risks from August CPI inflation data today and Bank of England Monetary Policy Committee minutes tomorrow. While a series of positive data surprises has made the job of the MPC harder in terms of establishing its forward guidance, a slight dip in CPI and possible shift of a couple of MPC members to restart voting for more asset purchases (no votes for further purchases at the last meeting) likely to be revealed in the minutes of the September meeting, could provoke some profit taking and act as a short term cap on GBP.

Despite the ongoing pressure on the USD, the rally in Asian currencies appears to have stalled although they continue to remain well supported amid a generally positive risk environment. Returning portfolio investment flows have helped, with the INR in particular benefitting from renewed inflows. The INR took the above consensus August WPI inflation reading in its stride although the data did reinforce the view that the central bank (RBI) will refrain from shifting policy rates at its meeting later this week.

Summers’ departs Fed race, risk assets supported

Another weaker than forecast US economic release, namely August retail sales has obscured the picture ahead of the mid week Fed FOMC meeting. Moreover, the data alongside news that one of the leading candidates to take over as Fed Chairman, Lawrence Summers, has withdrawn his candidacy has helped to undermine the USD. Summers is perceived as relatively hawkish and less in favour of quantitative easing than the other leading contender Janet Yellen.

Summer’s departure from the Fed race will help to buoy risk assets and cap US bond yields. His candidacy faced increased resistance from both sides of the political spectrum, with an “acrimonious” confirmation ahead of him. Yellen is now the clear front runner in the race although she may still face competition from former vice-chairman Donald Kohn.

Ahead of the FOMC meeting there is likely to be little directional bias for markets, with the Fed expected to announce USD 10 billion in tapering in an even split between Treasuries and mortgage backed securities. Additionally the Fed is set to strengthen its forward bias in order to soothe markets and this ought to alleviate some of the impact some of the potential pressure on risk assets from the announcement of tapering.

In Europe politics will be in focus, with Senate hearings on the Berlusconi case in Italy continuing, heightening cross party tensions and maintaining the threat of a government collapse. Meanwhile in Germany Chancellor Merkel gained some momentum ahead of national elections as her ally, the CSU took an absolute majority in Bavaria.

However, the fact that her Federal government partner the Free Domocrats failed to reach the 5% threshold to enter the Bavarian parliament, means that Merkel still faces the prospect of having to enter into a grand coalition if they record a similar performance in national elections. EUR may face some restrain given the uncertainty around political events in Europe.

In Asia currencies are likely to find further support from the news that Summer’s has pulled out of the Fed race. Already over recent weeks there was strong evidence of a resumption of equity capital inflows to the region, helping to steady many Asian currencies. If the Fed attempts to counter any pressure from tapering news with reinforced forward guidance it ought to leave Asian currencies supported in the near term.

The INR has been the outperformer so far this month and will benefit further over the short term although the Reserve Bank of India policy meeting under new governor Rajan this week will give further clues on the direction of the currency.

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