Global Themes

February 11, 2011 — Mitul Kotecha

It’s definitely been a strange start to the year, with markets taking plenty of time to get their bearings. Some general themes have developed but none have provided clear direction. As a result, the path over coming weeks and months is likely to remain highly volatile and in this respect, currencies, equities and bonds will continue to see strong gyrations.

One theme that has been evident since the start of the year is an improvement in sentiment towards the eurozone periphery as hopes of an enlargement/extension of the European Union bailout fund (EFSF) have increased. This is a key reason why the EUR has strengthened this year although nervousness on this front appears to have returned over recent days (note the recent widening in peripheral bond spreads, drop in EUR and European Central Bank purchases of Portuguese debt). It seems that a lot of good news has already been discounted in relation to the eurozone periphery and now markets are in wait and see mode for the EU Council meeting on 24/25 March. There is a strong chance that eventually market expectations will prove overly optimistic and the EUR will drop but more on that later.

The second theme is global inflation concerns, driven by higher food and energy prices. Certainly this has had an impact on interest rate expectations and in some cases resulted in a hawkish shift in central bank language, notably in the eurozone and UK. Although European Central Bank (ECB) President Trichet has toned down his comments on tighter monetary policy compared to the more hawkish rhetoric following the last ECB council meeting, expectations for monetary tightening in the eurozone still look overly hawkish, with a policy rate hike currently being priced in for August/September this year, which looks way too early. The EUR has benefitted from the relative tightening in eurozone interest rate expectations compare to the US but will suffer if and when such expectations are wound down.

Elsewhere in many emerging markets the impact of higher food prices is finding its way even more quickly into higher inflation, forcing central banks to tighten policy. In Asia, the urgency for higher rates is even more significant given that real interest rates (taking into account inflation) are negative in many countries. China has accelerated the pace of its rate hikes over recent months and looks set to continue to tighten policy much further to combat inflation. In India, worries about inflation and the need for further monetary tightening have clearly weighed on equity markets, with more pain to come. Although not the sole cause by any means, in the Middle East and Africa higher food prices are feeding social tensions such as in Egypt.

Another clear theme that has developed is the improvement in US economic conditions. The run of US data over recent months has been encouraging, confirming that the economy is gaining momentum. Even the disappointing January non-farm payrolls report has not dashed hopes of recovery, with many other job market indicators pointing to strengthening job conditions such as the declining trend in weekly US jobless claims. Manufacturing, business and consumer confidence measures have strengthened whilst credit conditions are easing, albeit gradually. The US economy is set to outperform many other major economies this year, especially the eurozone, which will be beset with a diverging growth outlook between northern and southern Europe.

Although the US dollar has not yet benefitted from stronger US growth given the still dovish tone of the Fed and ongoing asset purchases in the form of quantitative easing, the rise in US bond yields relative to other countries, will likely propel the dollar higher over 2011 after a rocky start over Q1 2011. In contrast, the EUR at current levels looks too strong and as noted above, hopes of a resolution of eurozone peripheral problems look overdone. EUR/USD levels above 1.3500 provide attractive levels to short the currency. Other growth currencies that will likely continue to do well are commodity currencies such as AUD, NZD and CAD, whilst the outlook for Asian currencies remains positive even despite recent large scale capital outflows. The JPY however, will be one currency that suffers from an adverse yield differential with the US as US bond yields rise relative to Japan.

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Beyond Expectations

February 7, 2011 — Mitul Kotecha

Egypt worries continue to reverberate across markets, yet there appears to be growing resilience or at least some perspective being placed on problems there. Encouraging economic data, particularly in the US has helped to shield markets to some extent, with equity market rallying and US bond yields rising last week. The main impact of Egypt and worries about Middle East contagion continues to be felt on oil prices.

Even the mixed US January jobs report has failed to dent market sentiment; the smaller than expected 36k increase in payrolls was largely attributed to severe weather. A further surprising drop in the unemployment rate to 9.0% due mainly to a significant drop in the labor force was also well received by the market.

There will be less market moving releases on tap this week and the data are unlikely to dent recovery hopes. Michigan confidence is set to record an improvement in February whilst the December trade deficit is set to widen to around $41.0 billion. There are also plenty of Federal Reserve speakers this week including a testimony by Chairman Bernanke.

One central bank that has softened its hawkish rhetoric is the European Central Bank (ECB), with President Trichet dampening speculation of an early rate hike last week and alleviating some of the pressure on eurozone interest rate markets. Consequently the EUR fell as the interest rate differential with the USD became somewhat less attractive. The EUR was also undermined by the opposition from some member states to French and German ideas for greater fiscal policy coordination, an aim apparently not shared across euro members.

Data in Europe will be largely second tier. The EUR will look increasingly vulnerable to a further drop this week especially given the increase in net positioning over the past week to (1st February) according to the CFTC IMM data. The potential for position squaring looms large as positioning is now well above the three-month average. Stops are seen just below EUR/USD 1.3540.

In the UK the Bank of England policy meeting will take centre stage but there is unlikely to be any change in policy settings. Clues to policy thinking will be available in the monetary policy committee meeting minutes in two weeks times but it seems unlikely that any more members have joined the two voting for a hike at the last meeting.

Recent data have been a little more encouraging helping to wash off the disappointment of the surprise drop in Q4 GDP. The UK industrial production report is likely to be similarly firm on Thursday, with the annual pace accelerating. GBP/USD may however, struggle to make much headway against the background of a firmer USD and the weigh of long positioning, with GBP/USD 1.6279 seen as strong resistance.

There are plenty of releases in Australia this week to focus including the January employment data, consumer confidence, and a testimony by RBA governor Stevens in front of the House of Representatives on Friday. The data slate started off somewhat poorly this week, with December retail sales coming in softer than expected, up 0.2% MoM. AUD/USD is likely to be another currency that may struggle to sustain gains this week but much will depend on data over coming days. Resistance is seen around 1.0255.

On a final note, the weekend’s sporting events highlight how it’s not just economic data or moves in currencies that don’t always go as expected. After a solid run in the Ashes cricket England slumped to a 6-1 series loss to Australia in the one-day series, putting the Ashes win into distant memory. A similarly solid performance by Man United was dented with their unbeaten record broken by bottom of the table Wolves.

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Euro Sentiment Jumps, USD Sentiment Dives

January 24, 2011 — Mitul Kotecha

The bounce in the EUR against a broad range of currencies as well as a shift in speculative positioning highlights a sharp improvement in eurozone sentiment. Indeed, the CFTC IMM data reveals that net speculative positioning has turned positive for the first time since mid-November. A rise in the German IFO business confidence survey last week, reasonable success in peripheral bond auctions (albeit at unsustainable yields), hawkish ECB comments and talk of more German support for eurozone peripheral countries, have helped.

A big driver for EUR at present appears to be interest rate differentials. In the wake of recent commentary from Eurozone Central Bank (ECB) President Trichet following the last ECB meeting there has been a sharp move in interest rate differentials between the US and eurozone. This week’s European data releases are unlikely to reverse this move, with firm readings from the flash eurozone country purchasing managers indices (PMI) today and January eurozone economic sentiment gauges expected.

Two big events will dictate US market activity alongside more Q4 earnings reports. President Obama’s State of The Union address is likely to pay particular attention on the US budget outlook. Although the recent fiscal agreement to extend the Bush era tax cuts is positive for the path of the economy this year the lack of a medium to long term solution to an expanding budget deficit could come back to haunt the USD and US bonds.

The Fed FOMC meeting on Wednesday will likely keep markets treading water over the early part of the week. The Fed will maintain its commitment to its $600 billion asset purchase program. Although there is plenty of debate about the effectiveness of QE2 the program is set to be fully implemented by the end of Q2 2011. The FOMC statement will likely note some improvement in the economy whilst retaining a cautious tone. Markets will also be able to gauge the effects of the rotation of FOMC members, with new member Plosser possibly another dissenter.

These events will likely overshadow US data releases including Q4 real GDP, Jan consumer confidence, new home sales, and durable goods orders. GDP is likely to have accelerated in Q4, confidence is set to have improved, but at a low level, housing market activity will remain burdened by high inventories and durable goods orders will be boosted by transport orders. Overall, the encouraging tone of US data will likely continue but markets will also keep one eye on earnings. Unfortunately for the USD, firm US data are being overshadowed by rising inflation concerns elsewhere.

Against the background of intensifying inflation tensions several rate decisions this week will be of interest including the RBNZ in New Zealand, Norges Bank in Norway and the Bank of Japan. All three are likely to keep policy rates on hold. There will also be plenty of attention on the Bank of England (BoE) MPC minutes to determine their reaction to rising inflation pressures, with a slightly more hawkish voting pattern likely as MPC member Posen could have dropped his call for more quantitative easing (QE). There will also be more clues to RBA policy, with the release of Q4 inflation data tomorrow.

Both the EUR and GBP have benefitted from a widening in interest rate futures differentials. In contrast USD sentiment has clearly deteriorated over recent weeks as highlighted in the shift in IMM positioning, with net short positions increasing sharply. It is difficult to see this trend reversing over the short-term, especially as the Fed will likely maintain its dovish stance at its FOMC meeting this week. This suggests that the USD will remain on the back foot.

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Talk but no action

January 19, 2011 — Mitul Kotecha

The eurozone periphery remains in the eye of the storm but markets may have to wait before any concrete action is taken. The possibility of increasing the size of the bailout fund (EFSF), preparation of new European bank stress tests and/or allowing the EFSF to purchase eurozone government debt are all on the table but so far agreement has been lacking. Ministers apparently rejected the idea of increasing the size of the fund from EUR 440 billion to EUR 750 billion whilst disagreement over stricter criteria may also be hampering any progress.

Nonetheless, the EUR has found renewed support, helped by the firm German IFO investor confidence survey and news that Russia is looking to buy EFSF bonds. EUR/USD upside may be face a hurdle around 1.3500 over the short term and gains above this level are likely to be difficult to sustain given the ongoing uncertainties about the EFSF none of which are likely to be resolved anytime soon. The bottom line is that talk but not action will not be sufficient to keep the EUR supported.

GBP is also doing well, partly on the coat tails of a firmer EUR but also in the wake of an acceleration in UK CPI inflation which came in at 3.7% YoY a two year high, surpassing the Bank of England’s (BoE) ceiling for the 10th straight month. Inflation is likely to remain elevated pushing closer to 4% due to the VAT hike to 20% which came into effect at the beginning of this year. The data puts the BoE in a difficult situation testing the Monetary Policy Committee (MPC) expectation that the jump in inflation will prove temporary. However, the market is increasing taking the stance that a rate hike is going to take placer sooner rather than later, with a growing probability of a rate hike.

Since the end of last year there has been a 25bps spread widening (between 2nd contract rate futures) as markets have become more hawkish on UK interest rate expectations. This has coincided with an increasing correlation with GBP/USD resulting in the currency pair cracking above the psychologically important 1.60 level. Much will depend on whether the BoE’s predictions come true. If inflation remains sticky on the upside the Bank may be forced into an earlier tightening. Whether this is good news for GBP will depend on the economy. The worst case scenario is premature monetary tightening just as austerity measures start to bite.

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Data and earnings focus

January 17, 2011 — Mitul Kotecha

Friday’s round of US data were generally upbeat, highlighting that consumer spending is coming back to life. Inflation pressures however, remain benign at least on the core reading highlighting the Fed’s concern that inflation is running below the level consistent with its mandate. In other words it will be a long time, probably late into 2012 before policy rates increase.

While the Fed is no hurry to raise rates despite a few hawkish rumblings within the FOMC the European Central Bank (ECB) in contrast appears to have become more eager to pull the trigger for higher rates. ECB President Trichet’s hawkish press conference last week set the cat amongst the pigeons and marked a clear shift in ECB rhetoric towards a more hawkish stance.

A very big problem for the ECB is that the eurozone economy is not performing along the lines that its hawkish rhetoric would suggest, especially in the periphery. Growth momentum in the core in contrast, as likely reflected in the January ZEW investor confidence and IFO business confidence survey data this week in Germany, remains positive. Both surveys are likely to stabilize at healthy levels but how long can the likes of Germany drag along the eurozone periphery?

There will be relatively more attention on the meeting of Eurogroup/Ecofin officials, with focus on issues such as enlarging the size of the European Financial Stability Facility (EFSF) bailout fund and development of a “comprehensive plan” to contain the eurozone crisis. Don’t look for any conclusive agreements as this may have to wait until the European Union (EU) Council meeting on 4 February assuming (optimistically given ongoing German resistance) some agreement can even be reached.

Following the success (albeit at relatively high yields) of the eurozone debt auctions last week, sentiment for peripheral debt will face further tests this week in the form of debt sales in Spain, Belgium and Portugal.

The US Martin Luther King Jr. holiday will result in a quiet start to the week for markets but there will be plenty to chew on. This week’s key earnings reports include several banks scheduled to release Q4 earnings. Financials are a leading sector in the rally in equities at present and these earnings will be critical to determine whether the rally has legs.

The US data slate includes January manufacturing surveys in the form of the Empire and Philly Fed, both of which are likely to post healthy gains whilst existing home sales are also likely to rise. This will not change the generally weak picture of the US housing market, with high inventories and elevated foreclosures characterizing conditions. As if to prove this, housing starts are set to drop in December. On the rates front, the Bank of Canada is likely to keep its policy rates on hold this week.

After coming under pressure last week much for the USD will depend on the eurozone’s travails to determine further direction. Concrete evidence of progress at the Ecofin may bolster the EUR further, with resistance seen around 1.3500 but don’t bank on it. The ability of eurozone officials to let down often lofty expectations should not be ignored. In any case following sharp gains last week progress over coming days for the EUR will be harder to achieve.

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