Equity flows to Asia surge

Equity flows to Asia have begun the year in solid form. Although not quite as strong as in 2010 the pace of recent acceleration in flows has been more rapid, suggesting that it will soon overtake the year to date inflows seen over 2010. In total Asia has registered around $4.955 billion in foreign equity inflows. Korea has received the biggest inflows at $2.4 billion followed by India $1.04bn and Taiwan $1.03 billion.

The Indian rupee (INR) has been a clear beneficiary of such flows while the Korean won (KRW) has also strengthened. I suspect that official resistance may have limited Taiwan dollar (TWD) gains but clearly the risk on start to the year has resulted in strengthening inflows and in turn stronger Asian currencies.

Unless there is a disaster in Greece or elsewhere in Europe next week there is little to stop the short term trend but I remain wary over coming weeks and am cautious about extrapolating this trend forward. Like in 2010 and 2011 equity flows began the year strongly only to drop over following weeks and currencies were not slow to follow.

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Resilient Markets

Risk assets have registered a good start to the year despite ongoing tensions in the Eurozone. US stocks rose overnight, with the S&P 500 extending its rally to 4% year to date. Evidence that markets are becoming increasingly resilient to bad news emerged from the muted reaction to sharp downgrades in growth forecasts by the World Bank, with the world economy expected to grow by 2.5% this year compared to a June forecast of 3.6%.

US markets also reacted positively to news that the US NAHB Homebuilders index rose to its highest level in more than 4 years and while industrial output expanded, albeit less than expected. Markets will continue to keep one eye on earnings to ascertain whether the equity rally can be sustained, with at least 48 S&P 500 companies reporting earnings this week including Morgan Stanley Bank of America, Intel and Google today. So far, relatively more companies have fallen short of expectations than have beaten expectations.

Even in the Eurozone the news has been slightly more encouraging than of late, with reports that a deal between Greece and private creditors on the extent of debt writedowns could be reached by the end of this week. Moreover, the International Monetary Fund (IMF) is reported to be raising $500 billion in new funds for bail out funds, another factor that has helped to shore up market sentiment. The net result has been to see peripheral bond yields ease further and the EUR to strengthen, helped by the fact that the market is extremely short.

There is still plenty of event risk on the horizon, however, including debt auctions in Spain and France today although these ought to pass relatively smoothly. US data are likely to be mixed today, with benign inflation keeping the door open to more Fed quantitative easing (QE) while a gain in the Philly Fed manufacturing survey will continue to reveal signs of economic recovery. In the short term risk assets look supported but given the risks ahead any bounce still looks to be short-lived.

Euro sentiment dives to a new low

Equity markets in Europe began the year in positive mood, with gains led by the German DAX index following the release of firmer than expected readings for Eurozone purchasing managers indices (PMI). Chinese data which showed an increase in its PMI also helped to boost sentiment. The Eurozone data however, remained at a weak level, contracting for a fifth month in a row, and still consistent with Eurozone recession.

It seems unlikely that equity gains will be sustained over the rest of this week, with risk aversion set to remain elevated against the background of ongoing Eurozone debt and global growth concerns. Indeed, both French and German leaders in their new-year messages warned about the risks ahead. A meeting between Germany’s Merkel and France’s Sarkozy is scheduled for January 9th ahead of an EU Finance Ministers summit on January 23rd. It is unlikely that there will be any significant policy decisions in Europe before then.

Meanwhile, press reports noting that Germany is pushing for an even bigger write down of Greek debt than previously agreed will only add to risk aversion over the short term. The report in the Greek press highlighted the prospect of a 75% write down of Greek debt a far cry from the 20% proposed some months ago. Eurozone markets continue to be haunted by the prospects of credit downgrades by major ratings agencies at a time when many countries have to issue large amounts of debt to satisfy their funding requirements.

Against this background the EUR is set to remain under pressure, with a notable drop below EUR/JPY 100, its lowest level in over a decade registered. Reflecting the deterioration in sentiment for the currency, EUR speculative position hit an all time low at the end of last year according to the CFTC IMM data. This is unlikely to reverse quickly, with sentiment set to deteriorate further over coming weeks and months as the EUR slides further.

Germany Caught in the Contagion

Equity markets came off their lows overnight despite a 236 point drop in the Dow Jones, but sentiment remains extremely fragile and any let up in pressure on risk assets will prove temporary. A weak bond auction in Germany highlights the severity of contagion across Europe. If the core is being hit then there is no safe haven in Europe anymore. On a positive note it might just make German officials finally realise that they need to act quickly to provide solutions to the crisis.

Weak data notably outside the US adds to the malaise, with in particular China’s HSBC November weaker purchasing managers’ indices coming in below the 50 boom/bust level. Europe’s weaker purchasing managers indices highlight the prospects of looming recession while the news in Germany is not only bad on the bond front bad also on the data front. Today’s German November IFO survey will continue in the same vein, with further weakness in this business survey expected.

Bearing in mind the US Thanksgiving holiday today thin liquidity will mean that conditions are ripe for exaggerated market moves. EUR/USD has already sustained a drop below the important 1.3500 level as even the underling strong Asian demand appears to have been pulled back. More downside is expected but technicals suggests that it will be hard trudge lower, with near term support seen around 1.3285 (10 day Bollinger Band). The near term range is likely to be 1.3285-1.3505 although given the US holiday the range may be even tighter.

Aside from the IFO attention today will focus on a meeting between Chancellor Merkel, President Sarkozy and Prime Minister Monti. As usual expect a lot of hot air but little action. Also note there is a general strike in Portugal today protesting against austerity measures in the country.

Eurozone contagion spreading quickly

Contagion from the eurozone debt crisis is spreading quickly, threatening to turn a regional crisis into a global crisis. As highlighted by Fitch ratings further contagion would pose a risk to US banks. Consequently risk assets continue to be sold but interestingly oil prices are climbing. Taken together with comments earlier in the day from the Bank of England that failure to resolve the crisis will lead to “significant adverse effects” on the global economy, it highlights the risks of both economic and financial contagion.

Predominately for some countries this is becoming a crisis of confidence and failure of officials to get to grips with the situation is resulting in an ever worsening spiral of negativity. Although Monti was sworn in as Italian Prime Minister and Papademos won a confidence motion in the Greek parliament the hard work begins now for both leaders in convincing markets of their reform credentials. Given that there is no agreement from eurozone officials forthcoming, sentiment is set to worsen further, with safe haven assets the main beneficiaries.

EUR/USD dropped sharply in yesterday’s session hitting a low around 1.3429. Attempts to rally were sold into, with sellers noted just below 1.3560. Even an intensification of bond purchases by the European Central Bank (ECB) failed to prevent eurozone bond yields moving higher and the EUR from falling.

Against this background and in the absence of key data releases EUR will find direction from the Spanish 10 year bond auction while a French BTAN auction will also be watched carefully given the recent increase in pressure on French bonds. Having broken below 1.3500, EUR/USD will aim for a test of the 10 October low around 1.3346 where some technical support can be expected.

US data releases have been coming in better than expected over recent weeks, acting to dampen expectations of more Fed quantitative easing and in turn helping to remove an impediment to USD appreciation. While the jury is still out on QE, the USD is enjoying some relief from receding expectations that the Fed will forced to purchase more assets. Further USD gains are likely, with data today including October housing starts and the November Philly Fed manufacturing confidence survey unlikely to derail the currency despite a likely drop in starts.

EUR falls, JPY retraces after intervention

Risk aversion has come back in full force, with various concerns weighing on markets. Once again attention is firmly fixed on the eurozone and worryingly last week’s European Union (EU) rescue agreement has failed to prevent a further widening in eurozone peripheral bond spreads. This will come as a blow to eurozone officials as the agreement was aimed to prevent exactly this.

A lack of detail in the plans announced last week has come back to haunt markets. Moreover, given the event risk of the RBA, ECB and Fed central bank meetings this week plus the US October jobs report at the end of the week, nerves will likely remain frayed over coming days. Overall, the tone will likely be on of selling risk assets on rallies over the short term.

The EUR has unwound a significant part of its gains from last week as various doubts about the eurozone rescue package have surfaced. The measures announced by EU officials have failed to prevent a jump in Italian and Spanish bond yields. News that MF Global has filed for bankruptcy while the Greek Prime Minister has called for a referendum on the EU’s debt deal dealt markets a blow overnight.

As it was doubts had been creeping in due to the lack of detail in the rescue package including but not limited to the lack of specifics on the leveraging of the EFSF bailout fund. The pattern appears to have followed the reaction to previous EU announcements to stem the crisis, namely short lived euphoria followed by a sell off in risk assets. The EUR is likely to struggle further over the near term, with the current pull back likely to extend to around the 21 October low of 1.3705.

Japanese officials had blamed the strength of the JPY on speculative flows and have threatened more FX intervention following yesterday’s Judging by the price action this morning the threat has been followed up by action. In order for USD/JPY to sustain a move higher it will require both a widening in yield differentials and easing risk aversion. Neither are guaranteed to happen any time soon as was evident overnight with risk aversion rising. US data has improved but it is insufficient to provoke a sharp back up in US bond yields.

Consequently in the coming weeks USD/JPY topside momentum will be limited. A break above USD/JPY’s 200 day moving average level of 79.89 could prove decisive in terms of JPY long capitulation and once above this level USD/JPY will target the 11 July high of 80.83. However, this will require further intervention otherwise the underlying trend in JPY will continue to remain positive.

Plenty of event risk

This week is heavy with event risk, with a lot expected from EU leaders. So far the risk on tone to markets has held up, with for example the VIX fear gauge resting below the key 30.0. The G20 meeting over the weekend set the deadline for action for concrete solutions to the eurozone debt crisis for the October 23 EU Summit.

However, there will be little detail on issues such as banking sector recapitalisation, private sector involvement in any debt restructuring or ‘leveraging’ the EFSF bailout fund until the report on Wednesday night by the Troika on Greece. The reward to EU leaders would be the potential for more aid from the IMF but even now it seems that a German government official has poured cold water of a plan being announced at the EU Summit which will disappoint markets.

There are also plenty of data releases for markets to digest over coming days including inflation releases, manufacturing surveys and industrial production data in the US while in Europe the German IFO and ZEW surveys are scheduled for release. The data will follow on from the better than expected September US retail sales releases at the end of last week continuing to dampen expectations that the global economy is falling in recession though there will be a marked deceleration in European data.

Meanwhile the US Q3 earnings season rolls. The risk on tone will likely continue to weigh on the USD and weigh on bonds but unlike a few weeks ago when a lot of bad news was priced in, the scope for disappointment is becoming increasingly high.

Many currencies remain highly correlated with gyrations in risk and in this respect the improvement in risk appetite is good news for high beta / commodity. AUD, NZD, CAD and JPY are amongst the most sensitive currencies and therefore prone to a bigger reaction as risk improves, with the former three strengthening and the JPY weakening. Asian currencies poised to benefit from firmer risk appetite include INR and KRW, both with relatively high correlations with risk.

EUR/USD has made a solid recovery over recent days from its lows around 1.3146 spurred by hopes of action by European officials. Such hopes may yet be dashed but the EUR looks supported over coming days ahead of the EU summit Speculative positioning also reflects a slight improvement in EUR sentiment as IMM short positions have declined in the last week but its worth noting that this week’s European data are unlikely to be supportive for the EUR.

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