Dollar firm, but beware of a short covering euro bounce

May 21, 2012 — Mitul Kotecha

The USD has risen sharply since the end of April, benefiting from the ongoing turmoil in the Eurozone and rise in US Treasury yields (2-year). Markets have managed to brush US fiscal and political concerns under the carpet as focus centres on Europe. The USD also managed to shrug off a soft April retail sales report and a slightly more cautious set of FOMC minutes.

A recovery in April durable goods orders, new homes sales and a relatively stable reading for Michigan confidence should ensure that the USD’s upward trajectory remains unimpeded this week. Given the potential for continued uncertainty ahead of Greek elections in mid June, risk aversion and the USD are set to remain elevated.

In Europe, it’s all about Greece and the machinations ahead of fresh elections in mid June. The EUR shows little sign of stabilising ahead of these elections. Data releases will take a back seat although the calendar will be heavy. FX markets will have one eye on the May German IFO survey and the flash readings in purchasing managers indices. The PMI data will give no relief to the EUR, with the data consistent with growth contraction for the most part while the IFO is set to register a decline too.

Meanwhile, pressure on German Chancellor Merkel to accept measures that were previously vetoed at an informal EU summit on Wednesday has also heightened. Such measures include direct recapitalisation of banks and/or unlimited purchases of peripheral country debt by the ECB and through the Eurozone rescue fund.

Admittedly the large extent of short market positioning (the latest CFTC IMM report revealed an all time low for EUR positioning) means that the risk of a bounce is high in the event of any good news or perhaps in the wake of any renewed securities markets purchases by the ECB or fresh hints of a third LTRO. Whether there will actually be any good news is another question entirely.

USD/JPY has been relatively stable despite a rise in US bond yields compared to Japanese JGB yields, with rising risk aversion helping to keep the JPY firm. The Bank of Japan meeting this week has the potential to change the currency pair’s trajectory but is unlikely to do so. No action is expected at the policy meeting on Wednesday, leaving the JPY with a firm bias.

Trade data will provide some justification for a more bearish stance on the JPY, with another deficit set to be registered in April as export conditions remain weak. However, as usual the JPY will continue to ignore domestic economic data and focus more on relative yields and risk.

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What would a Greek exit mean for the euro?

May 17, 2012 — Mitul Kotecha

Excuse the lack of posts over recent days. I’m just finishing up a trip to London and am back in HK at the end of the week. I thought in the meantime it would be worth discussing the impact on the euro of a potential Greek exit.

The fact that European officials are openly talking about the prospects of a Greek exit from the Eurozone highlights just how drastic the situation has become. Much will depend on the outcome of new government in Greece in mid June following inconclusive elections recently. Even fresh elections in mid June does not mean that it will be any easier to form a government, leaving the option of a euro exit firmly on the table.

If Greece was to leave the Eurozone there would be a significant amount of confusion in FX markets. It is not obvious that the EUR would strengthen. It could be argued that the departure of Greece would eliminate the weakest link in the chain thus allowing the EUR some relief. Should Greece default on its debt and leave the Eurozone it would not have a marked direct impact on the Eurozone economy but the biggest risk is the financial contagion to other Eurozone countries.

A Greek exit would imply a new currency (Drachma) for the country, a separate monetary policy etc. However, any competitive gain from a weaker currency would be lost in a huge increase in inflation while the local corporate sector would be forced to default en mass on any EUR debt that they hold. Confidence in the new currency would be weaker leading to an exodus of capital further strengthening the EUR.

Admittedly the Eurozone would be stronger without Greece but it would not be long before market attention turned to Portugal and Ireland and even Spain as the next candidates for exit. Indeed, a Greek exit would set a precedent that did not exist previously. It would imply a significant increase in volatility for the EUR given the uncertainty it would create for other Eurozone members. Any rally in the EUR that would be experienced following a Greek exit would therefore be very short lived.

Ultimately for the EUR to experience a sustained strengthening it would require some sign that policy makers are addressing growth concerns as well as progress on austerity and deficit reduction. The formation of a common Eurobond, increased spending on investment projects to enhance productivity, reform of labour markets and a bolstering of the firewall around other peripheral countries would help confidence.

However, this is a long way off and the EUR is likely to suffer for some months to come as growth worries and peripheral country tensions persist. The downside risks to the EUR are clearly opening. The fact that the market is very short EUR already may limit the pace of decline but not stem it. There may be some stabilisaiton of the EUR towards year end assuming Eurozone officials get their act together.

However, in the interim the situation could become far more dire. If Greece were to exit, the prospects of further financial contagion would result in more and not less pressure on the EUR, leading to a potential drop to around the mid 2010 lows just below 1.20. Even if Eurozone political and debt tensions subside I still believe the EUR will decline based on an unfavourable growth and yield differential trajectory but it is clear that the downside risks are much greater even with short market positioning, should the situation deteriorate. In this event, even the strong bids from official investors (namely Asian central banks and sovereign wealth funds) will pull back and the EUR could plunge sharply.

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Euro grinding lower as officials talk about Greek exit

May 14, 2012 — Mitul Kotecha

The week begins in sour mood although notably Asian market pressure was limited even in the face of ongoing Eurozone tensions. China’s cut in its RRR over the weekend helped to limit the damage to markets but there are still plenty of negatives to chew on. Notably European officials are openly discussing and even preparing for the possibility of a Greek exit from the euro, an outcome that has grown in probability as fresh elections loom in Greece.

FX markets have finally awoken from their stupor, with a spike in volatility and moves out of long worn ranges registered. The USD has extended its upward trajectory that began in this cycle on 27th April. The rally looks strong and sustainable but is built largely on the fact that the USD looks less ugly than some other currencies rather than on positive US economic developments.

Admittedly US recovery is taking shape but the data is not sufficiently strong to erase expectations of further Fed quantitative easing, a factor that will limit the ability of the USD to capitalise on weakness elsewhere. Data over coming days will not help to provide much clarity on the issues, with April retail sales likely to be soft and the Fed FOMC minutes unlikely to deliver much new information. Even so, risk aversion is intensifying, providing the USD with firm support, suggesting that the USD will continue to edge higher over coming days.

The EUR in particular has sustained a drop below the psychologically important 1.30 level, spelling more downside risks. Greek politics and the potential for fresh elections remain at the forefront of attention. A small amount of relief on upcoming Greek bond redemptions following the EU’s deliverance of EUR 4.2 billion funds will not be sufficient to offset political worries.

EUR will also find direction from the Eurogroup meeting of finance ministers meeting today who aside from Greek issues will also discuss the Spanish banking sector. Meanwhile, a meeting between French President and Hollande and Germany’s Chancellor Merkel will have the potential to move markets but the chances of a breakthrough on any fresh deal is limited.

Data releases will confirm Eurozone recession while the May German ZEW investor confidence survey is set to record a decline. All of this will not bode well for the EUR, with the currency set to grind lower over coming sessions. EUR/USD 1.2852 will be a crucial support level, a break of which will see EUR slide much further.

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Risk currencies under pressure

May 9, 2012 — Mitul Kotecha

Risk aversion continues to edge higher. This spells more bad news for risk/high beta currencies including many highly correlated currencies such as AUD, NZD and emerging market currencies.

Greece’s travails have come back to haunt markets and the inability to form a government puts at risk the whole bailout programme and possibly Greece’s ability to stay within the Eurozone. A failure to form a government will mean fresh elections in mid June and a delay in aid disbursements.

EUR/USD began the European session below the 1.30 level but I’m not convinced its heading much lower in the short term. The fact that the market is highly short (looking at the CFTC IMM data) means that positioning has already become very negative. Moreover, as in past months, there is plenty of inherent demand for EUR below this level. The better option is to play EUR weakness on the crosses.

UK economic news was soft overnight with the BRC retail sales survey plunging by 3.3%. GBP has acted as a semi safe haven against the background of the current Eurozone malaise but the data highlights that the job of the Bank of England is not particularly clear cut. No action is expected at tomorrow’s policy meeting leaving GBP reasonably well supported.

Safe haven currencies remain favoured, leaving the likes of the USD, JPY and CHF well supported. My quant models point to more short term downside for USD/JPY with a further decline below 80 remaining in place. One other currency that looks relatively attractive is the CAD. Relatively favourable fundamentals highlight the potential for CAD outperformance on the crosses

AUD downside remains intact and a drop below parity with the USD looms. A relatively austere budget after Prime Minister Gillard dropped a corporate tax cut has opened the door to potentially bigger easing from the RBA. While a lot of easing is already priced in the market will react by pricing in more cuts. Moreover, with a likely soft jobs report expected tomorrow and AUD’s susceptibility to risk aversion it all spells more weakness for AUD.

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US dollar on a firm footing

March 12, 2012 — Mitul Kotecha

The stronger than expected US February jobs report (227k versus 210k consensus) and the Greek debt swap should by rights have set a positive tone to markets this week. Unfortunately this is not the case and cautious is set to prevail, with sentiment dampened in part by China’s wider than expected $31.5 billion trade deficit posted in February.

Officials in Europe are set to finalise Greece’s second bailout today but sentiment is unlikely to be boosted as various concerns creep into the market. Growing scepticism about the fact that the Greek bailout fails to correct the country’s underlying problems, worries about whether Portugal will follow in Greece’s wake, fiscal slippage in Spain and the Irish referendum, all point to ongoing tensions in the weeks ahead.

The Federal Reserve FOMC meeting takes centre stage over coming days while data releases including retail sales, industrial production and manufacturing surveys will also prove important for USD direction. The USD reacted positively to the lack of quantitative easing (QE) hints by Fed Chairman Bernanke recently and the stronger than expected February jobs report has reinforced this view.

The USD starts the week on a firm footing but could face renewed pressure if the FOMC statement proves to be more ambiguous on the issue of QE. US data releases will reinforce signs of economic recovery and if they play into a ‘risk on’ tone the USD could suffer. We believe this is unlikely however, with risk assets set to correct lower over coming weeks, playing positively for the USD.

Having rallied following the growing optimism over the Greek PSI debt swap the EUR will find limited support in the days ahead. News of 85.8% participation will have come as relief but the use of collection action clauses (CAC) is not so positive. At least finalisation of the second Greek bailout will now move ahead, with officials set to rubber stamp the deal today.

Data releases such as the March German ZEW survey tomorrow will highlight the sharp turnaround in investor confidence following the ECB’s LTRO and progress on Greece. This would usually bode well for the EUR. However, it is already proving to be a case of buy on rumour, sell on fact outcome for the currency. Potential for a drop below support around EUR/USD 1.3055 is growing as the USD builds momentum.

Following February’s surprise decision by the Bank of Japan to expand its asset purchases and set an inflation goal, the outcome of the policy meeting on Tuesday will deliver few punches. Having weakened in the wake of the last BoJ meeting, partly as a result of higher US bond yields relative to Japan, the JPY threatens to pull back against the USD to support around 80.50.

Improved risk appetite has helped to maintain some pressure on the JPY but this impact ought to prove limited unless yield differentials continue to widen. While the BoJ’s actions will likely keep Japanese government yields supressed, JPY direction will continue to be dictated by the gyrations in US bond yields.

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