Will The Risk Rally Endure?

There has been a definitive turnaround in risk sentiment this week, with equities rallying and bonds falling.  Whether it can be sustained is another question. I think it will be short-lived.

Markets are pinning their hopes on trade talks which have been agreed be US and Chinese officials to take place in October.  These would be the first official talks since July and follow an intensification of tariffs over recent weeks.  However, talks previously broke up due to a lack of progress on various structural issues and there is no guarantee that anything would be different this time around.  Nonetheless, such hopes may be sufficient to keep market sentiment buoyed in the short term.

Data overnight was bullish for risk sentiment, with the US August ADP employment report revealing private sector gains of +195k, which was higher than expected.  The US ISM non-manufacturing index was also stronger than expected, rising to 56.4 in August from 53.7 previously.  This contrasted with the slide in the manufacturing PMI, which slipped in contraction below 50, reported earlier this week.  The data sets up for a positive outcome for the US August jobs report to be released later today, where the consensus (Bloomberg) is for a 160k increase in payrolls and for the unemployment rate to remain at 3.7%.

As risk appetite has improved the US dollar has come under pressure, falling from its recent highs.  Nonetheless, the dollar remains at over two year highs despite speculation that the US authorities are on the verge of embarking on intervention to weaken the currency.  While I think such intervention is still very unlikely given that it would do little to change the factors driving the dollar higher, chatter about potential intervention may still keep dollar bulls wary.  While intervention is a risk, I don’t think this stop the USD from moving even higher in the weeks ahead.

Conversely China’s currency, the renminbi has reversed some of its recent losses, but this looks like a temporary retracement rather than a change in trend.  China’s economy continues to weaken as reflected in a series of weaker data releases and a weaker currency is still an effective way to alleviate some of the pressure on Chinese exporters. As long as the pace of decline is not too rapid and does incite a sharp increase in capital outflows, I expect the renminbi to continue to weaken.

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Calmer market tone ahead of key events

Markets have taken on somewhat of a calmer tone in part due to hopes that discussions between the US and Russia will find some form of solution to the recent escalation of tensions in Ukraine. The nearing of European Central Bank and Bank of England policy decisions today and the US jobs report on Friday have also led to inaction and range trading in markets. Consequently US equities ended flat overnight while risk appetite improved.

Meanwhile, investors are continuing to ignore poor US data attributing it to the weather, with a weaker than forecast February ADP private sector jobs report (139k versus 155k consensus) and February ISM non manufacturing survey (51.6 versus 53.5 consensus), registered overnight. Notably the Fed’s Beige Book repeatedly highlighted the weather impact on US data. Clearly weaker data is not being seen as changing the path of Fed tapering over coming months.

Attention turns to ECB and BoE

Ahead of two key central bank policy decisions by the European Central Bank and Bank of England where no change is expected as well as tomorrow’s release of the US jobs report, range trading is likely to dominate. Risk aversion measures remain elevated however, and further slippage by US stocks was recorded overnight.

The USD remained supported within ranges, helped by firmer US Treasury yields. Fed officials overnight showed little inclination to alter the pace of tapering despite the recent turmoil in emerging markets suggesting that emerging markets can expect little relief from the Fed.

Meanwhile, US data releases provided mixed signals, with the ADP private sector employment report (a key indicator for tomorrow’s non farm payrolls data) coming in below consensus at 175k in January (consensus 185k) while the US ISM non manufacturing survey (a survey of service sector participants) was slightly higher than consensus at 54.0 in the same month.

Aside from the policy rate decisions December US trade data and Q4 non farm productivity are on tap today although neither are likely to be big market movers.

Fed shift hits the dollar

The economic trajectory into Q2 continues to worsen, a factor which likely played into the statement from the Federal Reserve that it is “prepared to increase or reduce the pace of its purchases” of assets, a marked shift from the previous stance of assessing the timing of a reduction of Fed asset buying noted at the March FOMC meeting.

Reinforcing the view was the weaker than expected increase in private sector payrolls in the April ADP jobs report (119k versus 150k consensus), implying downside risks to the consensus for tomorrow’s April non-farm payrolls data. Indeed, we now look for a 120k increase in payrolls compared to 150k previously expected.

March US construction spending was also weaker than forecast while the ISM manufacturing index dropped, albeit remaining in expansion territory (above 50). The data led to a further drop in the USD, commodity prices, equities and lower US Treasury yields.

Little change in market direction is expected today, with caution ahead of tomorrow’s US jobs report. Ahead of this, a likely 25bps cut in policy rates by the European Central Bank will capture attention. Although by no means a done deal, the majority of the market has shifted towards such an expectation in the wake of weaker data.

The real surprise from the ECB could come from any further hint or announcement of non conventional measures. In turn any such hint could dent the EUR limiting its ability to capitalise on a weaker USD tone. In any case sellers are likely to emerge on any rally in EUR/USD to resistance around 1.3220.

Final readings of purchasing managers’ indices in Europe, US March trade data and Q1 non farm productivity will account for the remaining releases today although none of these are likely to be market movers, leaving the USD under pressure ahead of tomorrow’s jobs report.

Pulling the rug from under the Euro

The USD was spurred by stronger US data and a further deterioration in EUR sentiment. The data including an improvement in consumer confidence and in particular a strong (+325k) ADP private sector jobs report, support the case for medium term USD outperformance amid growing evidence of relatively superior US growth.

While having a limited impact on interest rate expectations due to the Fed’s commitment to maintain very accommodative policy and thus also limiting the scope of USD gains, the data nonetheless, highlights the scope for a relative rise in US bond yields relative to bunds over the medium term and in turn a firmer USD versus EUR.

Whether the December ADP data translates into a similarly strong December payrolls outcome today is debatable but consensus forecasts have been likely revised higher. We look for a 190k increase, which ought to provide more evidence of US economic and USD outperformance.

Part of the explanation for USD strength is simply a weaker EUR. Although France’s debt auction yesterday was not particularly negative it did reveal an increase in borrowing costs while yields in peripheral bond markets continue to move higher. As noted, data releases in the Eurozone are providing little support to the currency and today’s November retail sales release will add to the evidence of weakening growth, with a further contraction expected.

Central banks and official investors in general appear to be pulling the rug from under the EUR’s feet, meaning that the usual support for the currency is disappearing fast while German bond yields have moved below US 2-year yields. Nonetheless, the market is heavily short EUR and further downside may not be as rapid. Technically, a break below EUR/USD support around 1.2767 will open the door to a drop to 1.2642.

Following yesterday’s slightly disappointing trade data markets will turn their attention to next week’s November retail sales, building approvals and January consumer confidence data in Australia. AUD has held up relatively well in the first week of the new year despite the ongoing tensions in the Eurozone and related rise in risk aversion.

Fortunately for the AUD its correlation with risk aversion is quite low, suggesting some resilience to higher risk aversion. Nonetheless, the market appears long of the AUD and it may extend yesterday’s pull back as investors take profits ahead of the US jobs report.

Euphoria fades, risk currencies weaker

The euphoria emanating from last week’s eurozone agreement will likely fade into this week as renewed doubts creep in. Details of how the EFSF bailout fund will be leveraged or how the special purpose vehicle will be utilised have yet to emerge while the firewall to protect countries such as Italy and Spain may still be insufficient given that the use of the European Central Bank (ECB) to provide unlimited support has been ruled out.

With more questions than answers markets will be hungry for further details over coming weeks and until then it is difficult to see risk appetite stretching too far. One indication of such concern was the fact that Italy’s borrowing costs climbed to euro-era highs the day after the European Union (EU) plan was agreed. The G20 meeting on 3-4 November will be eyed for further developments as well as further reaction to the EU agreement.

There are plenty of events to digest this week that could add to any market nervousness. In terms of central banks we do not expect to see any change in policy stance from the ECB, Federal Reserve or Reserve Bank of Australia (RBA) this week but the decisions may be close calls. The ECB under the helm of new President Draghi will be under pressure to ease policy as growth momentum has clearly weakened but the Bank will likely hold off for the December meeting when new growth and inflation forecasts will be released.

The RBA may also take some solace from a better global economic and market climate but the market disagrees having priced in a cut this week. The Fed will look to see how ‘Operation Twist” is faring before moving again but recent indications from some Fed officials suggest growing support for purchases of mortgage backed securities.

On the data front eurozone inflation today will be the key number in Europe while the US jobs report at the end of the week will be the main release in the US. Ahead of the payrolls data, clues will be garnered from the ISM manufacturing data and ADP jobs report. The consensus is for a 95k increase in non-farm payrolls and the unemployment to remain at 9.1% maintaining the trend of only gradual improvement in the US jobs market.

Recent data releases have turned less negative, however, and at the least have helped to alleviate renewed recessionary concerns. Overall, I suspect that markets will come back down to the reality of slow growth and unanswered questions this week, with risk assets likely to lose steam over coming days.

Ecofin, ECB, US jobs report in focus

The USD index remains close to its recent highs, maintaining a positive tone amid elevated risk aversion. Data releases have tended to take a back seat to events over recent weeks, but this week the all important US September jobs report may provide the bigger focus for US markets. The consensus expectation is for a 50k increase in payrolls and the unemployment rate remaining at 9.1% an outcome that would do nothing to assuage US growth worries. As usual markets will gauge clues to the jobs data from the ADP jobs data and employment components of the ISM data but an outcome in line with consensus expectations will likely keep risk aversion elevated and the USD supported unless the data is so bad that it results in an increase in expectations for Fed QE3.

There will be plenty of attention on the Ecofin meeting of European finance ministers today especially given that much of the reason for the stability in markets recently is the hope of concrete measures to resolve the crisis in the region. In this respect the scope for disappointment is high, suggesting that the EUR is vulnerable to a further drop if no progress is made at today’s meeting. While the extent of short market positioning has left open some scope for EUR short covering the absence of any good news will mean the impetus for short covering will diminish.

While attention in Europe will predominately remain on finding a resolution to the debt crisis and the saga of Greece’s next loan tranche, the European Central Bank (ECB) meeting will also be in focus this week especially given expectations that the ECB will cut interest rates. While hopes of a 50 basis points rate cut may have taken a knock from the firmer than expected reading for September flash CPI released at the end of last week the EUR could actually react positively to an easing in policy given that it may at least help to allay some of the growing growth concerns about the eurozone economy. However, any EUR will be limited unless officials in the eurozone get their act together and deliver on expectations of some form of resolution to the crisis in the region.

Strong words from Japan’s Finance Minister Azumi failed to have any lasting impact on USD/JPY. Japan will bolster funds to intervene in currency markets by JPY 15 trillion and extend the monitoring of FX positions until the end of December. Japan did not intervene during September but spent around JPY 4.5 trillion in FX intervention in August to little effect. For markets to be convinced about Japan’s conviction to weaken the JPY it will require putting intervention funds to active use, something that doesn’t seem to be forthcoming at present. A factor that may give some potential upside momentum for USD/JPY is the slight widening of US versus Japan bond yield differentials over recent days, which could finally result in a sustained move above 77.00 if it continues into this week.

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