Contagion spreading like wildfire

EUR continues to head lower and is is destined to test support around 1.3484 versus USD where it came close overnight. Contagion in eurozone debt markets is spreading quickly, with various countries’ sovereign spreads widening to record levels against German bunds including Italy, Spain, France, Belgium and Austria. Poor T-bill auctions in Spain and Belgium, speculation of downgrades to French, Italian and Austrian debt, and a weak reading for the November German ZEW investor confidence index added to the pressure.

A bill auction in Portugal today will provide further direction but the precedent so far this week is not good. The fact that markets have settled back into the now usual scepticism over the ability of authorities in Europe to get their act together highlights the continued downside risks to EUR/USD. Although there is likely to be significant buying around the 1.3500 level, one has to question how long the EUR will continue to skate on thin ice.

The Bank of Japan is widely expected to leave policy unchanged today but the bigger focus is on the Japanese authorities’ stance on the JPY. Finance Minister Azumi noted yesterday that there was no change in his stance on fighting JPY speculators. To some extent the fight against speculators is being won given that IMM speculative positions and TFX margin positioning in JPY has dropped back sharply since the last FX intervention to weaken the JPY.

However, this has done little to prevent further JPY appreciation, with USD/JPY continuing to drift lower over recent days having already covered around half the ground lost in the wake of the October 31 intervention. Markets are likely therefore to take Azumi’s threats with a pinch of salt and will only balk at driving the JPY higher if further intervention takes place. Meanwhile, USD/JPY looks set to grind lower.

GBP will take its direction from the Bank of England Quarterly Inflation Report and October jobs data today. There will be particular attention on the willingness of the BoE to implement further quantitative easing. A likely dovish report should by rights play negatively for GBP but the reaction is not so obvious. Since the announcement of GBP 75 billion in asset purchases a month ago GBP has fared well especially against the EUR, with the currency perhaps being rewarded for the proactive stance of the BoE.

Moreover, the simple fact that GBP is not the EUR has given it a quasi safe haven quality, which has helped it to remain relatively resilient. Nonetheless, GBP will find it difficult to avoid detaching from the coat tails of a weaker EUR and in this respect looks set to test strong support around GBP/USD 1.5630 over the short term.

Upside risks to US payrolls

An encouraging run of US data releases over recent weeks became even more solid overnight. In particular the December ADP private sector jobs report revealed a whopping 297k increase, its highest ever reading. Although the outsized gain may be attributable to distortions such as seasonal factors it will lead many to scramble to revise higher estimates for non-farm payrolls to around 200k+ (consensus currently is 150k). Similarly the December ISM non-manufacturing survey came in higher than expected at 57.1, its highest reading since May 2006. Notably the employment component softened in contrast to the ADP data.

Whilst the US outlook appears to be improving the eurozone picture is looking decidedly shaky. Peripheral bonds remain under pressure as reflected in the renewed widening in German-Greek spreads whilst Portugal’s sale of 6m bills revealed good demand but at a much higher yield (3.69% vs. 2.05% in September). Press reports that the Swiss National Bank has stopped accepting Irish government debt as collateral didn’t help matters whilst talk of conditions attached to any Chinese support for eurozone countries also weighed on sentiment.

Adding to concerns is the ongoing political impasse in Belgium where 7 months after elections there has yet to be a new government formed. The risk of a downgrade to the country’s credit ratings is high especially given the lack of progress on deficit reduction. Meanwhile on the data front the Eurozone service sector PMI was stronger than forecast in December at 54.2 but the country breakdown revealed more divergence in economic conditions. This was echoed in the manufacturing PMI. Divergence in growth is likely to widen further this year and whilst the strength of Germany may prevent a sharp slowing in overall growth in the eurozone, growing divergence will make the job of the ECB difficult.

The net result of firmer US data is a broadly stronger USD and higher Treasury yields. The EUR in contrast looks as though it is on the verge of a sharper decline below 1.3000, with technical support seen around 1.2969 whilst the JPY could see further weakness given the move in relative US/Japan bond yields. There will be little direction today from data with just Eurozone sentiment gauges and retail sales tap whilst in the US jobless claims will be in focus. However, there will probably be little movement ahead of the US jobs report tomorrow.

What Stress?

Fed Chairman Bernanke has inadvertently fuelled an increase in risk aversion in the wake of his testimony to the Senate. Although Bernanke noted that he did not see the prospects of a double-dip as a high probability event he stated that the economic outlook is “unusually uncertain”. Nonetheless, although such measures would be implemented if the situation deteriorated further, the Fed was not planning on extending its non-traditional policy options in the near term.
USD benefits as Bernanke does not indicate more quantitative easing.

A combination of caution about growth prospects and disappointment that Bernanke stopped short of indicating that the Fed would embark on further non-conventional policy measures left equities weaker, but the USD was stronger, both due to higher risk aversion as well as less risk of the Fed turning the USD printing press back on again. Bernanke is back at Congress today, with a speech to the House Panel. Although this is effectively a repeat of yesterday’s testimony, the Q&A session may throw up additional clues to Fed thinking and potential for extending quantitative easing but I suspect the USD will retain its firmer tone.

In Europe, most attention remains on the upcoming release of EU bank stress test results. Leaks suggest most banks will likely pass the EU bank stress tests, with the notable exceptions of a few Spanish Cajas and German Landesbanks. Already governments in Germany, France, Greece and Belgium have said their banks are likely to pass. We should all be bracing ourselves for relief to flow through European financial markets, but somehow this does not feel like an environment that will welcome such a result. More likely questions will be asked about why did so few banks fail and why the tests were not rigorous enough?

For example, the test for “sovereign shock” is said to affect only the value of government bonds that banks mark to market, but what about the far larger proportion of government debt that is held in banking books? There are also question marks over the capital hurdle, with the most adverse scenario that banks need to reach a maximum Tier 1 capital ratio of at least 6% by end 2011. Moreover, there have also been reported divisions within European Union (EU) members about how much information to divulge. EUR has also ready lost ground over recent days but the currency could face much more selling pressure into next week if the tests are found to lack credibility.

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