ECONOMETER

Markets appear to be entering into a more nervous period following several weeks of upside for risk assets. While risk appetite measures remain elevated equity markets appear to be running out of momentum in the short term.

A combination of European political concerns as elections approach in Italy, corruption allegations in Spain, currency frictions, the continued impasse in the US over impending spending cuts or simply a market that has overtaken reality, it appears that a pause in the rally in risk assets is on the cards.

A test of sentiment towards Spain will take the form of a Spanish bond auction today while central bank policy decisions in the Eurozone and UK will garner most attention today although no big surprises are expected as both central banks are set to keep policy on hold.

Anyone expecting the European Central Bank to echo the views on some European politicians by taking a stand against the strength of the EUR will be sorely disappointed. While clearly uncomfortable from a growth perspective the rise in EUR will be rationalised as a reflection of better market sentiment towards Eurozone assets. In fact the ECB could be a cause of EUR strength with its shrinking balance sheet playing a role in supporting EUR especially as it contrasts with the Fed’s balance sheet expansion.

Further ECB balance sheet contraction in the months ahead as LTRO payments are made could put into jeopardy my forecast of a lower EUR/USD (1.25 by end 2013). In the past the ECB has verbally intervened by warning on the strong volatility of the EUR but this is unlikely to happen anytime soon as 3 month EUR/USD implied volatility is still close to multi month lows. In any case the market may already be self correcting, with EUR appearing to lose some steam over recent days. Near term consolidation is likely around the ECB meeting.

The Bank of England in contrast to the ECB may be welcoming the moves in GBP over recent weeks given the stimulus provided to the UK economy from a weaker pound. An unchanged BoE policy decision today will have minimal impact on GBP, with more attention on the testimony of incoming governor Carney, especially given his recent comments about tying monetary policy to economic growth during “exceptional times”. The comments had already dealt a blow to GBP but unless Carney elaborates further I do not expect GBP to be hit much more.

Even so, GBP/USD risks remain to the downside given ongoing concerns about a credit ratings downgrade and a negative technical picture. Taking a short EUR/GBP position may offer some better prospects for those wishing to enter GBP long positions as the upside momentum in the currency pair appears to be flagging although I suggest waiting for more concrete signals of a turnaround before entering into such a position.