Euro treads water ahead of ECB decision

EUR/USD has been treading water in a relatively tight range ahead of the European Central Bank meeting later today but the currency looks vulnerable to further slippage in the days ahead. Having dropped from its high around 1.3898 on 27 December the EUR has failed to sustain any bounce.

The ECB is unlikely to offer any support to the currency especially given that there is a small chance that they may even trim policy rates at today’s meeting. If the Bank does not cut rates today, the ECB is set to open the door to a cut in March, something that would undermine the EUR further.

Either way, the EUR is losing support and our quantitative models highlight the potential for further downside moves in the currency. Other measures such as short term interest rate differentials also highlight risks to EUR.

EUR/USD is set to edge lower to technical support around 1.3477 in the near term.

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Risk and carry attraction increasing

The outcome of the EU Summit together with hopes of monetary stimulus has definitely helped to put a floor under risk appetite. Indeed, such monetary stimulus expectations are reflected in the price of gold which continued to rise overnight. Risk assets in general have maintained a positive tone recently and even forward looking indicators of global activity such as the Baltic Dry Index have been trending higher.

Although it is difficult to become too positive given the still very significant downdraft to global growth officials in Europe have bought some time to get their collective house back in order. Whether they will use it wisely is another question entirely. It is difficult to see much of a market move ahead of the ECB Council meeting and US June jobs report this week. Moreover, the US Independence Day holiday will keep trading subdued today.

My Risk Barometer has moved back into ‘risk neutral’ territory following several weeks of remaining in ‘risk hating’ territory. Consequently the backdrop for risk currencies has turned positive. Although FX trading has become more subdued amid summer conditions and a US holiday today as reflected in the drop in implied volatilities, there is a clear sense that investors are increasingly moving into carry trades.

My Yield Appetite Index {YAI) has surged over recent weeks, now at its highest in several months. I remain concerned that markets are addicted to stimulus while underlying economic conditions remain weak as likely revealed in today’s releases of June service sector purchasing managers’ indices in Europe.

Nonetheless, it seems likely according to my risk measures that the current tone of risk / carry attraction will persist for some weeks to come. The currencies that will benefit in an environment of improving risk appetite / yield attraction are the ZAR, MXN, PLN, CAD & NOK by order of magnitude of correlation with our risk barometer.

However, the beneficiaries are by no means limited to these currencies. Almost every currency except the ARS and PHP has a statistically significant correlation with the risk barometer. The only currencies that come under pressure as risk appetite improves are the USD and JPY given their negative correlations.

Currencies with healthy carry such as the AUD, which broke above its 200 day moving average versus USD overnight, will be even bigger beneficiaries as investors pile into carry trades over coming weeks as indicated by the jump in our YAI.

Notably there is plenty of scope to build carry positions as our speculative measure of yield attraction (based on CFTC IMM data) remains relatively low, suggesting that leveraged investors have still not jumped on the carry bandwagon.

Plenty of event risk

In the wake of the EU Summit at the end of last week sentiment has stabilised, with risk indicators such as the VIX ‘fear gauge’ reflecting a firmer tone to risk appetite. Although a few stumbling blocks have arisen such as the objections by both Finland and Holland to bond purchases by the ESM bailout fund they may not be sufficient to derail the project. The euphoria is likely to fade in the days ahead but the US Independence day holiday tomorrow may keep trading somewhat subdued.

There are plenty of events this week including central bank decisions by the RBA (Australia), Riksbank (Sweden), ECB (Eurozone) and BoE (UK), to provoke some excitement. A likely rate cut from the ECB and an extension of asset purchases by the BoE will give markets plenty to chew on. Finally, at the end of the week the US June jobs report will also be closely watched. We forecast a 100k increase in payrolls but will look for clues from tomorrow’s ADP jobs report.

The disappointing US June ISM manufacturing survey released yesterday highlighted that growth risks will remain a key weight on the market dampening any improvement in risk appetite over coming weeks. Moreover, weaker growth in Europe will make it more difficult to achieve budget targets, while adding to pressure to ease bailout terms. Undoubtedly the European summit was a step in the right direction but with plenty of details still needing to be thrashed out and growth concerns intensifying it would be highly optimistic to expect a fully fledged ‘risk on’ to ensue.

Notably the EUR has given back some of its gains after failing to break above 1.2700 against the USD. Further downside is likely but the EU Summit outcome has meant that the risk of a sharp drop lower has receded. Although there is likely to have been some short covering following the summit outcome EUR short positions remain significant, a factor that may also limit downside in the currency. EUR/USD will find some short term support around 1.2553 but will likely edge down to around 1.2500 over coming sessions.

Chronology of a Crisis – endgame?

Please see below an extract from my forthcoming book Chronology of a Crisis (Searching Finance 2012).

The departure of Greece from the Euro is by no means a forgone conclusion but if it happens it is not clear that global policy makers have much ammunition left to shield markets from the resulting fallout.

Stimulus after stimulus has only left governments increasingly indebted. The price of such largesse is now being paid in the form of higher borrowing costs. Even central banks do not have much ammunition left. Admittedly further rounds of quantitative easing, and central bank balance sheet expansion may help to shore up confidence but the efficacy of such policy actions is questionable. Moreover, policy support may only help to buy time but if underlying structural issues are not resolved pressure could resume quickly.

Against this background Europe is under intense pressure and there is little time left before it results in something catastrophic for global markets via a disorderly break up of the Eurozone. EU leaders and the European Central Bank (ECB) have to act to stem the crisis. However, at the time of writing the ECB under the helm of Mario Draghi is steadfastly refusing to provide further assistance to the Eurozone periphery either directly via lower interest rates or securities market purchases or indirectly via another Long term refinancing operation (LTRO). Any prospect of debt monetization as carried out already by other central banks including the Fed and Bank of England is a definite non-starter. The reason for this intransigence is that the ECB does not want to let Eurozone governments off the hook, worrying that any further assistance would allow governments to slow or even renege upon promised reforms.

Whether this is true or not it’s a dangerous game to play. The fact that the previously unthinkable could happen ie a country could exit the Eurozone should have by now prompted some major action by European officials. Instead the ECB is unwilling to give ground while Germany continues to stand in the way of any move towards debt mutualisation in the form of a common Eurobond and/or other measures such as awarding a banking license to the EFSF bailout fund which would effectively allow it to help recapitalize banks and purchase peripheral debt. Germany does not want to allow peripheral countries to be let off the hook either, arguing that they would benefit from Germany’s strong credit standing and lower yields without paying the costs.

To be frank, it’s too late for such brinkmanship. The situation in The Eurozone is rapidly spiraling out of control. While both the ECB and Germany may have valid arguments the bottom line is that the situation could get far worse if officials fail to act. As noted above there are various measures that could be enacted. Admittedly many of these will only buy time rather than fix the many and varied structural problems afflicting a group of countries tied together by a single currency and monetary policy and separate fiscal policies but at the moment time is what is needed the most. Buying time will allow policymakers to enact reforms, enhance productivity, reform labour markets, increase investment funds etc. Unfortunately European policy makers do not appear to have grasped this fact. Now more than at any time during the crisis much depends on the actions of policy makers. This is where the major uncertainty lies.

If officials do not act to stem the crisis, economic and market turmoil will reach proportions exceeding that of even the Lehmans bust.

Euro eyes ECB, Yen intervention risks rise

Following an onslaught of disappointing economic news globally the outcome of the US May ISM non-manufacturing index came as a relief, with the index rising to 53.7 from 53.5. Taken together with reports of a credit line to Spain from Europe’s bailout fund, it left markets in perkier mood overnight.

As per usual form, the emergency G7 conference call on the Eurozone turned out to be a non event while Fed speakers including Bullard and Fisher downplayed May’s soft jobs report. Much in terms of market direction today will hinge on the outcome of the European Central Bank (ECB) meeting and press conference, with positive sentiment likely to trickle through into trading until then.

The ECB will be under considerable pressure to cut interest rates today and a 25bps rate cut could be delivered. While the outcome is by no means clear cut and not pre-warned by the ECB a rate cut would at least help to alleviate a little of the pain in Europe. The fact that EUR/USD has a reasonably strong correlation with interest rate differentials over the past 3-months suggests that the EUR will actually come under pressure in the wake of such a move.

Even the reaction is not obvious, however. Arguably a rate cut could also be good news for the EUR as it would help to underpin growth. Moreover, a policy rate cut is largely priced in so the impact on the EUR will not be as potent as it could have been had it not been discounted. The accompanying statement will also be of interest. If the ECB indicates that it will cut rates further it will put even further more pressure on the EUR. Near term downside EUR/USD support is seen around 1.2375.

USD/JPY shows little sign of breaking its downtrend. A combination of further yield compression (2 year US bond yield advantage over Japanese yields continues to narrow) and elevated risk aversion has led to a firmer JPY much to the frustration of Japanese officials. Against this background it was perhaps unsurprising that Japanese finance minister Azumi pushed for the G7 to reaffirm its policy stance that excess volatility and disorderly FX movements are undesired. He faced no opposition in his request, paving the way for Japanese FX intervention to weaken the JPY.

The problem for Japan is that the impact of any intervention will be short lived against the factors mentioned above. Nonetheless, intervention fears will at least engineer a degree of two way risk into markets. Technical support for USD/JPY will be seen around 77.95.

Euro under growing pressure

A risk off tone has developed in the wake of disappointing economic data (Eurozone April purchasing managers indices, rise in March Eurozone and German unemployment, weaker US ADP jobs report). Additionally the second round of French Presidential elections is helping to keep Eurozone markets nervous. While hitting equities, the weaker market tone is likely to keep the USD buoyed.

The soft ADP report in particular highlights downside risks to the consensus for the April non-farm payrolls data, with analysts set to revise lower their forecasts fuelling concerns about a renewed weakening in the US jobs market. Ahead of this data, markets will contend with the outcome of the European Central Bank (ECB) policy meeting and bond auctions in France and Spain today. Several Fed speakers today will also be on tap.

The EUR will struggle to make any headway in the short term, having suffered in the wake of weak data. An unchanged policy decision from the ECB will give the EUR no assistance leaving EUR/USD vulnerable to a test of strong support around 1.3104. The ECB considers current policy settings as ‘appropriate’ but weaker growth data argue for lower rates.

The reality is that the ECB does not want to give Eurozone governments an excuse to renege on reforms. Should the ECB hint at lower rates in the near future it might actually play well for the EUR helping to alleviate growth concerns, but I suspect such a message is unlikely to emerge.

GBP has lost some ground after hitting a high just above 1.63 at the end of April but the currency looks reasonably well supported, especially against EUR. UK data remains relatively better looking as reflected in stronger readings for the PMI construction index, consumer credit and mortgage approvals.

EUR/GBP has broken its relationship with movements in EUR/USD for the time being, with independent GBP strength being seen. This is been reinforced by the shift in interest rate differentials between the UK and Eurozone, a move which has gone in favour of GBP strength. Indeed my quantitative model for EUR/GBP points to some further downside potential in this currency pair, with a test of technical support around 0.8067 on the cards.

Calm ahead of US payrolls and ECB meeting

It’s non-farm payrolls week in the US, with currencies treading water until Friday when the report is released. Ahead of the data there are several other releases on tap which will give clues to the outcome of the April jobs report, including the ISM manufacturing survey and ADP jobs report. The USD has taken a softer tone as risk appetite improved and US bond yields dropped further.

Given the Fed kept open the door to more easing it will act as a restraint on the USD unless markets become convinced that there will no further Fed balance sheet expansion over coming months. In the meantime unless risk aversion spikes again the USD is set to find it difficult to sustain any gains.

It’s always the same story with the EUR, a tale of ongoing resistance to bad news. Weaker Eurozone confidence surveys as well as a downgrade to Spain’s credit ratings did little to weaken the EUR. The key event is the European Central Bank (ECB) meeting on Thursday but despite growing growth worries, a policy rate cut is unlikely as the ECB remains in wait-and-see mode.

Data releases will not be too damaging for the EUR, with monetary and credit aggregate set to rise and German retail sales set to rebound in March. The EUR looks poised to edge higher against this background in the short term, but will be constrained by uncertainty ahead of the US jobs report. Technical resistance to the upside will be found around the 1.3265 area.

The JPY barely flinched when the Bank of Japan announced an expansion of its asset purchase fund by JPY 10 trillion in its aim to reach a 1% inflation goal. Unfortunately for the BoJ the ongoing narrowing in the US Treasury yield premium over Japan JGB yields overwhelmed the negative impact of its action on the JPY.

Overall, my quantitative models continue to show USD/JPY lower over the short term, with a move below 80.00 on the cards. If as I expect, risk aversion also creeps higher, it will imply more short term upside JPY pressure. Trading will be relatively quiet, with no major data on the calendar due to Golden Week holidays in Japan.

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