Sell into Euro rallies

November 29, 2011 — Mitul Kotecha

The USD will have found the news that Fitch Ratings lowered its outlook on the US AAA long term ratings to negative unwelcome. Nonetheless, USD sentiment has been recently as reflected in the jump in CFTC IMM USD positioning to multi week highs. The USD will however, face some headwinds from speculation that the Federal Reserve is about to embark on a fresh round of quantitative easing by purchasing mortgage backed securities.

The firm start to the week in terms of risk appetite helped the EUR to recover some ground but the currency remains vulnerable to event risk. High among the event risk is the Eurogroup and Ecofin meetings today, which will decide whether or not to approve Greece’s next loan tranche as well as EFSF leveraging options. Progress on the latter is likely to be limited leaving the EUR vulnerable to disappointment.

Attention will also focus on Italy’s sale of up to EUR 8 billion of BTPs and the likelihood that the country may have to face a yield above the critical 7% threshold. An increase in funding costs will not bode well for EUR sentiment especially following warnings by Moody’s about potential downgrades to sovereign ratings across the region.

EUR/USD failed to follow through on gains overnight but as reflected in the IMM speculative positioning there may be some scope for further short covering given that the net EUR short position reached its highest since June 2010 last week. Nonetheless, upside potential for EUR/USD is likely to be restricted to resistance around 1.3415.

Relatively dovish comments by Bank of England officials and weak data will keep GBP on the back foot over the short term. BoE governor King highlighted the risk of an inflation undershoot while Fisher noted that the BoE expanded QE by a minimum in October and can do more.

The Office for Budget Responsibility is set to cut UK growth forecasts significantly today. Against this background prospects for more BoE QE remain high. In the short term GBP will likely struggle against both the USD and EUR although we expect weakness versus EUR to be short lived, and would sell into any EUR/GBP rally to around 0.8665 support.

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Contrasting US and European data

November 14, 2011 — Mitul Kotecha

While the week is likely to commence in a positive mood as political uncertainties in Greece and Italy ease somewhat, there are still plenty of uncertainties that could derail risk appetite. In particular, there has been little progress on agreeing on further details on leveraging the EFSF bailout fund. Moreover, many are looking to the European Central Bank (ECB) to take up the role as lender of the last resort. Indeed, the difficulty of the EFSF debt issue last week to garner demand puts the onus firmly on the ECB.

While it is likely that the ECB will have to step up its bond purchases especially given the heavy bond supply this week from Italy, France and Spain, the ECB is very reluctant to take up this mantle. As a result, peripheral and increasingly core bond market sentiment will remain fragile while the EUR will be vulnerable to a drop lower, especially given how rich it looks around current levels close to 1.38 versus USD. The week will likely be one of selling risk on rallies.

Data releases this week will show some contrasts between the US and Europe. US data will further dampen expectations of more Fed quantitative easing, with October retail sales and industrial production set to register gains and November manufacturing surveys likely to bounce. Several Federal Reserve speeches this week will shed more light on the FOMC’s stance and likely some support for purchases of mortgage backed securities will be reiterated.

In contrast eurozone data will show further deceleration. Industrial production in September is likely to have dropped sharply while the German ZEW investor confidence survey is set to have dropped further in November. Even an expected bounce in eurozone Q3 GDP will do little to stave off recession concerns given that growth in the final quarter of the year will have been much weaker. Banking sector develeraging will only add to growth concerns as credit expansion in curtailed.

In FX markets, the risk currencies will be vulnerable to selling pressure. EUR/USD has rebounded having tested highs around 1.3815 this morning but its gains look increasingly fragile. USD/JPY continues to grind lower, with no sign of further intervention from the Japanese authorities. Elevated risk aversion and the narrow US yield advantage continues to support the JPY making the job of weakening the currency harder. GBP has done well although it has lagged the EUR against the USD over recent days. A likely dovish stance in the Bank of England (BoE) quarterly inflation report will see GBP struggle to extend gains above 1.60 against the USD.

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Risk appetite remains fragile

November 11, 2011 — Mitul Kotecha

Fortunately for the USD the situation in the eurozone has become so severe that the problems in the US are all but being ignored. Even in the US, attention on the nomination of the Republican presidential candidate has over shadowed the looming deadline for an agreement on medium term deficit reduction measures.

The Joint Select Committee on deficit reduction is due to submit a report to Congress by November 23 and a final package would be voted on by December 23. A lack of agreement would trigger automatic deficit reduction of $1.2 trillion, a proportion of which would take place in 2012. If this is the case it could potentially tip the economy into recession, necessitating QE3 and consequently a weaker USD.

Reports that the eurozone could fall apart at the seams as countries exit have shaken confidence, yet the EUR has managed to hold above the psychologically important 1.35 level. The strong reluctance of the European Central Bank (ECB) to embark on unsterilized bond purchases and to act as lender of the last resort, suggests that the crisis could continue to brew for a long while to come.

Nonetheless, the EUR found a semblance of support from news that former ECB vice-president Papademos was named new Prime Minister of Greece, the ECB was reported to be a strong buyer of peripheral debt, Italy’s debt auction was not as bad as feared, affirmation of the EFSF’s AAA rating by Moody’s and France’s AAA rating by S&P (following an erroneous report earlier). EUR/USD remains a sell on ralliesup to resistance around 1.3871, with initial resistance around the 1.3665 level.

The underlying pressure over the near term is for further JPY strength in the face of rising risk aversion and a narrowing in the US yield advantage over Japan. Given that the situation in the eurozone remains highly fluid as well as tense, with little sign of resolution on the horizon, risk aversion is set to remain elevated. Moreover, yield differentials have narrowed sharply and the US 2-year yield advantage over Japan is less than 10bps at present.

Against this background it is not surprising that the Japanese authorities are reluctant to intervene aggressively although there are reports that Japan has been conducting secret interventions over recent weeks. However, given that speculative and margin trading net JPY positioning have dropped significantly the impact of further JPY intervention may be less potent. In the meantime USD/JPY will likely edge towards a break below 77.00.

Swiss officials have continued to jawbone against CHF strength, with the country’s Economy Minister stating that the currency remains massively overvalued especially when valued against purchasing power parity. Such comments should be taken at face value but the CHF is unlikely to embark on a weaker trend any time soon.

Although the EUR/CHF floor at 1.20 has held up well while the CHF has lost some its appeal as a safe haven the deterioration in the situation in the eurozone suggests that the CHF will not weaken quickly.

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The Italian Job

November 10, 2011 — Mitul Kotecha

Italy looks too big to rescue yet is too big to fail. The country has around EUR 1.9 trillion in public debt (around 5 times that of Greece) and is the third largest country in the eurozone. Therefore it cannot be as easily dealt with as Greece.

Italy needs to raise around EUR 18 billion per month to cover its budget deficit and bond redemptions and with a continued increase in yields (hitting close to 7.5% for 10 year bonds) borrowing costs are rising sharply and fast becoming unsustainable. Higher collateral haircuts on Italian debt are adding to the pressure.

Although Italian Prime Minister Berlusconi has said he will step down in the wake of reform measures to be voted on by the Italian parliament the vote on the measures may not take place for weeks. Moreover, Berlusconi may attempt to seek re-election after stepping down, which could bring the situation back to square one.

In the meantime speculation that Italy may be the next country to need to a bailout will intensify. However, with only around EUR 270 billion remaining in the EFSF bailout fund and details of how the fund will be leveraged to a planned EUR 1 trillion still lacking, doubts about whether it will have sufficient resources will grow. Press reports that Germany and France have begun talks to break up the eurozone due to fears that Italy will be too big to rescue will only add to the malaise.

Focus over the short term will turn to today’s 12 month auction of EUR 5 billion in Italy. Last month’s 12 month auction saw an average yield of 3.57% but this time around yields could rise above 6%. Worryingly it appears that even with the European Central Bank (ECB) buying Italian debt it has been insufficient to prevent yield rising.

In any case, given the ECB’s reluctance to become lender of the last resort to European peripherals, any support from this direction will be limited. Against this background the EUR remains highly vulnerable to a further drop. Indeed, the EUR’s recent resilience looks all the more misplaced. A test of the 4 October low around EUR/USD 1.3146 is on the cards over coming days.

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Dollar firmer, Euro vulnerable, Yen wary

November 6, 2011 — Mitul Kotecha

multitude of market moving events last week led to severe gyrations in risk appetite but with no clear direction for currencies. Indeed, currency markets were whipsawed as the news flow shifted back and forth. Major events such as the European Central Bank (ECB) and US Federal Reserve meetings, and US jobs data provided plenty of volatility points for markets. This week’s US data slate is less littered with first tier data, with trade data and Michigan confidence, the highlights of the week. Against this background the USD will take direction from events in the eurozone and in our view will likely trade with a firmer bias given that eurozone tensions will not ease quickly.

The EUR was relatively resilient despite a referendum (later cancelled) that could have spelled the beginning of the end of Greece’s membership in the eurozone. Nonetheless, the currency still dropped over the week. This week will be no different as markets sift through various pieces of news regarding Greece and the EU rescue plan. Although the Greek Prime Minister survived a confidence vote the EUR will remain vulnerable to a lack of detail about the EU rescue plan including but not limited to how the mechanism for leveraging the EFSF bailout fund. The longer the delay in providing such details the bigger the risk to the EUR. Data releases will be unhelpful for the EUR, with hard data such as German industrial production confirming a slowdown in activity.

Japan’s FX intervention at the beginning of last week has all but been forgotten among the plethora of other market moving news. Expectations that it would be followed up by more intervention proved incorrect as the Japanese authorities refrained from more action. Perhaps the onset of the G20 meeting stayed their hand but markets will be wary of more intervention this week. However, as the strengthening current account data in Japan will likely reveal this week, Japan’s strong external position continues to feed the underlying upward pressure on the JPY for the time being.

Interestingly FX markets appear to be reacting to growth orientated central bank policy rather than yield as reflected in the fact that EUR and GBP both strengthened despite additional quantitative easing from Bank of England at its last meeting and a rate cut from the ECB last week. This week however, inaction from the BoE will provide little direction to GBP while a likely drop in industrial production will raise fears that the economy continues to be in need of more remedial action from the central bank. GBP continues to be favoured but after having made up a lot of ground versus EUR it could lose some steam this week.

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