Cyprus deal reached but risk rally to fade

A deal between Cyprus and the Troika has been reached “in principle”, an outcome that will be met with relief across markets, with the EUR and risk assets rallying. Most details have yet to emerge but it appears that only depositors above EUR 100k will be hit by a levy while the country’s second largest bank will be closed. However, the levy is likely to be fairly hefty.

The bailout deal will mean that the risks of Cyprus defaulting and leaving the Eurozone will have significantly diminished. Nonetheless, the deal will still involve a huge amount of work on Cyprus’ part to find the USD 5.8 billion needed to supplement the EUR 10 billion bailout and subsequently a lot of economic pain involved. The current risk rally is likely to fade quickly as markets begin to focus on the task at hand.

Elsewhere Italy begins the formal process of forming a government this week but the prospects of a quick resolution to the political impasse in the country looks very limited, with fresh elections still a very possible outcome. Reflecting the uncertainty both around Cyprus and Italy, economic sentiment gauges in Europe will likely decline in March.

Meanwhile in the US data releases will look more impressive, with Durable goods orders set to record an impressive gain in February and Q4 GDP likely to be revised sharply higher. Although consumer confidence and new home sales will slip, this will take place from healthy levels.

EUR/USD broke through 1.3000 following the Cyprus deal but will run into resistance around 1.3135 and we expect gains to fade in the short term as markets look past the headlines. Downside risks to EUR will remain in place due to relatively unfavourable data releases and ongoing political uncertainty in Italy.


No Fed suprises, Cyprus unresolved, Kuroda weakens yen

The Fed delivered no surprises overnight, with policy settings and guidance left unchanged and only minor changes the statement. Slight downward revisions to near term growth and the unemployment rate reflected recent fiscal issues but the Fed sounded more upbeat on current economic conditions. The Fed statement helped markets retain a better mood despite the continued fluidity of the situation in Cyprus.

On this front, as Cyprus tries to renegotiate the terms of EUR 10 billion the country appears to be stuck between a rock and a hard place. Increasing the levy on higher value deposits as has been suggested threatens to infuriate Cyprus’ biggest creditor Russia but at the same time a lack of any forthcoming deal will put at jeopardy and liquidity support from the ECB to Cyprus’ banks. Markets appear to be giving the country and Eurozone officials some leeway leaving most asset markets in ranges.

Although the saga in Cyprus had helped to extend the EUR’s decline the truth is that the currency was already in decline from its 1 February high around 1.3712 in the wake of an increasingly adverse growth and yield gap with the US and Italian political uncertainty.

While market panic over Cyprus appears to have eased helping the EUR to find some stability the fact remains that no solution is on the table and once again it feels as though Eurozone officials are belatedly scrambling to find solutions before market patience runs out. EUR/USD looks supported however, around the 200 day moving average at 1.2878.

USD/JPY has been correlated most with the relative move in 10Y yield differentials between US Treasuries and Japanese JGBs. Given the prospects that the 10Y differential in terms of Treasuries versus JGBs will widen further it implies yet more gains in USD/JPY.

It is worth watching yields closely but at this point I await stronger signals that US bond yields are headed higher before contemplating a further JPY decline. In the near term USD/JPY looks supported around 94.72 as risk appetite returns and ahead of an inaugural speech by BoJ Governor Kuroda in which he is expected to announce a major policy shift aimed at bold easing according to Japanese press.

USD undermined, CHF and NZD risks

The surprise drop in US Q4 GDP (-0.1% QoQ annualised) and relatively cautious but not much different Fed statement (pause in growth, elevated unemployment, inflation below long term objective) helped to undermine risk assets, and the USD overnight while 10 year Treasury yields slipped back below 2%. Consequently EUR/USD was propelled above the 1.35 level. Gold prices benefitted however, with the precious metal trading above its 200 day moving average.

The Fed showed little indication of pulling back from its USD 85 billion in monthly asset purchases but that did little to prevent stocks from closing lower. The data calendar is limited in terms of first tier releases today, with ranges likely to dominate and markets turning their attention to tomorrow’s US jobs report.

Following an impressive drop of around 3% from around 9 January the CHF appears to have stabilised, at least temporarily versus EUR. I believe this stability will prove short lived. CHF is finally seeing a reversal in safe haven flows while also suffering from its growing use as a funding currency (again). Indeed, recent weeks have seen a decline in speculative CHF appetite, which I expect to continue over coming weeks.

The recent drop in the CHF has done little to placate Swiss government officials however, while economic data such as the 8 month low registered for the January KoF leading indicator give further support for a weaker currency. There is even renewed speculation that the Swiss National Bank should catch markets on the hop by raising the EUR/CHF 1.200 floor. I don’t expect the floor to be raised anytime soon but do expect more weakness in the still overvalued CHF.

My quantitative models now send a ‘strong sell; signal for NZD but maintain a neutral signal for AUD. Is it time to buy AUD/NZD? Technical signals suggest little upside directional impetus in the short term. Moreover, speculative positioning in AUD/NZD looks stretched. In other words expect range trading in the near term and better opportunities once stale longs have been shaken out.

The RBNZ’s decision to keep policy on hold overnight will have little impact on the NZD given that it was widely expected but the concerns expressed about Kiwi strength will not go unnoticed by market players. NZD has benefited more from the risk rally over recent weeks than AUD but gains in risk appetite according to my risk barometer appear to have stalled. I suggest waiting for opportunities to sell kiwi on any move the 0.84 versus USD

Currency frictions

I would like to apologise for the lack of posts over the last couple of weeks. I have been on a client roadshow presenting our macro and markets outlook for 2013 to clients across Asia. Having returned the mood of the markets is clearly bullish as risk assets rally globally. Recovery hopes are intensifying as tail risk is diminishing while central banks continue to keep their monetary levers fully open.

A heavy slate of US data releases this week will keep markets busy but overall I see little to dent the positive tone to risk assets over coming sessions. The main events this week include the US January jobs report (forecast +160k) and Fed FOMC meeting (no change likely) while consumer and manufacturing confidence, Q4 GDP and December durable goods orders are also on tap.

In the Eurozone attention will focus less on data but more on Eurozone banks’ balance sheets, with further capital inflows likely to be revealed, marking another positive development following last week’s strong payback of LTRO funds. Elsewhere, industrial production in Japan is likely to reveal a healthy gain while an interest rate decision in New Zealand (no change likely) will prove to be a non event.

As fiscal and monetary stimulus measures are largely becoming exhausted or at least delivering diminishing returns the next policy push appears to be coming from the currency front. The issue of ‘currency war’ is once again doing the rounds in the wake of Japan’s more aggressive stance on the JPY leading to growing friction in currency markets.

In contrast the easing of Eurozone peripheral strains have boosted the EUR, in turn resulting in a sharp and politically sensitive move higher in EUR/JPY. Central banks globally are once again resisting unwanted gains in their currencies, a particular problem in emerging markets as yield and risk searching capital flows pick up. Expect the friction over currencies to gather more steam over the coming weeks and months.

In the near term likely positive news in the form of large capital inflows into Eurozone peripheral banks and sovereign bond markets will keep the EUR buoyed. The USD in contrast will be restrained as US politicians engage in battle over the looming budget debate and spending cuts despite the move to extend the debt ceiling until May.

GBP has slid further and was not helped by the bigger than expected drop in Q4 GDP revealed last week which in turn suggests growing prospects of a ‘triple dip’ recession. The lack of room on the fiscal front implies prospects for more aggressive Bank of England monetary policy especially under the helm of a new governor and in turn even greater GBP weakness.

Swiss franc under pressure

The US debt ceiling continues to garner most attention in markets, with US Treasury Secretary Geithner warning in a letter to Congress about the adverse economic impact of the failure to raise the ceiling. President Obama gave a similar warning, but with current extraordinary measures due to run out between mid February and early March timing is running out.

While Fed Chairman Bernanke echoed this assessment markets found some relief in his speech as it did not repeat the views of some Fed officials in hinting at an early ending of QE. Bernanke qualified his comments by stating that believes that inflation will stay below 2% over the medium term.

EUR/USD could not hold onto highs around 1.3404 but the currency pair does not looks as though it is running out of momentum. As sentiment towards the Eurozone periphery continues to improve and inflows into Eurozone assets increases the EUR is finding itself as a key beneficiary. However, the strength of the currency will only reinforce the weak economic backdrop across the region, which eventually will come back to bite the EUR.

Indeed data today is likely to confirm that the German economy recorded a weak pace of growth over 2012 finishing the year with a contraction in activity over Q4. Our forecast of no growth in the Eurozone this year could face downside risks should the EUR continue to rise. This is unlikely to stem the near term upside for EUR/USD but adverse growth and yield differentials compared to the US will mean that gains in EUR/USD will not be sustained.

The long awaited move higher in EUR/CHF appears to be finally occurring. EUR/CHF is trading at its highest level in over a year and looks set to make further gains. The fading of Eurozone crisis fears, better global economic developments and search for yield, are combining to pressure the CHF versus EUR although USD/CHF is trading near multi month lows.

Additionally improving sentiment outside of Switzerland is not echoed within the country as domestic indicators have worsened recently such as the KoF leading indicator, adding further pressure for a weaker CHF. Recent inflation data revealing a 0.4% YoY in December, the 15th month of annual declines have reinforced the fact that the currency is overly strong. EUR/CHF looks set to move higher, with the December 2011 high of 1.2444 the next target.

US dollar finding some support

Global growth concerns are contributing to undermine commodity prices, with most commodities dropping overnight. Gold was the biggest loser. Risk measures continue to creep higher as a host of worries especially the lack of traction in the Eurozone towards a Spanish agreement on a bailout and inability of Greece to agree on deficit cuts, afflicted markets.

The near term outlook is likely to remain one of caution until some progress in the Eurozone is in evidence. However, growth concerns suggest any improvement in sentiment will be tenuous at best.

On a more positive note, there at least appears to be some movement in the US towards finding a solution towards avoiding the fiscal cliff from taking effect as a bipartisan group of senators have agreed to formulate a deficit reduction plan.

The USD index has rallied over recent days despite expectations for weakness in the wake of the Fed;s announcement of QE3. It almost appears to be a case of sell on rumour, buy on fact. Admittedly the USD usually does weaken following QE with the USD index falling during the full periods of both QE1 and QE2 (-4.6% and -2.9%, respectively).

The counter argument in support of a firmer USD which we believe is supported by the massive deterioration in USD positioning over recent weeks and over 5% drop in the USD since 24 July is that the market has already priced in a lot of QE expectations into the currency.

Another factor that will likely play positive for the USD is the fact that the Fed is not alone in expanding its balance sheet. Many central banks are vying to maintain very easy monetary policy. The implication of this is that there is a battle of the balance sheets in progress that does not necessarily involve the USD being the loser.

EUR/USD has fallen well off its recent highs around 1.3173, with sentiment for the currency souring due to inaction by the authorities in Spain on requesting a bailout and disagreements over how to proceed on various issues including banking supervision. The drop in the September German IFO business climate survey, the fifth in a row, did little to help the EUR, with the survey adding to Eurozone growth worries.

Increasingly it looks as though EUR short covering is running its course and while there may yet be a further bounce in the EUR should the ECB begin its bond purchase programme, the near term outlook is more fragile. Business and consumer confidence surveys in Germany and France today will echo the weakness of the IFO in contrast to a likely firming in September US consumer confidence, contributing to a weaker EUR. A test of support around 1.2848 looms

So much in the price

The weaker than expected US August non farm payrolls data at the end of last week punished the USD and reinforced expectations that the Federal Reserve will announce a fresh round of quantitative easing at this week’s FOMC policy meeting. The shift in expectations for QE has been rapid over recent weeks and the jobs data acted as the icing on the cake. In part USD weakness reflects both QE expectations and the positive reaction to the European Central Bank’s bond buying plan announced last week. In this respect a lot is already priced in to currency markets and EUR/USD will struggle to sustain a move above 1.28 in the short term.

From a risk / reward perspective there are potentially plenty of stumbling blocks this week aside from the FOMC meeting that could skew market direction towards risk rather than reward. These include the German constitutional court decision on the ESM permanent bailout fund and Dutch elections both of which take place on Wednesday. The German court decision is the last needed before the ESM comes into force. Legal experts expect the court to approve the ESM but with tough conditionality. Should the ESM not be approved it would leave any more bailout funds to come only from the cash left in the temporary and dwindling EFSF. Separately the Dutch elections look set to end in weeks if not months of coalition building. These events occur gainst the backdrop of talks between the Greek government and its creditors following failure to agree on spending cuts between Greece’s coalition partners.

Ahead of these events the European Commission will reveal details of plans towards a single banking supervision mechanism. The G20 meeting in Mexico and Ecofin meeting at the end of the week will also garner attention, with any discussion on a European banking union of interest. Meanwhile, following the ECB’s announcement last week the ball is in the court of Spain and Italy to formally request An EU bailout and in turn accept various conditions and targets necessary to receive a bailout. Only then will the ECB commence its ‘unlimited’ bond buying. No date or deadline has been set for such requests for a bailout but given the sharp drop in peripheral Eurozone bond yields over recent weeks in anticipation of ECB bond purchases there is certainly scope for disappointment, with market patience likely to run thin.

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