Euro sentiment dives to a new low

Equity markets in Europe began the year in positive mood, with gains led by the German DAX index following the release of firmer than expected readings for Eurozone purchasing managers indices (PMI). Chinese data which showed an increase in its PMI also helped to boost sentiment. The Eurozone data however, remained at a weak level, contracting for a fifth month in a row, and still consistent with Eurozone recession.

It seems unlikely that equity gains will be sustained over the rest of this week, with risk aversion set to remain elevated against the background of ongoing Eurozone debt and global growth concerns. Indeed, both French and German leaders in their new-year messages warned about the risks ahead. A meeting between Germany’s Merkel and France’s Sarkozy is scheduled for January 9th ahead of an EU Finance Ministers summit on January 23rd. It is unlikely that there will be any significant policy decisions in Europe before then.

Meanwhile, press reports noting that Germany is pushing for an even bigger write down of Greek debt than previously agreed will only add to risk aversion over the short term. The report in the Greek press highlighted the prospect of a 75% write down of Greek debt a far cry from the 20% proposed some months ago. Eurozone markets continue to be haunted by the prospects of credit downgrades by major ratings agencies at a time when many countries have to issue large amounts of debt to satisfy their funding requirements.

Against this background the EUR is set to remain under pressure, with a notable drop below EUR/JPY 100, its lowest level in over a decade registered. Reflecting the deterioration in sentiment for the currency, EUR speculative position hit an all time low at the end of last year according to the CFTC IMM data. This is unlikely to reverse quickly, with sentiment set to deteriorate further over coming weeks and months as the EUR slides further.

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Eurozone contagion spreading quickly

Contagion from the eurozone debt crisis is spreading quickly, threatening to turn a regional crisis into a global crisis. As highlighted by Fitch ratings further contagion would pose a risk to US banks. Consequently risk assets continue to be sold but interestingly oil prices are climbing. Taken together with comments earlier in the day from the Bank of England that failure to resolve the crisis will lead to “significant adverse effects” on the global economy, it highlights the risks of both economic and financial contagion.

Predominately for some countries this is becoming a crisis of confidence and failure of officials to get to grips with the situation is resulting in an ever worsening spiral of negativity. Although Monti was sworn in as Italian Prime Minister and Papademos won a confidence motion in the Greek parliament the hard work begins now for both leaders in convincing markets of their reform credentials. Given that there is no agreement from eurozone officials forthcoming, sentiment is set to worsen further, with safe haven assets the main beneficiaries.

EUR/USD dropped sharply in yesterday’s session hitting a low around 1.3429. Attempts to rally were sold into, with sellers noted just below 1.3560. Even an intensification of bond purchases by the European Central Bank (ECB) failed to prevent eurozone bond yields moving higher and the EUR from falling.

Against this background and in the absence of key data releases EUR will find direction from the Spanish 10 year bond auction while a French BTAN auction will also be watched carefully given the recent increase in pressure on French bonds. Having broken below 1.3500, EUR/USD will aim for a test of the 10 October low around 1.3346 where some technical support can be expected.

US data releases have been coming in better than expected over recent weeks, acting to dampen expectations of more Fed quantitative easing and in turn helping to remove an impediment to USD appreciation. While the jury is still out on QE, the USD is enjoying some relief from receding expectations that the Fed will forced to purchase more assets. Further USD gains are likely, with data today including October housing starts and the November Philly Fed manufacturing confidence survey unlikely to derail the currency despite a likely drop in starts.

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.

Contrasting US and European data

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.

European agreement at last

Following a drawn out period of discussions European officials have finally agreed on a haircut or debt write off of around 50% of Greek debt versus 21% agreed in July. In addition the EFSF bailout fund will be leveraged up to about EUR 1.4 trillion, with the new EFSF scheduled to be in place next month. The haircut for Greek debt is aimed at ensuring that Greece’s debt to GDP ratio drops to 120% by 2012.

The reaction of markets was initially favourable with EUR/USD breaching 1.40 and risk / high beta currencies bouncing. I doubt that the upward momentum in EUR can be sustained, however, with plenty of questions on the mechanics of the deal, especially about leveraging the EFSF fund, remaining. I suspect that the EUR may have already priced in some of the good news.

Data releases, especially in the US are offering markets more positive news. Following on from firm readings for US durable goods orders and new home sales, today’s US Q3 GDP expected to reveal an acceleration in growth to a 2.5% annual rate, will help to alleviate recession fears to some extent. The USD may benefit if the data reduces expectations of further Fed quantitative easing especially given the recent comments from some Fed officials indicating that the door is open to more QE.

In Japan attention was firmly fixed on the Bank of Japan policy meeting and the prospects for FX intervention to weaken the JPY. In the event the BoJ kept its overnight rate unchanged at 0.1% as expected and expanded its credit program by JPY 5 trillion and asset purchase fund to JPY 20 trillion.

The measures are aimed to easing deflation pressure but the real focus in the FX market is whether there is any attempt to the weaken the JPY. I am currently in Tokyo and here there is plenty of nervousness about possible FX intervention being imminent. Speculation of such intervention will likely help to prevent USD/JPY sustaining a drop below the 75.00 over coming days.

Plenty of event risk

This week is heavy with event risk, with a lot expected from EU leaders. So far the risk on tone to markets has held up, with for example the VIX fear gauge resting below the key 30.0. The G20 meeting over the weekend set the deadline for action for concrete solutions to the eurozone debt crisis for the October 23 EU Summit.

However, there will be little detail on issues such as banking sector recapitalisation, private sector involvement in any debt restructuring or ‘leveraging’ the EFSF bailout fund until the report on Wednesday night by the Troika on Greece. The reward to EU leaders would be the potential for more aid from the IMF but even now it seems that a German government official has poured cold water of a plan being announced at the EU Summit which will disappoint markets.

There are also plenty of data releases for markets to digest over coming days including inflation releases, manufacturing surveys and industrial production data in the US while in Europe the German IFO and ZEW surveys are scheduled for release. The data will follow on from the better than expected September US retail sales releases at the end of last week continuing to dampen expectations that the global economy is falling in recession though there will be a marked deceleration in European data.

Meanwhile the US Q3 earnings season rolls. The risk on tone will likely continue to weigh on the USD and weigh on bonds but unlike a few weeks ago when a lot of bad news was priced in, the scope for disappointment is becoming increasingly high.

Many currencies remain highly correlated with gyrations in risk and in this respect the improvement in risk appetite is good news for high beta / commodity. AUD, NZD, CAD and JPY are amongst the most sensitive currencies and therefore prone to a bigger reaction as risk improves, with the former three strengthening and the JPY weakening. Asian currencies poised to benefit from firmer risk appetite include INR and KRW, both with relatively high correlations with risk.

EUR/USD has made a solid recovery over recent days from its lows around 1.3146 spurred by hopes of action by European officials. Such hopes may yet be dashed but the EUR looks supported over coming days ahead of the EU summit Speculative positioning also reflects a slight improvement in EUR sentiment as IMM short positions have declined in the last week but its worth noting that this week’s European data are unlikely to be supportive for the EUR.

Risk appetite remains fragile

The stabilisation in risk appetite over recent days looks highly fragile and markets will look to upcoming events in Europe and data releases to determine whether a rally in risk assets is justified. Discussions over the weekend between German Chancellor Merkel and French President Sarkozy delivered little in substance apart from a promise that a concrete response to the crisis will be delivered by the end of the month ahead of the 3 November G20 summit.

Both leaders agreed on the need for European banking sector recapitalisation and this issue along with whether or how to leverage the EFSF bailout fund and the extent of private sector participation in any Greek bailout is likely to take growing prominence for markets over coming weeks ahead of the EU summit on 17-18 October. In the meantime, markets may give Eurozone officials the benefit of the doubt but patience will run thin if no progress is made on these fronts.

The US jobs report at the end of last week which revealed a bigger than expected 103k increase in payrolls and upward revisions to previous months will have helped to allay fears about a renewed recession in the US and global economy. Indeed, recent surveys reveal that analysts expected weak US growth rather than recession. This week’s data will help to shore up such expectations with US data including retail sales and consumer confidence likely to outshine European data, including likely declines in industrial production in the region.

Overall, this will help to buoy risk appetite which may leave the USD with less of a safe haven bid but at the same time it will also reduce expectations of more quantitative easing (QE3) in the US, something that will bode well for the USD. Markets are set to begin the week in relatively positive mood but we remain cautious about the ability of risk appetite to be sustained. On balance, firmer risk appetite will play negatively for the USD early in the week but any drop in the USD will be limited by the fragility of risk appetite and potential for risk aversion to intensify again.

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