Central banks ready to act

Markets are in wait and see mode ahead of Greek elections with range trading likely to dominate market action, albeit with a slightly risk on bias. US data disappointed once again, with jobless claims coming in worse than expected, compounding the growing fears about deterioration in US job market conditions. Perversely the poor jobs data coming against the background of soft May CPI inflation data have fuelled expectations of Fed action at next week’s Federal Reserve FOMC meeting.

It is not only the Fed that markets believe may act, with reports overnight suggesting that there may be some form of coordinated action by central banks should the Greek election outcome prove to be unfavourable. On this front, the news appears to be a little more encouraging as expectations that pro bailout parties will garner relatively more votes has grown as reflected in the 10% rally in Greek shares overnight.

If it takes weak economic data for markets to rally nowadays then there will be plenty available today, with declines expected for the May Empire manufacturing survey and June Michigan confidence, while industrial production is only likely to register a marginal gain in May. While the data may add more fuel to the fire, I suspect it will still be insufficient to result in more Fed balance sheet expansion.

European Central Bank (ECB) President Draghi is scheduled to speak today but I doubt he will suggest a move towards another LTRO or Securities Market Purchases. On the subject of central banks the Bank of Japan will announce its policy decision today but I expect no change in stance despite the fact that the 1% inflation goal remains a long way off. Currencies will remain in ranges but hopes of central bank action and a favourable outcome to the Greek elections will provide support for risk currencies and keep the USD under pressure.

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EUR range, CAD looks good versus AUD

Ahead of the European Central Bank (ECB) meeting and outcome of the Greek private sector involvement (PSI) debt swap it is very difficult to see the EUR moving out of ranges. I expect no surprises from the ECB and therefore little FX impact. Downward revisions to ECB growth forecasts will however, underpin the more negative tone to the EUR exhibited over recent days.

The bigger risk is the outcome of the PSI. Reports that Greece is nearing the minimum level of PSI participation of 66% will help erase market concerns of a complete collapse of the debt deal, but the risk of forcing a collection action clause and triggering credit default swaps (CDS) remains very much alive. EUR/USD is unlikely to recoup much of its recent losses against this background but will also not sustain any drop below technical support around 1.3055.

The CAD has pivoted around the parity level with the USD over recent weeks, showing little inclination to undertake a significant move in either direction. Notably USD/CAD has failed to sustain gains above its 200-day moving average level around 0.9997. Nonetheless, the CAD has held up relatively well compared to its commodity currency peers, specifically the AUD and NZD, which have both fallen over recent days.

The breakdown in correlation highlights the fact that CAD is regaining some of its old allure as a ‘turbo dollar’. My quantitative estimates show that USD/CAD has some further downward potential but I prefer to play potential CAD upside versus the AUD. The Bank of Canada (BoC) meeting today will do little to derail the CAD, with an unchanged policy decision in prospect, leaving the CAD to maintain gains against AUD.

Beware of EUR short covering

Europe has plenty of events to focus on over the next couple of days including the European Central Bank (ECB) Council meeting, and debt auctions in Spain and Italy. While I am by no means a EUR bull the risk is skewed towards some short term recovery or at least stabilization around EUR/USD 1.28. The speculative market is extremely short EUR while policy makers, specifically German Chancellor Merkel and French President Sarkozy are making the right noises. it appears to have finally dawned on Eurozone officials that its not just about austerity but also about growth and reform.

News that Fitch ratings is unlikely to downgrade France’s ratings this year has provided a boost to Eurozone confidence. Greece could yet spoil the party given the ongoing discussion with the Troika (Euuropean Commission, International Monetary Fund and ECB) to finalise the second bailout package for the country. Opposition resistance within Greece suggests that more austerity may not be easy to implement. Meanwhile there are ongoing questions about the extent of writedowns that Greek debt will undergo. Despite these issues it appears that markets are becoming somewhat more immune to events in the Eurozone. While still high bond yields for Italy and other debt still point to ongoing trouble, risk appetite has firmed.

One factor that is helping to boost sentiment is the encouraging news out of the US. Although the Q4 earnings season has not began particularly well data releases look somewhat more positive. Not only has positive impact of last week’s US December jobs report continued to filter through the market but so has other news such as a pick up in small business confidence and a rise in consumer credit. These lesser watched data highlight the gradual recovery process underway in the US and the growing divergence with the Eurozone economy and support the view of medium term USD outperformance versus EUR.

The Devil is in the details

The “partial solution” delivered by European Union (EU) leaders last week has failed to match the high hopes ahead of the EU Summit. Nonetheless, the deliverance of a “fiscal compact”, acceleration of the European Stability Mechanism (ESM) to July 2012 , no forced private sector participation in debt restructuring (outside Greece), and possible boost to the International Monetary Fund (IMF) of up to EUR 200 billion, are steps in the right direction. The fact that UK Prime Minister Cameron threw a spanner in the works to veto a joint proposal to revise the EU Treaty should not detract from the progress made.

Nonetheless, the measures may not be sufficient to allay market concerns, with disappointment at the lack of European Central Bank (ECB) action in terms of stepping up to the plate as lender of the last resort still weighing on sentiment. Data will add to the disappointment this week as “flash” Eurozone purchasing managers indices (PMI) drop further in December.

This week events in the US will garner more attention, including the Federal Reserve FOMC meeting, November inflation and retail sales data plus manufacturing confidence gauges as well as November industrial production on tap. The Fed will not shift its policy stance at this meeting but may sound a little more upbeat on the economy following recent firmer data. Inflation will likely remain subdued while the other data will continue to show gradual recovery.

Overall, the market is likely to thin further as the week progresses and holidays approach, with ranges likely to dominate against the background of little directional impetus. Our call to sell risk assets on rallies remains in place, however. The EUR will likely struggle to make much headway in the current environment, especially given that many details of the EU agreement still need to be ironed out and once again the risk to market confidence lies in implementation or lack of it. A range of EUR/USD 1.3260-1.3550 is likely to hold over the short term.

All Eyes On Europe

EUR looks range bound ahead of key events including the European Central Bank (ECB) meeting, European Union Summit and release of bank stress test results. A senior German official poured cold water over expectations of a concrete outcome from the EU Summit, dampening EUR sentiment as a result.

There will be plenty of attention on the ECB to determine whether they will give a little more ground and provide further assistance to the Eurozone periphery. While a refi policy rate cut is highly likely as well as additional liquidity measures I do not expect any move in the direction of more aggressive action to support peripheral bonds in terms of becoming “lender of the last resort’.

If however, the ECB hints at intensifying its securities market purchases of Eurozone bonds this will likely bode well for the EUR. Indeed, reports overnight suggest that the ECB will announce a set of measures to stimulate bank lending including easing collateral requirements for banks.

More weak UK data in the form a bigger than consensus drop in manufacturing and industrial production in October add to the soft BRC retail sales and house price data, in putting pressure on the Bank of England (BoE) to increase its quantitative easing at today’s policy meeting. While the BoE is set to keep policy unchanged it is only a matter of time before additional asset purchases are announced.

Despite the weaker IP data GBP has held up relatively well against the USD although downside risks appear to be intensifying. If I am correct in the view of no change by the BoE today we expect little change in GBP although there could be a risk of a push higher in EUR/GBP if the ECB delivers some positive news, with resistance seen around 0.8665.

The RBNZ unsurprisingly left policy rates unchanged at 2.5%, sounded less hawkish than the previous meeting and also lowered growth forecasts. The NZD was left unmoved by the rate decision and looks well supported at current levels perhaps due to relief that the statement was not more dovish. The kiwi has been an underperformer over the year but unlike the AUD it has not been particularly influenced by gyrations in risk aversion.

Interest rate futures differentials have seen a renewed widening versus the US over recent weeks. This is significant given that the NZ-US interest rate differentials have a very strong correlation with the performance of NZD/USD. If this widening is sustained it will point to upside potential for the Kiwi.

Super Failure By Supercommittee

The USD remains a clear beneficiary in the ‘risk off’ environment enveloping markets at present. Indeed as reflected in the latest jump in USD (IMM) speculative positioning the market is turning increasingly to the USD at a time of intense stress. Moreover, the run of better economic data over recent weeks including October existing home sales yesterday points to less need for further Fed quantitative easing, which comes as further relief to the USD.

Further information on this front will be revealed in the Federal Reserve FOMC minutes on Wednesday, with the Fed set to keep the option open. Even the lack of agreement by the US Congressional Supercommittee on a deal to cut the US budget deficit by $1.2 trillion has failed to dent the USD’s progress as the failure of deficit talks was largely expected. Further USD gains are likely but the pace of its upside move will slow.

Although sentiment towards the Eurozone has deteriorated further EUR/USD is just about clinging onto the 1.3500 level despite several forays lower. More active European Central Bank (ECB) bond buying likely helped dampen some bearishness on the currency although reports suggest that the central bank has imposed a limit of EUR 20 billion on such purchases.

The EUR is not being helped however, by ongoing rumblings of a EUR break up despite Greek Prime Minister Papademos attempting to downplay talk of a Greek EUR exit. A meeting today between Italian Prime Minister Monti and EU officials will be in focus, with markets looking to see further signs of commitment to reforms. We expect no let up in pressure on the EUR, though further declines are likely to be slower, with last week’s low around 1.3420 providing short term support.

GPB has been an underperformer, with the currency on the path for a re-test of the 6 October low around 1.5272. News this week will not be helpful for the currency, with potentially dovish Bank of England monetary policy committee (MPC) minutes likely to inflict further damage, with support from the MPC for more QE set to be revealed.

Ahead of the minutes, UK public finances data today will not make for attractive reading just over a week away from UK Chancellor Osborne’s Autumn statement, which will likely reveal a downward revision to growth forecasts and an upward revision to deficit forecasts. GBP has even lost ground against the beleaguered EUR although we continue to believe that the overall trend will continue to be lower for EUR/GBP over coming weeks.

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.

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