US dollar remains under pressure

Hopes of progress on the Eurozone debt crisis and encouraging data in the US have helped boost market confidence. However, the slightly disappointing US Q4 GDP report (2.8% Qoq annualised growth) revealed the markets continued vulnerability while Fitch’s downgrade of six Eurozone countries’ sovereign ratings brought a dose of reality back to the region.

Nonetheless, the Eurozone Central Bank (ECB) unlimited 3-year loans to banks and Fed hints at quantitative easing (QE3) have provided markets with a fillip and will help underpin risk assets over coming weeks. If Greek debt talks are wrapped up this week markets will take further solace but the European Union (EU) Summit beginning today will need to deliver on rubber stamping recent agreements for positive sentiment to be maintained.

This is a big week for US data releases and in turn the USD. Heavy weight data including January non-farm payrolls, ISM manufacturing confidence and consumer confidence readings are on tap over coming days. Although payrolls will not be as strong as in December the trend of data releases will continue to be one of improvement as likely to be revealed in the forward looking confidence surveys this week.

The USD may not benefit as much as it would otherwise have done given that the Fed has committed to easy monetary policy for a long while to come to end 2014. It is becoming increasingly clear that firmer activity data may still not prevent a further round of quantitative easing and attendant USD downside risks. Against this background a cautious stance on the USD over coming days is warranted, with the USD index likely to remain under near term pressure.

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Ratings agencies spoil the party

Just as I thought that attention may finally switch to the US along comes the ratings agencies to spoil the party once again. Moody’s and Fitch Ratings criticised last week’s European Union Summit outcome for falling short of a comprehensive solution to Eurozone ills. Consequently the risk of further sovereign credit downgrades across Europe remains high over coming weeks especially as economic growth weakens. Moody’s also put 8 Spanish banks and two bank holding companies on review for a possible downgrade.

The EUR and Eurozone bonds came under pressure as a result, with EUR/USD verging on its strong support level around 1.3146. Further pressure is likely into year end although the fact that the speculative market is still very short EUR may limit its downside potential in the short term. Disappointment that the ECB has not stepped up to the plate to support the Eurozone bond market more aggressively is also having a damaging effect on confidence. A test of sentiment will come from today’s EFSF and Spanish bill auctions while on the data front we look for a below consensus outcome for the German December ZEW survey, which will deteriorate further.

The comments from the ratings agencies resulted in risk assets coming under pressure once again, leaving the market open to further selling today given the lack of positives. US data and events will at least garner some attention, with the Federal Reserve FOMC meeting and November retail sales on tap. We do not look for any big surprise from either of these, but at least the Fed may sound a little more positive in light of firmer data over recent weeks. Even so, speculation of more Fed QE early next year will remain in place. In the current environment demand for US Treasuries remains strong with a Treasury auction yesterday receiving the highest bid/cover ratio since 1993.

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.

EUR falls, JPY retraces after intervention

Risk aversion has come back in full force, with various concerns weighing on markets. Once again attention is firmly fixed on the eurozone and worryingly last week’s European Union (EU) rescue agreement has failed to prevent a further widening in eurozone peripheral bond spreads. This will come as a blow to eurozone officials as the agreement was aimed to prevent exactly this.

A lack of detail in the plans announced last week has come back to haunt markets. Moreover, given the event risk of the RBA, ECB and Fed central bank meetings this week plus the US October jobs report at the end of the week, nerves will likely remain frayed over coming days. Overall, the tone will likely be on of selling risk assets on rallies over the short term.

The EUR has unwound a significant part of its gains from last week as various doubts about the eurozone rescue package have surfaced. The measures announced by EU officials have failed to prevent a jump in Italian and Spanish bond yields. News that MF Global has filed for bankruptcy while the Greek Prime Minister has called for a referendum on the EU’s debt deal dealt markets a blow overnight.

As it was doubts had been creeping in due to the lack of detail in the rescue package including but not limited to the lack of specifics on the leveraging of the EFSF bailout fund. The pattern appears to have followed the reaction to previous EU announcements to stem the crisis, namely short lived euphoria followed by a sell off in risk assets. The EUR is likely to struggle further over the near term, with the current pull back likely to extend to around the 21 October low of 1.3705.

Japanese officials had blamed the strength of the JPY on speculative flows and have threatened more FX intervention following yesterday’s Judging by the price action this morning the threat has been followed up by action. In order for USD/JPY to sustain a move higher it will require both a widening in yield differentials and easing risk aversion. Neither are guaranteed to happen any time soon as was evident overnight with risk aversion rising. US data has improved but it is insufficient to provoke a sharp back up in US bond yields.

Consequently in the coming weeks USD/JPY topside momentum will be limited. A break above USD/JPY’s 200 day moving average level of 79.89 could prove decisive in terms of JPY long capitulation and once above this level USD/JPY will target the 11 July high of 80.83. However, this will require further intervention otherwise the underlying trend in JPY will continue to remain positive.

Euphoria fades, risk currencies weaker

The euphoria emanating from last week’s eurozone agreement will likely fade into this week as renewed doubts creep in. Details of how the EFSF bailout fund will be leveraged or how the special purpose vehicle will be utilised have yet to emerge while the firewall to protect countries such as Italy and Spain may still be insufficient given that the use of the European Central Bank (ECB) to provide unlimited support has been ruled out.

With more questions than answers markets will be hungry for further details over coming weeks and until then it is difficult to see risk appetite stretching too far. One indication of such concern was the fact that Italy’s borrowing costs climbed to euro-era highs the day after the European Union (EU) plan was agreed. The G20 meeting on 3-4 November will be eyed for further developments as well as further reaction to the EU agreement.

There are plenty of events to digest this week that could add to any market nervousness. In terms of central banks we do not expect to see any change in policy stance from the ECB, Federal Reserve or Reserve Bank of Australia (RBA) this week but the decisions may be close calls. The ECB under the helm of new President Draghi will be under pressure to ease policy as growth momentum has clearly weakened but the Bank will likely hold off for the December meeting when new growth and inflation forecasts will be released.

The RBA may also take some solace from a better global economic and market climate but the market disagrees having priced in a cut this week. The Fed will look to see how ‘Operation Twist” is faring before moving again but recent indications from some Fed officials suggest growing support for purchases of mortgage backed securities.

On the data front eurozone inflation today will be the key number in Europe while the US jobs report at the end of the week will be the main release in the US. Ahead of the payrolls data, clues will be garnered from the ISM manufacturing data and ADP jobs report. The consensus is for a 95k increase in non-farm payrolls and the unemployment to remain at 9.1% maintaining the trend of only gradual improvement in the US jobs market.

Recent data releases have turned less negative, however, and at the least have helped to alleviate renewed recessionary concerns. Overall, I suspect that markets will come back down to the reality of slow growth and unanswered questions this week, with risk assets likely to lose steam over coming days.

Euro fails too hold on to gains

Any improvement in sentiment following the USD liquidity support announcement by various central banks last week is already filtering away against the background of European Union (EU) officials’ failure to make any headway at the Ecofin meeting over the weekend, a delay in the approval of the next bailout tranche for Greece and ongoing collateral dispute between Greece and Finland. On top of all of this German Chancellor Merkel suffered a further setback in regional elections over the weekend.

Greece will remain in focus this week and markets will look for signs that the country is back on track on its austerity plans and its next loan tranche. Prime Minister Papandreou cancelled a trip to the US while the Greek cabinet are apparently deciding on new fiscal measures. Attention will turn to a teleconference today from the Greek Finance Minister with EU and IMF officials.

Speculative sentiment for the EUR has already soured further and according to the latest CFTC IMM report, positioning in EUR is at its lowest since the end of June 2010. EUR/USD will continue to look very vulnerable having already dropped sharply from a high of around 1.3899 in Asian morning trading as the bad weekend news hit the currency. EUR/USD will find some technical support just below 1.3500 this week but any upside is set to prove limited unless some concrete announcements are delivered relating to Greece over coming days.

In contrast to the EUR, USD speculative appetite has turned net long for the first time since July 2010. The extended Fed FOMC meeting will help to dictate USD sentiment as markets wait for further measures to stimulate the economy. The Federal Reserve has already committed to hold rates steady until at least mid 2013 and the extended two day meeting this week will likely discuss further options. However, more quantitative easing (QE3) appears unlikely at this stage while an ‘Operation Twist’ type approach is more probable. The USD will benefit from a lack of further quantitative easing but this is largely already priced in.

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