All Eyes on Greece

The USD is in a lose-lose situation courtesy of the Federal Reserve’s ultra easy stance. Positive economic data releases have been met with USD selling pressure as the data helps to fuel a rally in risk appetite. Although the USD benefited from the better than expected US January jobs report gains will prove fleeting as it is does not change expectations of more Fed quantitative easing (note the drop in the participation rate).

Following the jobs report, there is little on the data front over coming days (only December trade data for which a widening is likely and February Michigan confidence where a gain is expected) to shift USD direction. At best the USD will consolidate giving USD bulls some time to nurse their bruises.

A disaster in the Eurozone (e.g. Greek disorderly debt default) could help the USD but it appears that markets have become resilient to bad news giving officials in the region the benefit of the doubt. In particular, the ECB’s 3-year LTRO has calmed nerves somewhat.

The lack of a final deal on Greek debt restructuring has failed to dent the EUR although notably EUR/USD failed to extend gains above 1.32 and has drifted lower. EUR/USD will remain on tenterhooks ahead of a midday deadline today set by Greek PM Papademos for party leaders to accept strong terms to qualify for a second bail out.

In the absence of agreement prospects of a disorderly debt default will loom large especially given that there is a EUR 14.5 billion bond repayment on March 20. Such an outcome will undoubtedly derail the EUR. Moreover, a meeting of Eurozone Finance ministers this week will give some direction to the EUR while the ECB’s likely status quo on Thursday suggests that there will limited EUR reaction following the meeting.

The risk of JPY intervention has increased significantly as USD/JPY brushes the psychologically important 76.0 level. However, the feeling on the ground is that USD/JPY will need to broach 75.0 before intervention is actually seen. Jawboning by Japanese officials has intensified suggesting increased official concern.

However, in the short term the ability of the authorities to engineer a sustained drop in the JPY is limited given the compression in US – Japan bond yields. This appears to be outweighing even the drop in risk aversion, which in theory should be playing for a weaker JPY. USD/JPY will struggle to make any headway, with strong multi day resistance seen around 77.49.

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.

More Bad News In Europe

Several pieces of bad news soured sentiment at the end of last week undoing much of the good news since the beginning of the year and dashing hopes of a relatively swift resolution to Eurozone’s ills. S&P ratings agency downgraded nine Eurozone countries’ credit ratings leaving 14 on negative outlook. In particular France and Austria, which lost their triple AAA status while not particularly surprising, comes as a major blow to efforts to resolve the crisis. The downgrade puts at risk the EUR 180 billion in credit guarantees underpinning the EUR 440 EFSF bailout fund.

Separately the breakdown of talks on Greek debt restructuring and criticism by the Euuropean Central Bank (ECB) on a new draft of a treaty to ensure fiscal discipline added to the malaise, with the ECB noting that proposed revisions amount to a “a substantial watering down”. Such criticism will likely be an obstacle to the ECB stepping up its peripheral debt buying potentially threatening any decline in bond yields. It is difficult to see sentiment improving this week, with risk aversion set to remain elevated as Eurozone leaders attempt to restore confidence. In contrast, US data continues to support evidence of economic recovery, albeit gradual and this week’s releases including industrial production and manufacturing surveys will likely add to this.

The EUR slid further at the end of last week reversing earlier gains, as the bad news mounted in the Eurozone. Ratings downgrades, breakdown of Greek debt talks and ECB criticism over watered down fiscal rules, combined to make a dangerous concoction of negative headlines. The news put an end to the EUR’s short covering rally, leaving the currency vulnerable too further declines this week. Speculative sentiment according to IMM data reached another all time low last week (-155k net positions), suggesting that any good news could lead to a strong bounce as short positions are covered.

However, it is difficult to see where such news will come from and even a small expected bounce in the German January ZEW investor confidence survey this week will do little to detract from the negative news on the policy front. A meeting between Merkel, Monti and Sarkozy will be eyed closely as they prepare for a meeting of European Union (EU) Finance Ministers and markets will be looking for aggressive action to turn confidence around. Debt sales in In the meantime EUR/USD will continue to languish but strong technical support is seen around 1.2588.

Renewed Eurozone Tensions

The USD has so far failed to build on the strong momentum seen at the end of last year. Its early days yet however, and given the ongoing tensions in the Eurozone the USD is hardly likely to lose much ground in the weeks ahead. US data continues to impress relative to elsewhere as revealed in the December ISM manufacturing survey data and overnight news that sales at auto makers and retailers were firmer in December. This economic outperformance may however, feed into a tone of improved risk appetite which could play negatively for the USD.

The USD will face a test from the release of the December payrolls data tomorrow, with forecasts currently looking for the gradual improvement in job market conditions to continue. As usual the December ADP private sector jobs released today will be instrumental in finalising the forecasts for payrolls. Overall, the USD will continue to benefit from the travails in the Eurozone, keeping the USD index well supported around 80.00.

EUR/USD has failed to sustain gains above 1.3000 so far this week and has continued to come under pressure on the crosses. While the potential for short covering may limit its losses sentiment continues to be downbeat. Better than forecast December service sector PMI data have helped to allay the worse fears about the Eurozone economy but this will be of little help to the EUR as further deterioration is likely in the months ahead.

Meanwhile yield differentials continue to have some bearing on EUR/USD. The fact that German 2-year yields have dropped further below US 2-year yields therefore ought to spell bad news for the EUR and will likely act as a cap to any rally in the currency. The news flow in the Eurozone will continue to weigh on the EUR too, with speculation that Spain will need an European Union (EU) / International Monetary Fund (IMF) loan intensifying and press reports that Spain will need to increase its provisions for bad property assets by up to EUR 50 billion. Attention today will turn to a EUR 8 billion bond auction in France.

High Hopes for the EU Summit

Following the knock to the EUR from the S&P ratings news on Eurozone countries yesterday the currency has managed to regain a semblance of stability ahead of the European Union Summit beginning tomorrow. Expectations that the Franco-German deal announced late Monday (Fiscal compact etc) will be rubber stamped at the summit are high and the warning shot by S&P suggests that the stakes are even higher should there be no further progress this week.

Aside from putting the ratings of 15 Eurozone countries on negative watch S&P stated overnight that the EFSF bailout fund could be downgraded too. The EUR however, looks supported ahead of the summit and European Central Bank (ECB) meeting tomorrow, with news of discussions to beef up the bailout fund to two separate entities likely to further underpin the currency. EUR/USD short term support is seen around 1.3330.

The cut in the Reserve Bank Australia (RBA) cash rate piled on the pressure on the AUD, especially as a rate cut was not fully priced in although its weakness was limited by the relatively neutral RBA policy statement. The statement did not support expectations of more significant easing in the months ahead and data this morning in the form of a much stronger than expected Q3 GDP reading reinforced our view that markets are too dovish on Australian interest rate expectations.

Next it’s the turn of the Reserve Bank of New Zealand (RBNZ) but unlike the RBA we do not expect an interest rate cut. The room for policy easing in New Zealand is limited, especially given that inflation is above the Bank’s 1-3% target band. Both the AUD and NZD are highly correlated with interest rate differentials and therefore any shift in rate expectations will have an important bearing. AUD and NZD have benefitted from a widening in yield differentials with the US and are likely to find garner some resilience from this fact over coming sessions.

EUR/GBP has continued to grind lower over recent months while GBP/USD appears to have settled into a range. GBP sentiment has clearly worsened over recent weeks as reflected in the deterioration in speculative positioning in the currency, with the market becoming increasingly short. Data releases have not been particularly helpful, with data yesterday revealing that UK house prices fell in November and retail sales dropped more than expected.

There will be more disappointment, with October industrial production likely to drop today. Our forecast of a 0.8% monthly highlights the downside risks to consensus expectations and in turn to GBP today. The data releases will if anything add to pressure on the Bank of England to embark on more quantitative easing, which will be another factor that restrains GBP over coming weeks. We continue to look for more GBP strength versus EUR but weakness against the USD over the short term. A move to support around GBP/USD 1.5469 is on the cards over the near term.

S&P Spoils The Party

Although stock markets registered gains the rally in risk assets stumbled, with sentiment knocked by news that S&P ratings has placed 15 Eurozone countries on negative watch for a possible downgrade due to “systemic stresses”. Among the 15 were Germany and France. Weaker economic news in the form of service sector purchasing managers indices in China and the US also dented market sentiment.

The Eurozone countries including all six triple A rated governments have a one in two chance of a downgrade within 90 days. Although there has been speculation of a French downgrade the major surprise was the inclusion of Germany in the list. A downgrade of Eurozone countries would hit the ability of the EFSF bailout fund to finance rescue packages for countries give that it is supported by sovereign guarantees from the six AAA rated countries.

Ironically the S&P announcement followed news that German Chancellor Merkel and French President Sarkozy have agreed on treaty changes revealing some progress ahead of the Eurozone summit on 8/9th December. Among the details of the agreement private sector bond holders will not be asked to bear any losses on any future debt restructuring, automatic sanctions for countries that breach the 3% deficit / GDP rule, a “golden rule” on balanced budgets, and an earlier data for the launch of the European Stability Mechanism to 2012.

The “fiscal compact” will be welcomed by the European Central Bank (ECB), with hints by President Draghi that it could be followed by stronger action from the central bank. Although S&P spoiled the party somewhat overnight, markets will go into the EU Summit with high expectations, suggesting that risk assets will find some degree of support. EUR slipped on the S&P news but further losses will be limited ahead of the EU Summit, with markets looking for further concrete actions from Eurozone leaders. EUR/USD will be supported around 1.3260 in the short term.

Risk Appetite Buoyed by Central Banks

Co-ordinated central bank action led by the Federal Reserve to lower the rate on USD liquidity by 50bps was accompanied by a cut in China’s reserve requirements and an easing by Brazil of its benchmark Selic rate. Unsurprisingly risk assets have rallied strongly overnight but once the announcement effect wares off the reality that the underlying tensions in the Eurozone remain in place will see any boost to sentiment wane. The move by the Fed will be a boon to the banking sector but should actually not have been too surprising as this tool was an easy one to use and one that should have been expected given the ample room to cut pricing on USD liquidity swap arrangements.

The other boost to markets overnight was the strong November ADP jobs report, which came in at 206k in November, and will lead to upward revisions to Friday’s payrolls data. Indeed, we now look for a 175k increase in non-farm payrolls from 120k previously. The trend of better than expected US data continued with a stronger than forecast reading for November Chicago PMI at 62.6. We expect this to be echoed by an increase in the ISM manufacturing survey today and the Fed’s Beige Book, all of which will at least allay concerns of a renewed US recession.

What will be important is whether the Fed move will be followed up by other measures from governments and central banks over coming days. Although European Union (EU) leaders have agreed to enhance their bailout fund attention is centred on French and German leaders, with hints that there could be a strong announcement over coming days. At the least, the upcoming EU Summit on 8/9 December will be expected to deliver concrete results otherwise the market rout will continue.

The USD will remain under pressure following the moves by central banks in line with the improvement in risk appetite. High beta risk currencies ie those with the highest correlation to risk over the past 3-months will benefit the most. These include RUB, AUD, TRY, CNH, KRW, GBP and CAD in respective order of correlation. All of these currencies are likely to register gains over the short term, especially given anticipation of further announcements from European officials and a reasonable US jobs report tomorrow.

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