Contagion spreading like wildfire

November 16, 2011 — Mitul Kotecha

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.

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Data releases in focus

November 15, 2011 — Mitul Kotecha

For a change the markets may actually concentrate on data releases today rather than political events in the eurozone. The October US retail sales report and November Empire manufacturing survey are likely to paint a less negative economic picture of the US. The data will help to dampen expectations of more quantitative easing in the US but we will be able to hear more on the subject from the Fed’s Bullard and Williams in speeches today.

Overnight the Fed’s Fisher poured more cold water on the prospects of further QE by highlighting that the economy is “poised for growth”. While speculative data in the form of the CTFC IMM data shows a drop in USD sentiment to its lowest in several weeks we do not expect this to persist. The USD will likely benefit from the data today and we see the currency retaining a firmer tone over the short term especially as eurozone concerns creep back in.

The vote by German Chancellor Merkel’s party to approve a measure for a troubled country to leave the EUR opens up a can of worms and will hit EUR sentiment. But rather than politics there are several data releases on tap today that will provide some short term influence on the EUR, including Q3 GDP and the November German ZEW survey. FX markets will likely ignore a positive reading for GDP given that the outlook for Q4 is going to be much worse. The forward looking ZEW survey will record a further drop highlighting the risks to Europe’s biggest economy.

T-bill auctions in Spain and Greece may garner even more attention. Following on from yesterday’s Italian debt sale in which the yield on 5-year bond came in higher than the previous auction but with a stronger bid/cover ratio, markets will look for some encouragement from today’s auctions. Even if the auctions go well, on balance, relatively downbeat data releases will play negatively for the EUR.

When viewing the EUR against what is implied by interest rate differentials it is very evident that the currency is much stronger than it should be at least on this measure. Both short term (interest rate futures) and long term (2 year bond) yield differentials between the eurozone and the US reveal that EUR/USD is destined for a fall.

Europe’s yield advantage has narrowed sharply over recent months yet the EUR has not weakened. Some of this has been due to underlying demand for European portfolio assets and official buying of EUR from central banks but the reality is that the EUR is looking increasingly susceptible to a fall. EUR/USD is poised for a drop below the psychologically important level of 1.35, with support seen around 1.3484 (10 November low).

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Contrasting US and European data

November 14, 2011 — Mitul Kotecha

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.

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Risk appetite remains fragile

November 11, 2011 — Mitul Kotecha

Fortunately for the USD the situation in the eurozone has become so severe that the problems in the US are all but being ignored. Even in the US, attention on the nomination of the Republican presidential candidate has over shadowed the looming deadline for an agreement on medium term deficit reduction measures.

The Joint Select Committee on deficit reduction is due to submit a report to Congress by November 23 and a final package would be voted on by December 23. A lack of agreement would trigger automatic deficit reduction of $1.2 trillion, a proportion of which would take place in 2012. If this is the case it could potentially tip the economy into recession, necessitating QE3 and consequently a weaker USD.

Reports that the eurozone could fall apart at the seams as countries exit have shaken confidence, yet the EUR has managed to hold above the psychologically important 1.35 level. The strong reluctance of the European Central Bank (ECB) to embark on unsterilized bond purchases and to act as lender of the last resort, suggests that the crisis could continue to brew for a long while to come.

Nonetheless, the EUR found a semblance of support from news that former ECB vice-president Papademos was named new Prime Minister of Greece, the ECB was reported to be a strong buyer of peripheral debt, Italy’s debt auction was not as bad as feared, affirmation of the EFSF’s AAA rating by Moody’s and France’s AAA rating by S&P (following an erroneous report earlier). EUR/USD remains a sell on ralliesup to resistance around 1.3871, with initial resistance around the 1.3665 level.

The underlying pressure over the near term is for further JPY strength in the face of rising risk aversion and a narrowing in the US yield advantage over Japan. Given that the situation in the eurozone remains highly fluid as well as tense, with little sign of resolution on the horizon, risk aversion is set to remain elevated. Moreover, yield differentials have narrowed sharply and the US 2-year yield advantage over Japan is less than 10bps at present.

Against this background it is not surprising that the Japanese authorities are reluctant to intervene aggressively although there are reports that Japan has been conducting secret interventions over recent weeks. However, given that speculative and margin trading net JPY positioning have dropped significantly the impact of further JPY intervention may be less potent. In the meantime USD/JPY will likely edge towards a break below 77.00.

Swiss officials have continued to jawbone against CHF strength, with the country’s Economy Minister stating that the currency remains massively overvalued especially when valued against purchasing power parity. Such comments should be taken at face value but the CHF is unlikely to embark on a weaker trend any time soon.

Although the EUR/CHF floor at 1.20 has held up well while the CHF has lost some its appeal as a safe haven the deterioration in the situation in the eurozone suggests that the CHF will not weaken quickly.

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The Italian Job

November 10, 2011 — Mitul Kotecha

Italy looks too big to rescue yet is too big to fail. The country has around EUR 1.9 trillion in public debt (around 5 times that of Greece) and is the third largest country in the eurozone. Therefore it cannot be as easily dealt with as Greece.

Italy needs to raise around EUR 18 billion per month to cover its budget deficit and bond redemptions and with a continued increase in yields (hitting close to 7.5% for 10 year bonds) borrowing costs are rising sharply and fast becoming unsustainable. Higher collateral haircuts on Italian debt are adding to the pressure.

Although Italian Prime Minister Berlusconi has said he will step down in the wake of reform measures to be voted on by the Italian parliament the vote on the measures may not take place for weeks. Moreover, Berlusconi may attempt to seek re-election after stepping down, which could bring the situation back to square one.

In the meantime speculation that Italy may be the next country to need to a bailout will intensify. However, with only around EUR 270 billion remaining in the EFSF bailout fund and details of how the fund will be leveraged to a planned EUR 1 trillion still lacking, doubts about whether it will have sufficient resources will grow. Press reports that Germany and France have begun talks to break up the eurozone due to fears that Italy will be too big to rescue will only add to the malaise.

Focus over the short term will turn to today’s 12 month auction of EUR 5 billion in Italy. Last month’s 12 month auction saw an average yield of 3.57% but this time around yields could rise above 6%. Worryingly it appears that even with the European Central Bank (ECB) buying Italian debt it has been insufficient to prevent yield rising.

In any case, given the ECB’s reluctance to become lender of the last resort to European peripherals, any support from this direction will be limited. Against this background the EUR remains highly vulnerable to a further drop. Indeed, the EUR’s recent resilience looks all the more misplaced. A test of the 4 October low around EUR/USD 1.3146 is on the cards over coming days.

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