US Ratings Under Threat

June 3, 2011 — Mitul Kotecha

The USD succumbed to further pressure overnight as Moody’s Investor Service threatened to place the US Aaa rating on review for downgrade if there is no agreement reached on raising the US debt ceiling. Although the news prompted a rise in US Treasury yields it did little for the USD.

News that the Federal Reserve’s balance sheet expanded to a record $2.772 trillion in the week ending June 1 highlights the ongoing headwinds to the USD from Fed asset purchases. The fact that there is even talk of QE3 in the wake of weak US data suggests that the headwinds will not dissipate quickly.

Direction today will come from the US May jobs report though this is unlikely to deliver any good news for the USD. Forecasts for non-farm payrolls have likely been revised lower to sub 100k compared to the published consensus forecast of 165k following the weaker indications from the May ADP jobs report and ISM data this week. A weak payrolls outcome will only intensify worries about the depth and length of the US ‘soft patch’.

Although market expectations are also likely to have been downwardly revised, something that may cushion the blow to the USD, it will be difficult to get away from the fact that growth in Q2 is weaker than many had thought.

EUR was well supported overnight, boosted by a relatively successful Spanish bond auction yesterday and reports that officials have agreed in principle to a 3-year adjustment plan for Greece covering funding needs to 2013 although there was no confirmation of such an agreement.

As a result, EUR/USD tested 1.45 and looks supported ahead of today’s US payrolls data. EUR’s recovery in general has been impressive but gains above 1.45 are likely to prove more difficult even if an agreement on Greece is close to being achieved.

As usual Japan’s political gyrations are having little impact on the JPY as the currency is instead buffeted by risk aversion swings and yield differentials. In fact USD/JPY has been rather well behaved over recent weeks as indicated by implied options volatility.

Prime Minister Kan’s success in winning a no-confidence motion came at a cost and may provide very little political stability. Kan said will resign as soon as post-earthquake recovery efforts are completed and once he is gone there is likely to be some realignment of existing political parties.

As for the JPY it will remain unscathed by political events. Over the near term USD/JPY is likely to cling to the 81 handle but we maintain our bearish view on the JPY in the medium term under the assumption that there is a sharp widening in US – Japan bond yield differentials.

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US Economic Data Disappointments

June 2, 2011 — Mitul Kotecha

Risk gyrations continue, with a sharp shift back into risk off mood for markets driven in large part by yet more disappointing US economic data as the May ADP jobs report came in far weaker than expected at 38k whilst the ISM manufacturing index dropped to 53.5 in May, its lowest reading since September 2009. This was echoed globally as manufacturing purchasing managers indices (PMI) softened, raising concerns that the global ‘soft patch’ will extend deeper and longer than predicted.

The market mood was further darkened by news that Moodys downgraded Greece’s sovereign credit ratings to Caa1 from B1, putting the country on par with Cuba and effectively predicting a 50% probability of default.

The resultant jump in risk aversion was pretty extensive, with US Treasury yields dipping further, commodity prices dropping led by soft commodities, and equity volatility spiking although notably implied currency volatility has remained relatively well behaved.

Global growth worries led by the US have now surpassed Greek and eurozone peripheral country concerns as the main driver of risk aversion, especially as it increasingly looks as though agreement on a further bailout package for Greece is moving closer to being achieved. Moreover, it seems as though a ‘Vienna initiative’ type of plan is moving towards fruition involving a voluntary rollover of debt.

The lack of first tier economic data releases today suggests that it will be a case of further digestion or perhaps indigestion of the weak run of US data releases over recent weeks and the implications for policy. For instance, it is no coincidence that QE3 is now being talked about again following the end of QE2 although it still seems very unlikely.

Bonds may see some respite from the recent rally given the lack of data today although this may prove short-lived as expectations for the May US jobs report tomorrow are likely to have been revised sharply lower in the wake of the weak ADP jobs data and ISM survey yesterday, with an outcome sub 100k now likely for May US non-farm payrolls.

Meanwhile, FX markets are caught between the conflicting forces of higher risk aversion and weaker US data, leaving ranges to dominate. On balance, risk currencies will likely remain under pressure today and the USD may get a semblance of support in the current environment.

This may be sufficient to prevent EUR/USD from retesting its 1 June high around 1.4459 as markets wait for further developments on the Greek front. Once again the likes of the CHF and to a lesser extent JPY will do well in a risk off environment whilst the likes of the AUD and NZD will suffer.

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Euro Resilience To Fade

May 31, 2011 — Mitul Kotecha

There will at least be a little more liquidity in FX markets today following yesterday’s public holidays in the US and UK. Whether this means that there will be a break out of recent ranges is another matter. Clearly global growth worries as well as eurozone peripheral debt concerns are having an important impact on market dynamics but are also providing conflicting signals.

On the one hand the USD ought to garner support from Europe’s problems but on the other, safe haven demand and growth concerns is bolstering demand for US Treasuries keeping US bond yields at very low levels despite the lack of progress on increasing the US debt ceiling and agreeing on medium to long term deficit reduction.

In the wake of a run of US data disappointments including April durable goods orders, Q1 GDP and weekly jobless claims last week, fears of a loss of momentum in the US economy have intensified. Manufacturing and consumer confidence surveys in the form of the May Chicago PMI and Conference Board consumer confidence survey today will be closely scrutinised to determine whether the ‘soft patch’ in the US economy will persist.

This will have important implications for the USD as worries about growth may feed into expectations that the Fed’s ultra loose monetary policy will be sustained for longer. As it is US 2-year bond yields have dropped to their lowest level this year.

Fortunately for the USD only USD/JPY and USD/CHF have maintained a statistically strong correlation with bond yield differentials although we expect the break in relationship for other currencies to prove temporary. In the case of USD/JPY, yield differentials have narrowed between the US and Japan, a factor playing for JPY appreciation.

Perhaps the fact that unlike the US Japanese data has on balance been beating expectations notwithstanding disappointing April household spending and industrial output data has helped to narrow the yield gap with the US. One explanation is that that worst fears of post earthquake weakness have not been borne out, suggesting that economic expectations have been overly pessimistic. In any case, USD/JPY 80 is still a major line in the sand for the currency pair.

The EUR continues to show impressive resistance, with EUR/USD breaking technical resistance around 1.4345, which opens up a test of 1.4423. Reports that Greece had failed to meet any of its fiscal targets and of harsh conditions set by European officials for further aid have failed to dent the EUR. Whether the market is simply becoming fatigued or complacent will be important to determine if the EUR can gain further.

A report in the WSJ that Germany is considering dropping its push for early rescheduling of Greek debt has given some support to the EUR too. Ongoing discussions this week are unlikely to prove conclusive however, with attention turning to meetings of European officials on 20th and 24th June. I still believe EUR gains will limited, with the break above 1.4345 likely to prove shortlived.

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Greece’s trials and tribulations

May 30, 2011 — Mitul Kotecha

Two main influences on markets continue to weigh on sentiment. Firstly the trials and tribulations of the eurozone periphery remain centre of attention. The failure of Greek Prime Minister Papandreou to win cross party support for austerity measures at the end of last week highlights the problems Greece is facing both domestically and externally.

Reports that European officials are negotiating tough bailout conditions including major external intervention in terms of tax collection and privatisation suggest that gaining further aid will not be easy. The second weight on market sentiment is global growth concerns, with a string of disappointing data releases over recent weeks leading to an intensification of concerns about the pace of recovery.

Markets will likely remain nervous in this environment and it is difficult to see risk appetite improving to any major degree. This has proven bullish for bond markets, with the tone set to continue this week. Currencies remain in ranges and holidays today in the US and UK will likely result in thin trading. The resilience of the EUR to peripheral concerns has been impressive but at the same time Greek concerns will limit any gains. Meanwhile, gold and precious metals look to remain well supported, with gold’s safe haven bid remaining solid.

USD sentiment has improved sharply according to the latest CFTC IMM report which reveals that net USD short positions have been cut in half over the last two weeks with positioning well above the 3-month average. Conversely net EUR longs continue to shrink as speculative investors off load the currency. The fact that the EUR is not weaker than it is points to the influence of official demand for the currency, especially from Asia.

This week will likely be dominated by ongoing discussions about Greece and given the opposition to austerity measures and potentially strict bailout terms, forging an agreement will not be easy. Reports suggest that around half of Greece’s financing needs until the end of 2013 could be accounted for without new loans via privatisation and changes in terms for private bondholders, with Europe and the IMF needed to lend an additional EUR 30-35 billion on top of the EUR 110 already slated.

Data releases are likely to take a back seat but there will still be plenty of attention on the key release of the week, namely the May US jobs report. The market looks for a 185k increase in payrolls, with the unemployment rate edging lower to 8.9%. This would mark the lowest payrolls reading in 4 months. Clues to the jobs data will be garnered from the May ADP jobs report, ISM manufacturing survey and consumer confidence data earlier in the week.

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Risk on, risk off

May 27, 2011 — Mitul Kotecha

The USD has lost some upward momentum as risk appetite improved but FX markets remain skittish as sentiment gyrates between ‘risk on’ and ‘risk off’. The fact that US Q1 GDP was left unrevised whilst jobless claims surprisingly increased together with ongoing Greece concerns suggests that a risk off mood may filter into markets despite positive US earnings. Although the USD has not particularly benefitted from any rise in risk aversion lately, worries about the next IMF tranche being withheld from Greece will likely play more positively for the USD.

Nonetheless, lurking in the background and helping to keep the USD restrained is the Fed’s ongoing asset purchases as QE2 remains in place until the end of June. Moreover US data disappointments points to risks that the Fed will only slowly embark on its exit strategy. Additionally any agreement towards extending the US debt ceiling appears to be far off, and threatens to go down to the wire all the way to August 2. US debt markets and the USD appear to be downplaying this issue at present but it remains a clear threat to US markets.

Continuing to limit any upside in the EUR is the fact that officials and markets continue to gyrate on whether Greece will or will not restructure its debt. Apparent divisions between the view of some officials and the ECB are adding to the confusion whilst fresh worries about the IMF withholding funding for Greece will likely keep EUR/USD capped.

Peripheral worries as well as growth concerns are clearly weighing on confidence and a broad based decline in economic and business confidence in various eurozone May measures is expected to be revealed in data today . Weaker data taken together with ongoing concerns about the eurozone periphery will likely see the EUR struggle, with the currency set to settle into a range versus USD over the short-term, with technical support around 1.3968 and resistance at 1.4210.

The loss of USD momentum has also been exhibited in USD/JPY which has turned lower following its recent upward move hitting a low around 81.09. The big news was the fact that April nationwide core CPI recorded its first YoY increase since December 2008. At the margin may reduce the pressure on the Bank of Japan (BoJ) to enact more aggressive policy measures, which in turn is positive for the JPY. A big factor contributing to keeping the JPY supported over recent weeks is the ongoing inflow of foreign capital into Japan’s bond and equity markets, with Japan recording six straight weeks of net inflows.

USD/JPY is one currency pair where the correlation with US – Japan 2-year bond yield differentials is holding up well over the past 3-months. The fact that the yield differential has dropped to its lowest level since November 2010 at around 30bps reveals the declining US yield advantage, and plays for a lower USD/JPY. Against this background the JPY is likely to remain supported in the short-term, but will find it tough to break through technical support around USD/JPY 80.15.

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