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.

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Contagion spreading like wildfire

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.

Contrasting US and European data

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.

Risk appetite remains fragile

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.

Euro looking rich at current levels

Markets continue to be rumour driven with little concrete news to provide direction. The news that a comprehensive deal by European officials at this Sunday’s EU Summit is now very unlikely has come as a further blow to hopes of a swift resolution to the crisis.

So it seems that Sunday’s meeting will provide a forum to thrash out ideas before a second summit next Wednesday. As a reminder the issues at hand are leveraging the EFSF, banking sector recapitalisation and the extent of private sector participation in Greek debt write downs.

The main disagreement appears to be between Germany and France on method of additional funding the EFSF bailout fund (which has EUR 280billion of firepower left), with Germany and the European Central Bank (ECB) opposed to French demands to utilise the ECB to help back the EFSF with France wanting the facility being turned in a bank. In terms of write downs for Greek bond holders there is a push for at least a 50% reduction compared to the 21% agreed in July.

Separately speculation of the amount of new capital needed for banking sector recapitalisation now revolves around a figure of EUR 80 billion. One spanner in the works is that Chancellor Merkel will have to gain approval from the German parliament before agreeing on further changes to the EFSF, which may delay the process further.

Clearly as this week has gone on the air has continued to seep out of the balloon as the market braces for disappointment. Surprisingly the EUR has held up well and while it has failed to extend gains, hitting a high earlier in the week around 1.3915 but still pricing in some scope for success, at current levels.

Helping the EUR was the fact that the market was very short, and while it could still move higher next week if European officials agree on a plan it still looks like a sell on rallies, with the scope for further gains limited from current rich levels. Good news from Europe next week could see a test of EUR/USD 1.40 but this will prove to be a good selling area further out.

At least there was some good news from Greece for a change as the Prime Minister won a vote to pass further austerity measures to help secure the next tranche (delayed from September) of the bailout despite ongoing protests in the country. The near term focus will be on a meeting of Finance Ministers today ahead of Sunday’s summit.

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