Equity flows to Asia surge

Equity flows to Asia have begun the year in solid form. Although not quite as strong as in 2010 the pace of recent acceleration in flows has been more rapid, suggesting that it will soon overtake the year to date inflows seen over 2010. In total Asia has registered around $4.955 billion in foreign equity inflows. Korea has received the biggest inflows at $2.4 billion followed by India $1.04bn and Taiwan $1.03 billion.

The Indian rupee (INR) has been a clear beneficiary of such flows while the Korean won (KRW) has also strengthened. I suspect that official resistance may have limited Taiwan dollar (TWD) gains but clearly the risk on start to the year has resulted in strengthening inflows and in turn stronger Asian currencies.

Unless there is a disaster in Greece or elsewhere in Europe next week there is little to stop the short term trend but I remain wary over coming weeks and am cautious about extrapolating this trend forward. Like in 2010 and 2011 equity flows began the year strongly only to drop over following weeks and currencies were not slow to follow.

Beware of EUR short covering

Europe has plenty of events to focus on over the next couple of days including the European Central Bank (ECB) Council meeting, and debt auctions in Spain and Italy. While I am by no means a EUR bull the risk is skewed towards some short term recovery or at least stabilization around EUR/USD 1.28. The speculative market is extremely short EUR while policy makers, specifically German Chancellor Merkel and French President Sarkozy are making the right noises. it appears to have finally dawned on Eurozone officials that its not just about austerity but also about growth and reform.

News that Fitch ratings is unlikely to downgrade France’s ratings this year has provided a boost to Eurozone confidence. Greece could yet spoil the party given the ongoing discussion with the Troika (Euuropean Commission, International Monetary Fund and ECB) to finalise the second bailout package for the country. Opposition resistance within Greece suggests that more austerity may not be easy to implement. Meanwhile there are ongoing questions about the extent of writedowns that Greek debt will undergo. Despite these issues it appears that markets are becoming somewhat more immune to events in the Eurozone. While still high bond yields for Italy and other debt still point to ongoing trouble, risk appetite has firmed.

One factor that is helping to boost sentiment is the encouraging news out of the US. Although the Q4 earnings season has not began particularly well data releases look somewhat more positive. Not only has positive impact of last week’s US December jobs report continued to filter through the market but so has other news such as a pick up in small business confidence and a rise in consumer credit. These lesser watched data highlight the gradual recovery process underway in the US and the growing divergence with the Eurozone economy and support the view of medium term USD outperformance versus EUR.

Extreme Uncertainty

The level of uncertainty enveloping global markets has reached an extreme level. Who would have thought that close to 13 years after its introduction at a time when it has become the second largest reserve currency globally (26.7% of global reserves) as well as the second most traded currency in the world, European leaders would be openly talking about allowing countries to exit the EUR? No less an issue for currency markets is the sustainability of the USD’s role as the foremost reserve currency (60.2% of global reserves). The US debt ceiling debacle and the dramatic expansion of the Fed’s balance sheet have led to many official reserve holders to question their use of the USD. Perhaps unsurprisingly the JPY has been the main beneficiary of such concerns especially as global risk aversion has increased but to the Japanese much of this attention is unwanted and unwelcome.

The immediate focus is the travails of the eurozone periphery. Against the background of severe debt tensions and political uncertainties it is perhaps surprising that the EUR has held up reasonably well. However, this resilience is related more to concerns about the long term viability of the USD rather than a positive view of the EUR, as many official investors continue to diversify away from the USD. I question whether the EUR’s resilience can be sustained given that it may be a long while before the situation in the eurozone stabilises. Moreover, given the now not insignificant risk of one or more countries leaving the eurozone the long term viability of the EUR may also come into question. I believe a break up of the eurozone remains unlikely but such speculation will not be quelled until markets are satisfied that a safety net / firewall for the eurozone periphery is safely in place.

In this environment fundamentals count for little and risk counts for all. If anything, market tensions have intensified and worries about the eurozone have increased since last month. Politics remain at the forefront of market turmoil, and arguably this has led to the worsening in the crisis as lack of agreement between eurozone leaders has led to watered down solutions. Recent changes in leadership in Italy and Greece follow on from government changes in Portugal and Ireland while Spain is widely expected to emerge with a new government following elections. Meanwhile Chancellor Merkel has had to tread a fine line given opposition from within her own coalition in Germany while in France President Sarkozy is expected to have a tough time in elections in April next year. The likelihood of persistent political tensions for months ahead suggests that the EUR and risk currencies will suffer for a while longer.

Data releases in focus

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).

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.

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