Fade gains in the euro

The USD’s drop over recent days has almost wiped out half its rally since October 17. Only the JPY has lost ground over this period. More modest weakness is in prospect for the USD in the short term although I do not look for the currency to drop sharply. Given their strong correlations with the USD index any decline will bode well for EUR, GBP, SEK, CHF, CAD and several emerging market currencies.

Most commentators are ascribing USD weakness to the improving risk appetite but the USD index has maintained a low sensitivity to my risk aversion barometer, suggesting that the relationship is tenuous at present. The reality is that there is probably a bout a profit taking rather than any major shift in USD sentiment and this is set to continue for the time being.

EUR/USD’s impressive resilience over recent weeks highlights the hurdles to anyone wanting to short the currency. Underling EUR support remains firm as reflected in the recent turnaround in the Eurozone basic balance position (direct investment + portfolio flows + current account) while there may also be an element of FX reserves recycling flows providing support of the EUR.

Additionally the market has been giving Eurozone officials the benefit of the doubt with regard to a Greek debt sustainability solution and the lacklustre reaction of the EUR following the Greek deal this morning highlights that much was already priced in. The deal which effectively lowers interest rates that Greece has to pay on its debt while giving it more time to pay the debt paves the way for a EUR 34.4 billion loan tranche in December.

Finally, the threat of ECB Outright Monetary Transactions (OMT) activation continues to threaten to provide a major back stop to any EUR pressure. At current levels the upside for the EUR looks far less compelling. I suggest taking profits / fading the rally on any test of resistance around EUR/USD 1.3030 and EUR/GBP 0.8120.

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European agreement at last

Following a drawn out period of discussions European officials have finally agreed on a haircut or debt write off of around 50% of Greek debt versus 21% agreed in July. In addition the EFSF bailout fund will be leveraged up to about EUR 1.4 trillion, with the new EFSF scheduled to be in place next month. The haircut for Greek debt is aimed at ensuring that Greece’s debt to GDP ratio drops to 120% by 2012.

The reaction of markets was initially favourable with EUR/USD breaching 1.40 and risk / high beta currencies bouncing. I doubt that the upward momentum in EUR can be sustained, however, with plenty of questions on the mechanics of the deal, especially about leveraging the EFSF fund, remaining. I suspect that the EUR may have already priced in some of the good news.

Data releases, especially in the US are offering markets more positive news. Following on from firm readings for US durable goods orders and new home sales, today’s US Q3 GDP expected to reveal an acceleration in growth to a 2.5% annual rate, will help to alleviate recession fears to some extent. The USD may benefit if the data reduces expectations of further Fed quantitative easing especially given the recent comments from some Fed officials indicating that the door is open to more QE.

In Japan attention was firmly fixed on the Bank of Japan policy meeting and the prospects for FX intervention to weaken the JPY. In the event the BoJ kept its overnight rate unchanged at 0.1% as expected and expanded its credit program by JPY 5 trillion and asset purchase fund to JPY 20 trillion.

The measures are aimed to easing deflation pressure but the real focus in the FX market is whether there is any attempt to the weaken the JPY. I am currently in Tokyo and here there is plenty of nervousness about possible FX intervention being imminent. Speculation of such intervention will likely help to prevent USD/JPY sustaining a drop below the 75.00 over coming days.

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.

EU Deal Boosts Euro But Momentum To Fade

The European Union deal for Greece was clearly on the positive side of expectations and from that perspective helped to buoy sentiment for European assets. The fact that EU leaders managed to work over differences and emerge with a solid deal will help remove some of the uncertainty about Greece’s future and lower the risks of contagion.

To recap EU leaders announced a EUR 109 billion second aid package for Greece. Private bondholders will contribute a target of a further EUR 37 billion via bond swaps or rolling over existing debt for new bonds maturing in 30 years. Investors will have the option to exchange existing debt into four instruments. The aim is to obtain 90% participation from Greek bondholders.

Moreover, it appears that governments will guarantee any defaulted Greek debt offered as collateral until the country can return to the market. Effectively this means that even if ratings agencies declare a default rating on Greek debt, Greek banks may still be able to obtain funding from the European Central Bank (ECB) as the debt is guaranteed by national governments.

Greece, Portugal and Ireland will benefit from lower interest rates on loans and longer maturities. Moreover, the European Financial Stability Facility (EFSF) bailout fund will have a wider scope for bond buying directly from investors. This lets the ECB off the hook to avoid further use of its own bond purchase programme and removes any further impairing of its balance sheet. The idea of a tax on banks was removed, as criticism of the workability of such a plan increased.

The downside of the deal includes the fact that:
1) European tax payers are on the line for a potentially unlimited amount to guarantee defaulted Greek debt,
2) The bondholder programme is only limited to Greece, so there is no contingency should something similar be needed in other countries
3) The participation rate for private bondholders is yet to be known (but will most likely be high).
3) The deal will lead to a default on Greek debt given the programme amounts to a 21% drop in value but a credit event is unlikely to be triggered.
4) Greece still has a highly ambitious privatisation and austerity plan to implement which even some Greek officials have admitted is overly optimistic and at worst could turn into a fire sale of Greek assets.
5) EFSF bond purchases will need the “mutual agreement” of member states which is by no means guaranteed.
6) The fund size is not large enough should Italy and Spain need similar bailouts especially as leaders have stressed that the Greek package will not be replicated for other countries.

The EUR rallied on the outcome of the European talks. However, the EUR has plenty of other worries to deal with including divergence in growth across the eurozone, overly long EUR market positioning, EUR overvaluation, likely growth underperformance versus the US and a likely rebound in general for the USD over coming months especially if the Fed does not embark on QE3 and agrees a deal to raise the debt ceiling. EUR/USD is likely to remain supported in the near term, with near term resistance around 1.4467. I still suspect that the momentum will not last, with EUR/USD looking particularly rich at current levels.

Euro crisis intensifies

The blowout in eurozone non-core debt has intensified and unlike in past months the EUR has been a clear casualty. The lack of a concrete agreement over a solution given divergent views of EU officials, the European Central Bank (ECB) and private sector participants threatens a further ratcheting higher of pressure on markets over coming weeks.

The only real progress overnight as revealed in the Eurogroup statement appeared to be in the renewing the option of buying back Greek debt via the eurozone bailout fund, extending maturities and lowering interest rates on loans. This will be insufficient to stem the pressure on the EUR, with the currency verging on a sharp drop below 1.40.

The USD continues to take advantage of the EUR’s woes and has actually staged a break above its 100-day moving average yesterday after several attempts previously. This sends a bullish signal and the USD is set to remain supported given that there is little in sight of a resolution to the problems festering in the eurozone.

Today’s release of the June 22 Fed FOMC minutes will give some clues to Fed Chairman Bernanke’s testimony to the House of Representatives tomorrow, but as long as the minutes do not indicate a greater willingness to embark on more asset purchases, the USD is set to remain resilient.

GBP has also benefitted from the EUR’s weakness, and unlike the EUR has only drifted rather than dived versus the USD. However, the UK economy is not without its own problems as revealed in a further drop in retail sales overnight, albeit less negative than feared, with the British Retail Consortium (BRC) like for like sales falling 0.6% in June.

A likely increase in June CPI inflation in data today to a 4.8% annual rate will once again highlight the dichotomy between weak growth and high inflation. In turn, such data will only provoke further divisions within the Bank of England MPC. While further gains against the beleaguered EUR are likely, with a test of EUR/GBP 0.8721 on the cards in the short term, GBP will struggle to sustain any gain above 1.6000 versus USD.

Both AUD and NZD are vulnerable against the background of rising risk aversion and a firmer USD in general. However, both currencies are not particularly sensitive to risk aversion. Interestingly the major currency most sensitive to higher risk aversion in the past 3-months is the CAD and in this respect it may be worth considering playing relative CAD underperformance versus other currencies.

As for the AUD it is more sensitive to general USD strength, suggesting that it will be restrained over coming sessions too and given that market positioning is still very long AUD, there is scope for further downside pressure to around 1.0520 versus USD.

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