Risk Aversion to remain elevated

It remains a tumultuous time for markets, gripped by a cacophony of concerns ranging from the lack of resolution to the Eurozone debt crisis to the failure to reach agreement on raising the US debt ceiling and associated deficit reduction plans. Mingled among these is the growing evidence that economic growth is turning out weaker than expected. Meanwhile Europe’s crisis appears to be shifting from bad to worse, as reflected in a shift in attention towards the hitherto untouched Italy although Italian concerns have eased lately.

The release of the EU bank stress test results at the end of last week have not helped, with plenty of criticism about their severity and rigour following the failure of only 8 banks out of the 90 tested. Expectations centred on several more banks failing, with much more capital required than the EUR 2.5 billion shortfall revealed in the tests. Answering to this criticism officials note that there has already been a significant amount of capital raised over recent months by banks, but this will be insufficient to stem the growing disbelief over the results.

Attention is still very much focussed on Greece and reaching agreement on a second bailout for the country, with further discussions at the special EU summit on July 21. The contentious issue remains the extent of private sector participation in any debt restructuring. The decision to enhance the flexibility of the EFSF bailout fund to embark on debt buybacks has not helped. Consequently contagion risks to other countries in the Eurozone periphery are at a heightened state. Despite all of this the EUR has shown a degree of resilience, having failed to sustain its recent drop below 1.40 versus USD.

One explanation for the EUR’s ability to avoid a steeper decline is that the situation on the other side of the pond does not look much better. Hints of QE3 in the US and the impasse between Republicans and Democrats on budget deficit cutting measures tied to any increase in the debt ceiling are limiting the USD’s ability to benefit from Europe’s woes. Moreover, more weak data including a drop in the Empire manufacturing survey and a drop in the Michigan consumer sentiment index to a two-year low, have added to the worries about US recovery prospects.

Against this background risk aversion will remain elevated, supporting the likes of the CHF and JPY while the EUR and USD will continue to fight it out for the winner of the ugliest currency contest. Assuming that a deal will eventually be cobbled together to raise the US debt ceiling (albeit with less ambitious deficit cutting measures than initially hoped for) and that the Fed does not embark on QE3, the EUR will emerge as the most ugly currency, but there will be plenty of volatility in the meantime.

Data and events this week include more US Q2 earnings, June housing starts and existing home sales. While housing data are set to increase, the overall shape of the housing market remains very weak. In Europe, July business and investor surveys will be in focus, with a sharp fall in the German ZEW investor confidence survey likely and a further softening in July purchasing managers indices across the eurozone. The German IFO business confidence survey is also likely to decline in July but will still point to healthy growth in the country. In the UK Bank of England MPC minutes will confirm no bias for policy rate changes with a 7-2 vote likely, while June retail sales are likely to bounce back.

Euro support unwinding

The USD is set to end the year in firm form aided by rising US bond yields. Yesterday’s data supported this trend. The Empire manufacturing survey beat expectations rebounding nearly 22 points in December and industrial production rose 0.4% in November although there was a downward revision to the previous month. This was against the background of soft inflation, with headline and core CPI rising 0.1%, indicating that the Fed will remain committed to its $600 billion program of asset purchases.

EUR/USD dropped below support around 1.3280, weighed down by various pieces of negative news. Moodys downgrade of Spain’s credit ratings outlook dented sentiment but the bigger sell off in EUR followed the move in US bond yields. The prospect of EUR recovery over the short term looks limited. The issue of finding agreement on a permanent debt resolution fund continues to fuel uncertainty and will likely come to a head at the EU summit starting today.

Added to this Ireland’s main opposition party which will likely play a part in forming a new government early next year wants some of the debt burden shared with senior bank debt holders. The good news in Europe was few and far between but at least Ireland’s parliament backed the EU/IMF bailout for the country. Of course the backing could be derailed following elections in January. Perhaps the most surprising aspect of the move in EUR is that it’s not weaker. The next support level for EUR/USD is around 1.3160.

The divergence between the US and Europe on policy is stark, with loose fiscal and monetary policy in the US providing a significant prop to the US economy, whilst the much tighter fiscal stance and less loose monetary policy threatens to result in more pressure on eurozone growth especially against the background of an overvalued EUR. This divergence will manifest itself next year in the form of US growth outperformance and stronger USD vs. EUR.

The resilience of the UK consumer continues to surprise, with the CBI distributive trades survey coming in strong and rising further to +56 in December. The only problem with the survey data is that is has not tracked official data. November retail sales data today will give further clues to the strength of spending heading into Christmas. More worryingly from the Bank of England’s perspective is the fact that inflation continues to rise despite assurances that the increase in inflation is temporary. At the least the likelihood of more quantitative easing QE from the BoE has evaporated though it is still a long way off before interest rates are hiked. In the meantime GBP continues to underperform both EUR and USD though GBP/USD will find strong support around 1.5512.

Upward pressure on US yields and the USD us unlikely be derailed US data releases today. Housing starts are set to bounce back in November, with a 6% gain expected, whilst the trend in jobless claims will likely continue to move lower. The Philly Fed manufacturing survey is set to lose a little momentum reversing some of November’s sharp gain but will still remain at a healthy level.

Edging Towards A Bailout

A confluence of factors have come together to sour market sentiment although there appeared to be some relief, with a soft US inflation reading (core CPI now at 0.6% YoY) and plunge in US October housing starts reinforcing the view that the Fed will remain committed to carry out its full QE2 program, if not more.

However any market relief looks tenuous. Commodity prices remain weak, with the CRB commodities index down 7.4% in just over a week whilst the Baltic Dry Index (a pretty good forward indicator of activity and sentiment) continues to drop, down around 21% since its recent high on 27 October. Moreover, oil prices are also sharply lower. Increasingly the drop in risk assets is taking on the form of a rout and many who were looking for the rally to be sustained into year end are getting their fingers burnt.

Worries about eurozone peripheral countries debt problems remains the main cause of market angst, with plenty of attention on whether Ireland accepts a bailout rumoured to be up EUR 100 billion. Unfortunately Ireland’s reluctance to accept assistance has turned into a wider problem across the eurozone with debt in Portugal, Greece and also Spain suffering. An Irish bailout increasingly has the sense of inevitability about it. When it happens it may offer some short term relief to eurozone markets but Ireland will hardly be inspired by the fact that Greece’s bailout has had little sustainable impact on its debt markets.

Ireland remains the primary focus with discussions being enlarged to include the IMF a well as ECB and EU. What appears to be becoming clearer is that any agreement is likely to involve some form of bank restructuring, with the IMF likely to go over bank’s books during its visit. Irish banks have increasingly relied on ECB funding and a bailout would help reduce this reliance. Notably the UK which didn’t contribute to Greece’s aid package has said that it will back support for Ireland, a likely reaction to potential spillover to UK banks should the Irish situation spiral out of control. Any bailout will likely arrive quite quickly once agreed.

Although accepting a bailout may give Ireland some breathing room its and other peripheral county problems will be far from over. Uncertainties about the cost of recapitalising Ireland’s bank will remain whilst there remains no guarantee that the country’s budget on December 7 (or earlier if speculation proves correct) will be passed. Should Ireland agree to a bailout if may provide the EUR will some temporary relief but FX markets are likely to battle between attention on Fed QE2 and renewed concerns about the eurozone periphery, suggesting some volatile price action in the days and weeks ahead.

Reports of food price controls of and other measures to limit hot money inflows into China as well as prospects for further Chinese monetary tightening, are attacking sentiment from another angle. China’s markets have been hit hard over against the background of such worries, with the Shanghai Composite down around 10% over the past week whilst the impact is also being felt in many China sensitive markets across Asia as well as Australia. For instance the Hang Seng index is down around 7% since its 8 November high.

The Week Ahead

Equity markets and risk trades have generally performed well over the last couple of weeks, with for example the S&P 500 around 7.5% higher since its late August low, whilst equity and currency volatility have been generally low, the latter despite some hefty FX intervention by the Japanese authorities which did provoke a spike in USD/JPY volatility last week.

Risk appetite took a knock at the end of last week in the wake of worries that Ireland may seek EU / IMF assistance although this was denied by Irish officials. A similar worry inflicted Portugal, and as a result peripheral bond spreads were hit. Sovereign worries in Europe have not faded quickly and bond auctions in Greece, Spain and Portugal will garner plenty of attention this week. Renewed worries ahead of the auctions suggest that the market reception could be difficult.

Attention will swiftly turn to the outcome of the Fed FOMC meeting tomorrow and in particular at any shift in Fed stance towards additional quantitative easing following the decision at the August FOMC meeting to maintain the size of the Fed’s balance sheet. Given the recent improvement in US economic data the Fed is set to assess incoming data before deciding if further measures are needed.

Housing data in the US will also garner plenty of attention, with several releases scheduled this week. Increases in August housing starts, building permits, existing and new home sales are also expected. Whilst this may give the impression of housing market improvement, for the most part the gains will follow sharp declines previously, with overall housing market activity remaining weak following the expiry of the government tax credit.

Weakness in house prices taken together with a drop in equity markets over the quarter contributed to a $1.5 trillion drop in US household net wealth in Q2. Wealth had been recovering after its decline from Q2 2007 but renewed weakness over the last quarter will not bode well for consumer spending. Household wealth is around $12.4 trillion lower than its peak at the end of Q2 2007.

Aside from the impact of renewed sovereign concerns, European data will not give the EUR much assistance this week either, with Eurozone September flash PMIs and the German IFO survey of business confidence set to weaken as business and manufacturing confidence comes off the boil. If the Fed maintains its policy stance whilst risk aversion increases over coming days the USD may find itself in a firmer position to recoup some of its losses both against the EUR and other currencies.

This will leave EUR/USD vulnerable to drop back down to around support in 1.2955 in the very short-term. As indicated by the CTFC IMM data there has been further short EUR position covering last week whilst sentiment for the USD deteriorated, suggesting increased room for short-USD covering in the event of higher risk aversion.

The impact of Sweden’s election outcome over the weekend is unlikely to do much damage to the SEK despite the fact that the coalition government failed to gain an outright majority. EUR/SEK has edged higher over recent days from its low around 9.1528 but SEK selling pressure is unlikely to intensify following the election, with EUR/SEK 9.3070 providing tough technical resistance.

Quantitative easing and the USD

US earnings are coming in ahead of expectations, with Q2 income at the 42 S&P 500 companies reporting so far beating estimates by 11% whilst revenues are 3.3% ahead of forecasts, according to Bloomberg. The overall tone to equities looks positive helped by expectations of an agreement by BP to sell some of its assets and strong earnings reported by Apple after the close of US trade.

Market sentiment was also boosted by speculation that the Fed will embark on fresh monetary stimulus measures. Although there has been no indication that Fed Chairman Bernanke will announce such measures at his semi-annual testimony to the Senate today and to the House tomorrow, speculation of Fed action is rife and there is likely to be some questioning of Bernanke on the issue in the Q&A. If in any way quantitative easing is hinted at by Bernanke, it will act to undermine the USD.

US economic data is helping to compound expectations of further quantitative easing, with yet another weaker than forecast release in the form of a 5.0% drop in June housing starts as hinted at by the bigger than expected drop in homebuilders confidence on the previous day. Separately ABC consumer confidence declined more than expected in the week to July 18, its third consecutive weekly decline, supporting the evidence that consumer confidence is deteriorating once again.

In the absence of major data releases Bernanke’s testimony will be the main driver for markets but earnings from Coca-Cola and Morgan Stanley will also be of interest. Elsewhere the minutes of the Bank of England’s July MPC meeting will be under scrutiny. MPC member Sentance is expected to have voted for a rate hike at the meeting, but any sign that other members joined him, will give GBP a lift. Sentiment for European assets continues to improve, with Greece concluding a well received T-bill auction and Ireland auctioning EUR 1.5bn in 6 and 10-year bonds. Both were heavily oversubscribed although concerns over Hungary continue to linger.

There continue to be various leaks about the European bank stress tests. Banks are expected to detail three scenarios in the results including estimated Tier 1 capital ratios under a benchmark for 2011, an adverse scenario and finally, a “sovereign shock”, according to a document from the Committee of European banking Supervisors. Importantly and perhaps a factor that could hit the credibility of the tests, the sovereign shock scenario is said to not include a scenario of default on sovereign debt.

I continue to see downside risk for the EUR in the wake of the test results, with a “buy on rumour, sell on fact” reaction likely. EUR/USD is vulnerable to a short-term drop to technical support around 1.2763 but much depends on Bernanke’s speech today. Leaks, suggest that around 10-20 banks could fail the bank stress tests, with a total funding requirement in the region of EUR 70-90 billion. Confirmation will have to wait for the official release on Friday ahead of which most currencies are likely to remain range-bound.

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