The Week Ahead

September 20, 2010 — Mitul Kotecha

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.

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Split personality

August 25, 2010 — Mitul Kotecha

Markets are exhibiting a Strange Case of Dr Jekyll and Mr Hyde, with a clear case of split personality. Intensifying risk aversion initially provoked USD and JPY strength, with most crosses against these currencies under pressure. Both USD/JPY and EUR/JPY breezed through psychological and technical barriers, with the latter hitting a nine-year low. However, this reversed abruptly in the wake of extremely poor US existing home sales, which plunged 27.2% in July, alongside downward revisions to prior months, a much bigger drop than forecast.

Obviously double-dip fears have increased but how realistic are such fears? Whilst much of the drop in home sales can be attributed to the expiry of tax credits, investors can be forgiven for thinking that renewed housing market weakness may lead the way in fuelling a more generalized US economic downdraft. The slow pace of jobs market improvement highlights that the risks to the consumer are still significant, whilst tight credit and weaker equities, suggests that wealth and income effects remain unsupportive.

FX markets will need to determine whether to buy USDs on higher risk aversion or sell USDs on signs of weaker growth and potential quantitative easing. I suspect the former, with the USD likely to remain firm against most risk currencies. The only positive thing to note in relation to the rise in risk aversion is that it is taking place in an orderly manner, with markets not panicking (yet).

European data in the form of June industrial new orders delivered a pleasant surprise, up 2.5%, but sentiment for European markets was delivered a blow from the downgrade of Ireland’s credit rating to AA- from AA which took place after the close. The data suggests that the momentum of European growth in Q3 may not be as soft as initially feared following the robust Q2 GDP outcome.

Japan has rather more to worry about on the growth front, especially given the weaker starting point as revealed in recently soft Q2 GDP data. Japan revealed a wider than expected trade surplus in July but this was caused by a bigger drop in exports than imports, adding to signs of softening domestic activity. The strength of the JPY is clearly making the job of officials harder but so far there has been no sign of imminent official FX action.

Japan’s finance minister Noda highlighted that recent FX moves have been “one sided” and that “appropriate action will be taken when necessary”. The sharp move in JPY crosses resulted in a jump in JPY volatility, a factor that will result in a greater probability of actual FX intervention but the prospects of intervention are likely to remain limited unless the move in the JPY accelerates. USD/JPY hit a low of 83.60 overnight but has recovered some lost ground, with 83.50 seen as the next key support level. JPY crosses may see some support from market wariness on possible BoJ JPY action, but the overall bias remains downwards versus JPY.

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Two-way FX risk returns

August 18, 2010 — Mitul Kotecha

It appears that there is a bit of a sea change taking place in currency markets. Since early June the trend in currency markets would have looked like a one way bet to most casual observers. For instance, the USD index was declining fairly steadily and predictability as US growth worries intensified and markets anticipated a resumption of quantitative easing by the Fed. This changed quite dramatically over recent days, with a significant degree of two-way risk re-entering the market as the USD shook off worries about Fed quantitative easing and instead rallied in the wake of higher risk aversion.

The introduction of two-way risk into the market will cause a rethink of the increasingly fashionable view that the USD was about to embark on a renewed negative trend. This change in market perspective has coincided with renewed concerns about European sovereign risks, even as European growth has come in much stronger than expected over Q2. Other currencies have also lost ground against the USD more recently, with the notable exception of the JPY which remains close to the psychological level of 85.00.

Until recently the move in FX markets since early June contrasted with my view that Q3 would be a period of uncertainty and volatility. Improved risk appetite reflected a decline in uncertainty but whilst I now believe that Q3 will see less of an increase in risk aversion than previously anticipated, my core views remain unchanged. I see the USD resuming an appreciation trend against the EUR and funding currencies (JPY and CHF) whilst weakening against higher yielding risk currencies (AUD, NZD and CAD) over the medium term.

Although FX markets will likely gyrate between the influences of risk aversion on the one hand and growth/interest rates on the other, risk is likely to take the upper hand over the coming weeks. The influence of risk aversion has jumped sharply over the last few weeks for almost all currencies. As risk appetite was improving as it has done for much of the period since early June, it played negatively for the USD but the recent increase in risk aversion – brought about by renewed growth concerns, sovereign worries in the eurozone, with Ireland in particular coming under scrutiny – has managed to reverse this trend. The one-way bet for investors now appears to be over.

Only time will tell if the EUR’s recent bull run has come to an end but there is sufficient evidence to suggest that plenty of good news has now been priced in and that further upside will be much more difficult to achieve. Even the recently strong growth data in the eurozone has thrown up potential problems including growing divergence as well as the potential for a slowdown over coming quarters. Further strengthening of the EUR will be a particular problem for eurozone growth, especially for exporting countries such as Germany. In any case, even the recent drop in the EUR leaves the currency at an overvalued level and susceptible to further falls. Over the coming weeks a period of consolidation is likely, with the EUR set to take a weaker tone.

The JPY in contrast has shown little sign of weakening and continues to flirt with the key psychological level of 85.00 much to the detriment of the Japanese economy, leading to growing frustration from Japanese officials. Much weaker than expected Q2 GDP data has given even more reason to engineer a weaker JPY but as yet the only intervention has come verbally and even this has not been particularly strong. In the absence of FX intervention, the Japanese authorities may be forced to consider other options such as increasing outright JGB purchases.

Like the EUR and JPY, GBP will find it tough to extend gains against the USD especially given that the doves at the Bank of England will likely remain in the ascendancy as growth moderates. GBP is also less undervalued than it was just a few weeks back suggesting that the argument for GBP strength has weakened. Nonetheless, GBP is likely to outperform against a generally weaker EUR ending 2010 around 0.78.

Similarly, CHF will likely maintain its strength against the EUR in the short term but unlike GBP this will likely give way to weakness and a gradual move higher in EUR/CHF to around 1.37 by year end. An eventual improvement in risk appetite and some relative economic underperformance will undermine the case for holding CHF.

Scandinavian currencies are likely to struggle in the short term due to market nervousness about a US double dip in an environment of elevated risk aversion. Interest rates will also play an important role in driving NOK and SEK as will be the case for most currencies eventually. Divergence in rate views for Norway and Sweden suggests holding a short SEK long NOK position. Overall, with two-way risk now much more evident as many investors return from their summer break the FX market will look far less predictable than it did before they left.

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Quantitative easing and the USD

July 21, 2010 — Mitul Kotecha

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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Pandemonium and Panic

May 7, 2010 — Mitul Kotecha

Pandemonium and panic has spread through markets as Greek and related sovereign fears have intensified. The fears have turned a localized crisis in a small European country into a European and increasingly a global crisis.  This is reminiscent of past crises that started in one country or sector and spread to encompass a wide swathe of the global economy and financial markets such as the Asian crisis in 1997 and the recent financial crisis emanating from US sub-prime mortgages.  

The global financial crisis has morphed from a credit related catastrophe to a sovereign related crisis. The fact that many G20 countries will have to carry out substantial and unprecedented adjustments in their fiscal positions over the coming years means the risks are enormous as Greece is finding out. The IMF estimate that Japan, UK, Ireland, Spain, Greece, and the US have to adjust their primary balances from between 8.8 in the US to 13.4% in Japan. Such a dramatic adjustment never been achieved in modern history.

Equity markets went through some major gyrations on Thursday in the US, leading to a review of “unusual trading activity” by the US Securities and Exchange Commission in the wake of hundreds of billions of USDs of share value wiped off in the market decline at one point with the Dow Jones index recording its biggest ever points fall before recouping some of its losses. Safe haven assets including US Treasuries, USD and gold have jumped following the turmoil in markets whilst risk assets including high equities, high beta currencies including most emerging market currencies, have weakened. Playing safe is the way to go for now, which means long USDs, gold and Treasuries.

There is plenty of expectation that the G7 teleconference call will offer some solace to markets but this line of thought is destined for disappointment. Other than some words of comfort and support for Greece’s austerity measures approved by the Greek government yesterday, other forms of support are unlikely, including intervention to prop up the EUR. The ECB also disappointed and did not live up to market talk that the Bank could embark on buying of European debt and it is highly unlikely that the G7 will do so either. Into next week it looks like another case of sell on rallies for the EUR.   Remember the parity trade, well it’s coming back into play. 

Aside from the turmoil in the market there has been plenty of attention on UK elections. At the time of writing it looks as though the Conservatives will win most seats but fall short of a an overall majority. A hung parliament is not good news for GBP and the currency is likely to suffer after an already sharp fall over the last few days. GBP/USD may find itself back towards the 1.40 level over the short-term as concerns about the ability of the UK to cut its fiscal deficit grow. A warnings by Moody’s on Friday that the “UK can’t postpone fiscal adjustments any longer” highlights the risk to the UK’s credit ratings and to GBP.

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