Global Themes

February 11, 2011 — Mitul Kotecha

It’s definitely been a strange start to the year, with markets taking plenty of time to get their bearings. Some general themes have developed but none have provided clear direction. As a result, the path over coming weeks and months is likely to remain highly volatile and in this respect, currencies, equities and bonds will continue to see strong gyrations.

One theme that has been evident since the start of the year is an improvement in sentiment towards the eurozone periphery as hopes of an enlargement/extension of the European Union bailout fund (EFSF) have increased. This is a key reason why the EUR has strengthened this year although nervousness on this front appears to have returned over recent days (note the recent widening in peripheral bond spreads, drop in EUR and European Central Bank purchases of Portuguese debt). It seems that a lot of good news has already been discounted in relation to the eurozone periphery and now markets are in wait and see mode for the EU Council meeting on 24/25 March. There is a strong chance that eventually market expectations will prove overly optimistic and the EUR will drop but more on that later.

The second theme is global inflation concerns, driven by higher food and energy prices. Certainly this has had an impact on interest rate expectations and in some cases resulted in a hawkish shift in central bank language, notably in the eurozone and UK. Although European Central Bank (ECB) President Trichet has toned down his comments on tighter monetary policy compared to the more hawkish rhetoric following the last ECB council meeting, expectations for monetary tightening in the eurozone still look overly hawkish, with a policy rate hike currently being priced in for August/September this year, which looks way too early. The EUR has benefitted from the relative tightening in eurozone interest rate expectations compare to the US but will suffer if and when such expectations are wound down.

Elsewhere in many emerging markets the impact of higher food prices is finding its way even more quickly into higher inflation, forcing central banks to tighten policy. In Asia, the urgency for higher rates is even more significant given that real interest rates (taking into account inflation) are negative in many countries. China has accelerated the pace of its rate hikes over recent months and looks set to continue to tighten policy much further to combat inflation. In India, worries about inflation and the need for further monetary tightening have clearly weighed on equity markets, with more pain to come. Although not the sole cause by any means, in the Middle East and Africa higher food prices are feeding social tensions such as in Egypt.

Another clear theme that has developed is the improvement in US economic conditions. The run of US data over recent months has been encouraging, confirming that the economy is gaining momentum. Even the disappointing January non-farm payrolls report has not dashed hopes of recovery, with many other job market indicators pointing to strengthening job conditions such as the declining trend in weekly US jobless claims. Manufacturing, business and consumer confidence measures have strengthened whilst credit conditions are easing, albeit gradually. The US economy is set to outperform many other major economies this year, especially the eurozone, which will be beset with a diverging growth outlook between northern and southern Europe.

Although the US dollar has not yet benefitted from stronger US growth given the still dovish tone of the Fed and ongoing asset purchases in the form of quantitative easing, the rise in US bond yields relative to other countries, will likely propel the dollar higher over 2011 after a rocky start over Q1 2011. In contrast, the EUR at current levels looks too strong and as noted above, hopes of a resolution of eurozone peripheral problems look overdone. EUR/USD levels above 1.3500 provide attractive levels to short the currency. Other growth currencies that will likely continue to do well are commodity currencies such as AUD, NZD and CAD, whilst the outlook for Asian currencies remains positive even despite recent large scale capital outflows. The JPY however, will be one currency that suffers from an adverse yield differential with the US as US bond yields rise relative to Japan.

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Upside risks to US payrolls

January 6, 2011 — Mitul Kotecha

An encouraging run of US data releases over recent weeks became even more solid overnight. In particular the December ADP private sector jobs report revealed a whopping 297k increase, its highest ever reading. Although the outsized gain may be attributable to distortions such as seasonal factors it will lead many to scramble to revise higher estimates for non-farm payrolls to around 200k+ (consensus currently is 150k). Similarly the December ISM non-manufacturing survey came in higher than expected at 57.1, its highest reading since May 2006. Notably the employment component softened in contrast to the ADP data.

Whilst the US outlook appears to be improving the eurozone picture is looking decidedly shaky. Peripheral bonds remain under pressure as reflected in the renewed widening in German-Greek spreads whilst Portugal’s sale of 6m bills revealed good demand but at a much higher yield (3.69% vs. 2.05% in September). Press reports that the Swiss National Bank has stopped accepting Irish government debt as collateral didn’t help matters whilst talk of conditions attached to any Chinese support for eurozone countries also weighed on sentiment.

Adding to concerns is the ongoing political impasse in Belgium where 7 months after elections there has yet to be a new government formed. The risk of a downgrade to the country’s credit ratings is high especially given the lack of progress on deficit reduction. Meanwhile on the data front the Eurozone service sector PMI was stronger than forecast in December at 54.2 but the country breakdown revealed more divergence in economic conditions. This was echoed in the manufacturing PMI. Divergence in growth is likely to widen further this year and whilst the strength of Germany may prevent a sharp slowing in overall growth in the eurozone, growing divergence will make the job of the ECB difficult.

The net result of firmer US data is a broadly stronger USD and higher Treasury yields. The EUR in contrast looks as though it is on the verge of a sharper decline below 1.3000, with technical support seen around 1.2969 whilst the JPY could see further weakness given the move in relative US/Japan bond yields. There will be little direction today from data with just Eurozone sentiment gauges and retail sales tap whilst in the US jobless claims will be in focus. However, there will probably be little movement ahead of the US jobs report tomorrow.

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Risk on mood prevails

December 23, 2010 — Mitul Kotecha

The end of the year looks as though it will finish in a firmly risk on mood. Equity volatility in the form of the VIX index at its lowest since July 2007. FX volatility remains relatively low. A lack of market participants and thinning volumes may explain this but perhaps after a tumultuous year, there is a certain degree of lethargy into year end.

Whether 2011 kicks off in similar mood is debatable given the many and varied worries remaining unresolved, not the least of which is the peripheral sovereign debt concerns in the eurozone. It is no surprise that the one currency still under pressure is the EUR and even talk that China offered to buy Portuguese sovereign bonds has done little to arrest its decline.

Reports of officials bids may give some support to EUR/USD just below 1.31 but the various downgrades to ratings and outlooks from ratings agencies over the past week has soured sentiment for the currency. The latest move came from Fitch ratings agency which placed Greece’s major banks on negative ratings watch following the move to place the country’s ratings on review for a possible downgrade.

The USD proved resilient to weaker than forecast data including a smaller than forecast 5.6% gain in existing home sales in November. The FHFA house price index recorded a surprise gain of 0.7% in October, which mitigated some of the damage. The revised estimate of US Q3 GDP revealed a smaller than expected revision higher to 2.6% QoQ annualized from a previous reading of 2.5%. Moreover, the core PCE was very soft at 0.5% QoQ, supporting the view that the Fed has plenty of room to keep policy very accommodative.

Despite the soft core PCE reading Philadelphia Fed President Plosser who will vote on the FOMC next year indicated that if the economy continues to strengthen he will look for the Fed to cut back on completing the $600 billion quantitative easing (QE) program. Although the tax deal passed by Congress will likely reduce the need for QE3, persistently high unemployment and soft core inflation will likely see the full $600 billion program completed. Today marks the heaviest day for US data this week, with attention turning to November durable goods orders, personal income and spending, jobless claims, final reading of Michigan confidence and November new home sales.

Overall the busy US data slate will likely maintain an encouraging pattern, with healthy gains in income and spending, a rebound in new home sales and the final reading of Michigan confidence likely to hold its gains in December. Meanwhile jobless claims are forecast to match the 420k reading last week, which should see the 4-week average around the 425k mark. This will be around the lowest since August 2008, signifying ongoing improvement in payrolls. The data should maintain the upward pressure on US bond yields, which in turn will keep the USD supported.

Please note that this will be the last post on Econometer.org this year. Seasons greatings and best wishes for the new year to all Econometer readers.

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Irish bailout leaves EUR unimpressed

November 29, 2010 — Mitul Kotecha

As has been the case since the beginning of the global financial crisis policy makers have found themselves under pressure to deliver a solution to a potentially destabilising or even systemic risk before the markets open for a new week in order to prevent wider contagion. Last night was no different and following urgent discussions a EUR 85 billion bailout for Ireland to be drawn down over a period of 7 ½ years was agreed whilst moves towards a permanent crisis mechanism were brought forward. As was evident over a week ago a bailout was inevitable but the terms were the main imponderable.

Importantly the financing rate for the package is lower than feared (speculation centered on a rate of 6.7%) but still relatively high at 5.8%. Moreover, no haircuts are required for holders of senior debt of Irish banks and Germany’s call for bondholders to bear the brunt of losses in future crises was watered down. The package will be composed of EUR 45 bn from European governments, EUR 22.5 bn from the IMF and EUR 17.5 bn from Ireland’s cash reserve and national pension fund.

The impact on the EUR was stark, with the currency swinging in a 120 point range and failing to hold its initial rally following the announcement. A break below the 200-day moving average for EUR/USD around 1.3131 will trigger a drop to around 1.3020 technical support. Officials will hope that the bailout offers the currency some deeper support but this already seems to be wishful thinking. The EUR reaction following the Greek bailout in early May does not offer an encouraging comparison; after an initial rally the EUR lost close to 10% of its value over the following few weeks.

Although it should be noted that the bailout appears more generous than initially expected clearly the lack of follow through in terms of EUR upside will come as a blow. The aid package has bought Ireland some breathing space but this could be short lived if Ireland’s budget on December 7 is not passed. Moreover, the bailout will not quell expectations that Portugal and perhaps even Spain will require assistance. Indeed, Portugal is the next focus and the reaction to an auction of 12-month bills on 1 December will be of particular interest.

Taken together with continued tensions on the Korean peninsular, position closing towards year end ongoing Eurozone concerns will likely see a further withdrawal from risk trades over coming weeks. For Asian currencies this spells more weakness and similarly commodity currencies such as AUD and NZD also are likely to face more pressure. The USD remains a net beneficiary even as the Fed continues to print more USDs in the form of QE2.

Data and events this week have the potential to change the markets perspective, especially the US November jobs report at the end of the week. There is no doubt that payrolls are on an improving trend (145k consensus) in line with the declining trend in jobless claims but unfortunately the unemployment rate is set to remain stubbornly high at 9.6% and this will be the bigger focus for the Fed and markets as it implies not let up in QE. As usual further clues to the payrolls will be garnered from the ADP jobs report and ISM data on Wednesday.

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Temporary relief for US Dollar

October 15, 2010 — Mitul Kotecha

Downbeat US economic news in the form of a widening US trade deficit, increase in jobless claims and bigger than expected increase in top line PPI inflation contrasted with upbeat earnings from Google. Google shares surged over 9% in after hours trading but US data tarnished the risk on mood of markets, leaving commodity prices and equities lower and the USD firmer. Higher US Treasury yields, especially in the longer end following a poor 30 year auction, helped the USD to push higher.

The USD’s trend is undoubtedly lower but profit taking may be the order of the day ahead of a speech by Fed Chairman Bernanke on monetary policy later today and the release of the highly anticipated US Treasury Report in which China may be named as a currency manipulator. A speech by the Minneapolis Fed’s Kocherlatoka (non voter) this morning sounded downbeat, even suggesting that “Fed asset purchases may have a muted effect”. Despite such comments the Fed appears likely to embark on QE2 at its 3 November meeting.

Today is also a key data for US data releases with September data on US retail sales, and CPI and October data on Michigan confidence and Empire manufacturing scheduled for release. Retail sales are likely to look reasonable, with headline sales expected to rise 0.5% and ex-autos sales expected up 0.4%. The gauges of both manufacturing and consumer confidence are also likely to show some recovery whilst inflation pressures will remain benign. Given the uncertainty about the magnitude of QE the Fed will undertake in November, the CPI data will have added importance.

The US trade will likely have resulted in an intensification of expectations that China will be labelled as a currency manipulator in the US Treasury report later today. The August trade deficit with China widened $28.04 billion, the largest on record. At the least it will give further ammunition to the US Congress who are spoiling for a fight ahead of mid-term congressional elections, whilst heightening tensions ahead of the November G20 meeting.

Indeed currency frictions continue to increase although “currency war” seems to be an extreme label for it. Nonetheless, Singapore’s move yesterday to widen the SGD band highlighted the pressure that many central banks in the region are coming under to combat local currency strength. Singapore’s move may be a monetary tightening but it is also a tacit recognition of the costs of intervening to weaken or at least limit the strength of currencies in the region. To have maintained the previous band would have required ongoing and aggressive FX intervention which has its own costs in terms of sterilization.

This problem will remain as long as the USD remains weak and this in turn will depend on US QE policy and bond yields. A lot of negativity is priced into the USD and market positioning has become quite extreme suggesting that it will not all be a downhill bet for the currency. Many currencies breached or came close to testing key psychological and technical levels yesterday, with EUR/USD breaching 1.4000, GBP/USD breaking 1.6000, USD/CAD breaking below parity and AUD/USD coming close to testing parity. Some reversal is likely today, but any relief for the USD is likely to prove temporary.

Posted in Australia, central banks, Commodities, Currencies, Economics, Economy, equity markets, Federal Reserve, FX, Interest rates, Monetary Policy, Singapore, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , , , . Leave a Comment »
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