Edging away from the cliff

Risk appetite was decidedly firmer overnight as hopes of a US budget deal grew. Talks between President Obama and Congressional leaders have been labelled as ‘constructive’ implying some sign of compromise although there is a long way to go before a deal is likely. Sentiment was boosted further by encouraging housing news out the US, with home builders’ confidence and existing home sales beating expectations. Unfortunately housing starts data today will not be as upbeat.

News that France’s credit ratings were cut by Moody’s dampened the mood, ahead of a meeting by Eurozone officials to decide on the fate of Greece’s EUR 31.5 billion loan tranche. The French downgrade may cast a shadow over markets this morning but hopes of progress towards a solution to the fiscal cliff will keep markets buoyed.

Data releases in the Eurozone will do little to help the EUR given expectations of weak purchasing managers’ indices and a yet another drop in the German IFO business confidence survey over coming days. News on the Greek front might be a little better if the country’s loan tranche is approved today. However, any boost to EUR sentiment will be short lived as discussions about Greece’s sustainability and disagreements among its creditors hog the limelight.

My quantitative models suggest little directional bias, with EUR/USD close to its short term fair value. While all of this suggests that the EUR will fail to find much momentum its worth highlighting that EUR short speculative positioning is at its highest since 11 September and a great deal of bad news is already priced in.

While the Bank of Japan is set to deliver more easing over coming months today’s meeting will likely mark a pause in policy. I do not expect any surprises from the Bank of Japan today but the JPY remains on the back foot in the wake of calls for “unlimited easing” by the opposition LDP party. However, the outcome of elections is by no means clear cut and although the LDP will likely garner the lion’s share of the vote its policies may be constrained by coalition partners.

I remain cautious of calling the JPY higher from current levels, especially given that USD/JPY will be undermined somewhat by the drop in US bond yields. Moreover, my quantitative model shows a sell signal for USD/JPY. Technical resistance around 87.78 will likely cap any up move in the currency in the neat term.

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USD in a lose-lose situation, AUD caution

News that Moody’s Investor service cut the debt ratings on six European countries while revising its outlook on the UK’s and France’s AAA rating to “negative” dampened sentiment for the EUR. Markets will likely trade cautiously ahead of tomorrow’s meeting of European Union Finance Ministers especially as it appears that at least Germany and Netherlands remain sceptical of Greece’s austerity plans, which could frustrate the approval of a second EUR 130 billion bailout package.

The USD is firmer overnight but still struggling to make headway in an environment of improving risk appetite. The fact that USD speculative positioning has dropped sharply to its lowest level since September last year highlights a major shift in USD sentiment. The USD is currently in a lose-lose situation helped neither by economic data or risk appetite. For example a healthy gain in January retail sales expected today, will help to boost risk appetite which in turn will help maintain pressure on the USD.

Encouragingly for the USD, 2 year bond yields have been rising since the start of February in line with firmer economic data. However, rather than giving the USD a boost (except vs. JPY) it has been outweighed by the fact that bond yields elsewhere have risen even more aggressively. The net result is that the prospects for the USD to strengthen further look somewhat restrained over the short term.

AUD has benefited from a firmer tone to risk appetite at the start of the week but for a currency in which speculative positioning is fast approaching all time highs I would be cautious of adding to long positions at current levels. Remaining one of the most sensitive currencies to gyrations in risk appetite the AUD will continue to be mainly driven by global events especially the Greek saga.

Nonetheless, there a few data releases at home that will capture market attention, in particular the January jobs report on Thursday. After a surprisingly large 29.3k fall in December a bounce is expected in January, with around a 15k increase likely. The report will provide clues to just how long the RBA will pause in its rate cutting cycle. I suspect that even a positive outcome will have a briefly positive impact on AUD, with the currency set to struggle to break above resistance around its 2012 high at 1.0845 versus USD.

Ratings agencies spoil the party

Just as I thought that attention may finally switch to the US along comes the ratings agencies to spoil the party once again. Moody’s and Fitch Ratings criticised last week’s European Union Summit outcome for falling short of a comprehensive solution to Eurozone ills. Consequently the risk of further sovereign credit downgrades across Europe remains high over coming weeks especially as economic growth weakens. Moody’s also put 8 Spanish banks and two bank holding companies on review for a possible downgrade.

The EUR and Eurozone bonds came under pressure as a result, with EUR/USD verging on its strong support level around 1.3146. Further pressure is likely into year end although the fact that the speculative market is still very short EUR may limit its downside potential in the short term. Disappointment that the ECB has not stepped up to the plate to support the Eurozone bond market more aggressively is also having a damaging effect on confidence. A test of sentiment will come from today’s EFSF and Spanish bill auctions while on the data front we look for a below consensus outcome for the German December ZEW survey, which will deteriorate further.

The comments from the ratings agencies resulted in risk assets coming under pressure once again, leaving the market open to further selling today given the lack of positives. US data and events will at least garner some attention, with the Federal Reserve FOMC meeting and November retail sales on tap. We do not look for any big surprise from either of these, but at least the Fed may sound a little more positive in light of firmer data over recent weeks. Even so, speculation of more Fed QE early next year will remain in place. In the current environment demand for US Treasuries remains strong with a Treasury auction yesterday receiving the highest bid/cover ratio since 1993.

Pressure, panic and carnage

Pressure, panic and carnage doesn’t even begin to describe the volatility and movements in markets last week. If worries about global economic growth and the eurozone debt crisis were not enough to roil markets the downgrade of the US sovereign credit rating after the market close on Friday sets the background for a very shaky coming few days. All of this at a time when many top policy makers are on holiday and market liquidity has thinned over the summer holiday period.

The downgrade of US credit ratings from the top AAA rating should not be entirely surprising. After all, S&P have warned of a possible downgrade for months and the smaller than hoped for $2.1 trillion planned cuts in the US fiscal deficit effectively opened the door for a ratings downgrade. Some solace will come from the fact that the other two main ratings agencies Moody’s and Fitch have so far maintained the top tier rating for the US although Fitch will make it’s decision by the end of the month.

Comparisons to 2008 are being made but there is a clear difference time this time around. While in 2008 policy makers were able to switch on the monetary and fiscal taps the ammunition has all but finished. The room for more government spending in western economies has now been totally used up while interest rates are already at rock bottom. Admittedly the US Federal Reserve could embark on another round of asset purchases but the efficacy of more quantitative easing is arguably very limited.

Confidence is shattered so what can be done to turn things around? European policy makers had hoped that their agreement to provide a second bailout for Greece and beef up the EFSF bailout fund would have stemmed the bleeding but given the failure to prevent the spreading of contagion to Italy and Spain it is difficult to see what else they can do to stem the crisis.

Current attempts can be likened to sticking a plaster on a grevious wound. Although I still do not believe that the eurozone will fall apart (more for political rather than economic reasons) eventually there may have to be sizeable fiscal transfers from the richer countries to the more highly indebted eurozone countries otherwise the whole of the region will be dragged even further down.

Where does this leave FX markets? The USD will probably take a hit on the US credit ratings downgrade but I suspect that risk aversion will play a strong counter-balancing role, limiting any USD fallout. I also don’t believe that there will be a major impact on US Treasury yields which if anything may drop further given growth worries and elevated risk aversion. It is difficult for EUR to take advantage of the USDs woes given that it has its own problems to deal with.

Despite last week’s actions by the Swiss and Japanese authorities to weaken their respective currencies, CHF and JPY will remain in strong demand. Any attempt to weaken these currencies is doomed to failure at a time when risk aversion remains highly elevated, a factor that is highly supportive for such safe haven currencies. From a medium term perspective both currencies are a sell but I wouldn’t initiate short positions just yet.

US Economic Data Disappointments

Risk gyrations continue, with a sharp shift back into risk off mood for markets driven in large part by yet more disappointing US economic data as the May ADP jobs report came in far weaker than expected at 38k whilst the ISM manufacturing index dropped to 53.5 in May, its lowest reading since September 2009. This was echoed globally as manufacturing purchasing managers indices (PMI) softened, raising concerns that the global ‘soft patch’ will extend deeper and longer than predicted.

The market mood was further darkened by news that Moodys downgraded Greece’s sovereign credit ratings to Caa1 from B1, putting the country on par with Cuba and effectively predicting a 50% probability of default.

The resultant jump in risk aversion was pretty extensive, with US Treasury yields dipping further, commodity prices dropping led by soft commodities, and equity volatility spiking although notably implied currency volatility has remained relatively well behaved.

Global growth worries led by the US have now surpassed Greek and eurozone peripheral country concerns as the main driver of risk aversion, especially as it increasingly looks as though agreement on a further bailout package for Greece is moving closer to being achieved. Moreover, it seems as though a ‘Vienna initiative’ type of plan is moving towards fruition involving a voluntary rollover of debt.

The lack of first tier economic data releases today suggests that it will be a case of further digestion or perhaps indigestion of the weak run of US data releases over recent weeks and the implications for policy. For instance, it is no coincidence that QE3 is now being talked about again following the end of QE2 although it still seems very unlikely.

Bonds may see some respite from the recent rally given the lack of data today although this may prove short-lived as expectations for the May US jobs report tomorrow are likely to have been revised sharply lower in the wake of the weak ADP jobs data and ISM survey yesterday, with an outcome sub 100k now likely for May US non-farm payrolls.

Meanwhile, FX markets are caught between the conflicting forces of higher risk aversion and weaker US data, leaving ranges to dominate. On balance, risk currencies will likely remain under pressure today and the USD may get a semblance of support in the current environment.

This may be sufficient to prevent EUR/USD from retesting its 1 June high around 1.4459 as markets wait for further developments on the Greek front. Once again the likes of the CHF and to a lesser extent JPY will do well in a risk off environment whilst the likes of the AUD and NZD will suffer.

Euro resilient but for how long?

The resilience of the EUR to bad news has been impressive but is unlikely to persist. The recent negatives include 1) the rejection of the Portuguese government’s austerity plan and the increased likelihood of a bailout, 2) a likely delay in the decision on increasing the size and scope of the EFSF EU bailout fund, 3) a drop in Eurozone purchasing managers indices in March, 4) downgrades to Portugal’ sovereign credit ratings by Fitch last night and S&P and 5) Moodys downgrades of 30 Spanish banks. Despite all of this, and after hitting a low of around EUR/USD 1.4054, EUR has bounced back close to the 1.4200 level.

Further direction will come from the outcome of the EU leaders’ summit today and the March German IFO business confidence survey. For the former there is unlikely to be a decisive result, with the optimism following the informal March 11 leaders’ summit likely to give way to delay due to wrangling over details. For the latter, a slight moderation in the IFO is expected following February’s upside surprise. However, there is a bigger risk of a downside surprise following the softer than forecast March German manufacturing PMI released. Against this background, EUR/USD is likely to struggle to break resistance around 1.249.

In general FX markets look somewhat more stable and even the pressure on the USD appears to have abated slightly despite a much weaker than expected outcome for US February durable goods orders yesterday, which revealed a drop in both headline and ex-transportation orders. My composite FX volatility measure has dropped sharply over recent days, led by short term implied JPY volatility which has dropped close to pre-crisis levels. Lower volatility has also likely reduced the prospects of further FX intervention although USD/JPY 80 will continue to be well defended.

Lower volatility as also reflected in the sharp drop in the VIX index has corresponded with a general easing in risk aversion as both Middle East and Japan tensions have eased slightly. US data today are unlikely to offer much direction, with a slight upward revision to US Q4 GDP and an unchanged outcome for the final reading of Michigan consumer confidence expected.

Ratings rampage hits Euro

Both the data flow and market liquidity will be thin over the last couple of weeks of the year. After a bashing over much of H2 2010 it looks as though the USD will end the year in strong form having risen by over 6% since its early November low. In contrast the EUR is struggling having found no support from the meeting of European Union officials at the end of last week in which they agreed to a permanent sovereign debt resolution after 2013 but failed to agree on expanding the size of the bailout fund (EFSF). Similarly there was no traction towards a common euro bond. EUR/USD is now verging on its 200-day moving average around 1.3102, a break of which could see a drop to around 1.2960.

The failure to enlarge the size of the EFSF was disappointing given worries that it is perceived to be insufficient to cope with the bailout of larger eurozone countries if needed. It also highlight that the burden on the European Central Bank (ECB) to prop up eurozone bond markets until confidence improves. The increase in the size of ECB capital from EUR 5.8 billion to EUR 10.8 billion will help in this respect. Such support was clearly needed last week following the rampage across Europe by ratings agencies culminating in Moody’s five notch downgrade of Ireland’s credit ratings, surprising because of its severity rather than the downgrade itself. Ireland’s ratings are now just two notches above junk status and the negative outlook could mean more to come.

It was not just Ireland’s ratings that came under scrutiny. Ireland’s multi notch downgrade followed Moody’s decision to place Greece and Spain on review for a possible downgrade whilst S&P revised Belgium’s outlook to negative. Unsurprisingly peripheral debt markets came under renewed pressure as a result outweighing positive news in the form of strong flash eurozone PMI readings and firm German IFO business confidence survey. EUR did not escape and sentiment for the currency remains weak, with CFTC IMM speculative positioning data revealing a fourth straight week of net EUR short positioning in the week to 14th December.

In contrast, sentiment for the US economy continues to improve. Congress’ swift passage of President Obama’s fiscal plan will help to shore up confidence in US recovery. Data this week will be broadly positive too. On Wednesday, US Q3 GDP data is likely to be upwardly revised to a 2.8% QoQ annualized rate. Durable goods orders excluding transportation are set to increase by a healthy 2.0% (Thu) whilst both existing (Wed) and new (Thu) home sales will reveal rebounds in November following a drop in the previous month.

In the UK the main highlight is the Bank of England (BoE) MPC minutes. Another three way split is expected but this should not cause more than a ripple in FX markets. GBP/USD has slipped over recent days but there appears to be little other than general USD strength responsible for this. The currency pair looks vulnerable to a drop below 1.5500, with 1.5405 seen as the next support level. On balance, the USD will be in good form this week although the drop in US bond yields at the end of last week may take some of the wind out of its sails.

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