Resilient Markets

Risk assets have registered a good start to the year despite ongoing tensions in the Eurozone. US stocks rose overnight, with the S&P 500 extending its rally to 4% year to date. Evidence that markets are becoming increasingly resilient to bad news emerged from the muted reaction to sharp downgrades in growth forecasts by the World Bank, with the world economy expected to grow by 2.5% this year compared to a June forecast of 3.6%.

US markets also reacted positively to news that the US NAHB Homebuilders index rose to its highest level in more than 4 years and while industrial output expanded, albeit less than expected. Markets will continue to keep one eye on earnings to ascertain whether the equity rally can be sustained, with at least 48 S&P 500 companies reporting earnings this week including Morgan Stanley Bank of America, Intel and Google today. So far, relatively more companies have fallen short of expectations than have beaten expectations.

Even in the Eurozone the news has been slightly more encouraging than of late, with reports that a deal between Greece and private creditors on the extent of debt writedowns could be reached by the end of this week. Moreover, the International Monetary Fund (IMF) is reported to be raising $500 billion in new funds for bail out funds, another factor that has helped to shore up market sentiment. The net result has been to see peripheral bond yields ease further and the EUR to strengthen, helped by the fact that the market is extremely short.

There is still plenty of event risk on the horizon, however, including debt auctions in Spain and France today although these ought to pass relatively smoothly. US data are likely to be mixed today, with benign inflation keeping the door open to more Fed quantitative easing (QE) while a gain in the Philly Fed manufacturing survey will continue to reveal signs of economic recovery. In the short term risk assets look supported but given the risks ahead any bounce still looks to be short-lived.

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Eurozone contagion spreading quickly

Contagion from the eurozone debt crisis is spreading quickly, threatening to turn a regional crisis into a global crisis. As highlighted by Fitch ratings further contagion would pose a risk to US banks. Consequently risk assets continue to be sold but interestingly oil prices are climbing. Taken together with comments earlier in the day from the Bank of England that failure to resolve the crisis will lead to “significant adverse effects” on the global economy, it highlights the risks of both economic and financial contagion.

Predominately for some countries this is becoming a crisis of confidence and failure of officials to get to grips with the situation is resulting in an ever worsening spiral of negativity. Although Monti was sworn in as Italian Prime Minister and Papademos won a confidence motion in the Greek parliament the hard work begins now for both leaders in convincing markets of their reform credentials. Given that there is no agreement from eurozone officials forthcoming, sentiment is set to worsen further, with safe haven assets the main beneficiaries.

EUR/USD dropped sharply in yesterday’s session hitting a low around 1.3429. Attempts to rally were sold into, with sellers noted just below 1.3560. Even an intensification of bond purchases by the European Central Bank (ECB) failed to prevent eurozone bond yields moving higher and the EUR from falling.

Against this background and in the absence of key data releases EUR will find direction from the Spanish 10 year bond auction while a French BTAN auction will also be watched carefully given the recent increase in pressure on French bonds. Having broken below 1.3500, EUR/USD will aim for a test of the 10 October low around 1.3346 where some technical support can be expected.

US data releases have been coming in better than expected over recent weeks, acting to dampen expectations of more Fed quantitative easing and in turn helping to remove an impediment to USD appreciation. While the jury is still out on QE, the USD is enjoying some relief from receding expectations that the Fed will forced to purchase more assets. Further USD gains are likely, with data today including October housing starts and the November Philly Fed manufacturing confidence survey unlikely to derail the currency despite a likely drop in starts.

USD, EUR and JPY Outlook This Week

The USD lost more ground last week extending its drop from the early October. Interestingly its latest drop has occurred despite an uptick in risk aversion suggesting other factors are at work. Mixed US data and earnings have not given the USD much direction with a downbeat Beige Book counterbalanced by a firmer Philly Fed manufacturing survey and housing starts.

The data have not been sufficiently weak to fuel expectations of more Fed quantitative easing but some Fed officials including Yellen, Tarullo, Evans and Rosengren in indicating that further QE could be considered. The USD has therefore been somewhat undermined but will take its cue from data releases and events in Europe this week.

This data slate will be mixed but on balance will not support more Fed QE. In particular, Q3 Real GDP is expected to come in sharply higher than in Q2, with a 2.5% annual rate expected to be revealed. Other indicators will be less positive, with October consumer confidence set to slip further and remain at a recessionary level, while September durable goods orders will decline by around 1%.

Despite an expected increase in new home sales in September the overall picture of the US housing market will remain very weak. Overall, the USD may find some respite from the GDP report but the data will be seen as backward looking, with the jury still out on the issue of more quantitative easing.

The EUR struggled to make any headway last week amid a barrage of rumors about the outcome of Sunday’s EU Summit. In the event the summit failed to deliver concrete details although there appeared to be some progress in key areas. Attention will now turn to Wednesday’s summit but once again the risk of disappointment is high. EUR/USD will only extend gains if markets are satisfied at the result but this is by no means guaranteed.

Data releases will not be supportive for the EUR this week, with a further deterioration in ‘flash’ eurozone purchasing managers indices (PMIs) and European Commission confidence surveys expected in October but hopes of a concrete resolution at Wednesday’s EU Summit will keep the EUR/USD supported early in the week although it will find strong resistance around 1.3915.

The sensitivity of the JPY to risk aversion has actually fallen over the last three months while the influence of bond yield differentials also appears to have slipped. The fact that USD/JPY continues to remain in a very tight range with little inclination to break in either direction despite gyrations in risk and yield differentials almost appears if the currency pair has been pegged.
Obviously this is not the case but a break out of the current range does not look imminent.

Speculative JPY positioning has dropped over recent weeks while equity and bond flows have overall been negative but this has not been reflected in JPY weakness resulting in increased frustration by Japanese officials. We continue to look for the JPY to weaken over coming months but much will depend on a widening in US / Japan yield differentials and easing risk appetite as both will regain their hold on the currency. In the meantime, the currency will continue to offer little to get excited about.

Edging Towards A European Deal For Greece

The momentum towards some form of agreement at the Special EU Summit today is growing, with French and German leaders reaching a “joint position on Greece’s debt situation”. Details of this position are still unknown, however. EUR has found support as expectations of a positive outcome intensify.

However, given that positive news is increasingly being priced in, and the market is becoming increasingly long, upside EUR potential will be limited even in the wake of a comprehensive agreement. A break above EUR/USD resistance around 1.4282 would bring in sight the next key resistance level around 1.4375 but this where the rally in EUR/USD is set to be capped.

Prospects of a major US debt default or at the least a government shutdown appear to be receding as the US administration has indicated some willingness to opt for a short term increase in the US borrowing limit to give more time for a bigger deficit reduction deal to be passed by Congress. Meanwhile, there will be further news on the deficit reduction plans put forward by the “gang of six” US senators, with a press conference scheduled for later today.

Debt ceiling negotiations are likely to be the main focus of market attention, with the Philly Fed manufacturing survey and weekly jobless claims relegated to the background. A speech by Fed Chairman Bernanke is unlikely to deliver anything new today. The USD is likely to be on the back foot given expectations of a deal in Europe and improved risk appetite but we expect losses to be limited.

The JPY continues to defy my bearish expectations. Over recent days the US yield advantage over Japan in terms of 2Y bonds dropped to multi-year lows below 20bps. Given the high correlation between USD/JPY and yield differentials, this has corresponded with the fall below 80.00.

Expectations of JPY weakness versus USD is highly dependent on the US – Japan yield gap widening over coming months. For this to happen it will need concerns about the US economy and expectations of more Fed asset purchases to dissipate, something that may not happen quickly given the rash of disappointing US data releases lately.

GBP found itself on the front foot following the release of the Bank of England Monetary Policy Committee minutes, which were less dovish than anticipated. They also revealed that the BoE expects inflation to peak higher and sooner than previously expected. However, the fact that the overall tone was similar to the last set of minutes meant there was little follow through in terms of GBP.

Further direction will come from June retail sales data today and forecasts of a bounce in sales will likely help allay concerns about a downturn in consumer spending. Nonetheless, GBP is still likely to struggle to break through resistance around 1.6230 versus USD.

USD Pressured As Yields Dip

The USD came under pressure despite a higher than forecast reading for January US CPI and a strong jump in the February Philly Fed manufacturing survey. On the flip side, an increase in weekly jobless claims dented sentiment. The overnight rally in US Treasury yields was a factor likely weighing on the USD. The US calendar is light today leaving markets to focus on the G20 meeting and to ponder next week’s releases including durable goods orders, existing and new home sales.

The jump in the European Central Bank (ECB) marginal facility borrowing to EUR 15 billion, its highest since June 2009, provoked some jitters about potential problems in one or more eurozone banks. At a time when there are already plenty of nerves surrounding the fate of WestLB and news that Moody’s is reviewing another German bank for possible downgrade, this adds to an already nervous environment for the EUR.

Nonetheless, EUR/USD appears to be fighting off such concerns, with strong buying interest on dips around 1.3550. The G20 meeting under France’s presidency is unlikely to have any direct impact on the EUR or other currencies for that matter, with a G20 source stating that the usual statement about “excess volatility and disorderly movements in FX” will be omitted.

Although USD/JPY has been a highly sensitive currency pair to differentials between 2-year US and Japanese bonds (JGBs), this sensitivity has all but collapsed over recent weeks. USD/JPY failed to break the 84.00 level, coming close this week. There appears to be little scope to break the current range ahead of next week’s trade data and CPI.

Given the recent loss in momentum of Japan’s exports the data will be instructive on how damaging the strength of the JPY on the economy. In the near term, escalating tensions in the Middle East will likely keep the JPY supported, with support around USD/JPY 83.09 on the cards.

It seems that the jump in UK CPI this week (to 4.0%) provoked even more hawkish comments than usual from the Bank of England BoE’s Sentance, with the MPC member stating that the Quarterly Inflation Report understates the upside risks to inflation indicating that interest rates need to rise more quickly and by more than expected. Specifically on GBP he warned that the Bank should not be relaxed about its value.

Although these comments should not be particularly surprising from a known hawk, they may just help to underpin GBP ahead of the January retail sales report. Expectations for a rebound in sales following a weather related drop in the previous month will likely help prop up GBP, with GBP/USD resistance seen around 1.6279.

US Dollar Upside, Euro tensions

Following the famine that was last week this week will see a feast of data releases, which hopefully will give some clearer direction to currency markets. The key eurozone data focus for FX markets will be the German February ZEW survey and it should highlight that investor confidence is bouncing back smartly. This will be accompanied by data showing a slight acceleration in GDP in the eurozone in Q4 2010. Good news, but the reality is that the EUR is being driven more by peripheral bond tensions and relative yields.

Although the EUR may get a brief lift from the news of the resignation of Egypt’s President Mubarak this will likely prove temporary. Given that tensions are beginning to creep higher EUR/USD may struggle to make any headway this week and will more likely slip below 1.3500 for a test of 1.3440 as sentiment sours. Even the usual sovereign interest may look a little more reluctant to provide support this week. The net long positioning overhang as reflected in the CFTC IMM data suggests some scope for a squaring in long positions, likely accelerating any downside pressure.

As usual data releases are failing to have a major impact on the JPY whilst interest rate / yield differentials suggest the JPY should be much weaker. One explanation for the stubbornly strong JPY is the strength of recent portfolio inflows to Japan, especially into its bond markets. This could reverse quickly and IMM positioning suggests that the potential for a shakeout of long positioning looms large, something that many Japanese margin traders are well positioned for according to TFX data. USD/JPY 84.51 will provide firm resistance to a move higher in the short-term.

GBP will be guided by the Bank of England Quarterly Inflation Report on Wednesday as well as the January CPI and retail sales data. The Report will reveal that inflation moderates over the medium term, even if short-term projections are shifted higher. Consequently, interest rate markets may even pare back overly hawkish expectations for UK rates, leaving GBP vulnerable. Nonetheless, markets maybe somewhat more sceptical or at least nervous in light of a likely increase in UK CPI, albeit mostly due to the increase in value added tax (VAT) at the turn of the year. Moreover, GBP may find some solace from a rebound in retail sales in January.

Overall, GBP/USD will take its cue from EUR/USD and the currency is vulnerable to a sustained drop below 1.6000 this week. The fact that GBP/USD IMM positioning is at its highest since September 2008 suggests a lot of scope for a sell-off. EUR/GBP looks like its consolidating in an even narrower range between 0.8400-0.8500.

Another positive slate of US data releases and likely more pressure on US bond markets this week suggest that the USD will find further support, with the USD index likely to take a shot at the 79.00 level. Indeed a further improvement in both the Philly Fed and Empire manufacturing surveys is expected, providing more evidence of strengthening manufacturing momentum, will be borne out in the hard data, with a healthy gain in industrial output expected. Similarly a healthy reading for US retail sales will support the evidence that the US consumer is in full recovery mode.

The positive impact on the USD may be dampened however, by benign inflation readings this week, supporting the view that US policy rates will not be raised for a long time yet. This is likely to be echoed in the Fed FOMC minutes this week. Nonetheless, speculative positioning suggests plenty of scope for short USD covering, with the latest CFTC IMM report revealing the biggest net short position since October 2010.

Econometer.org has been nominated in FXstreet.com’s Forex Best Awards 2011 in the “Best Fundamental Analysis” category. The survey is available at http://www.surveymonkey.com/s/fx_awards_2011

Data and earnings focus

Friday’s round of US data were generally upbeat, highlighting that consumer spending is coming back to life. Inflation pressures however, remain benign at least on the core reading highlighting the Fed’s concern that inflation is running below the level consistent with its mandate. In other words it will be a long time, probably late into 2012 before policy rates increase.

While the Fed is no hurry to raise rates despite a few hawkish rumblings within the FOMC the European Central Bank (ECB) in contrast appears to have become more eager to pull the trigger for higher rates. ECB President Trichet’s hawkish press conference last week set the cat amongst the pigeons and marked a clear shift in ECB rhetoric towards a more hawkish stance.

A very big problem for the ECB is that the eurozone economy is not performing along the lines that its hawkish rhetoric would suggest, especially in the periphery. Growth momentum in the core in contrast, as likely reflected in the January ZEW investor confidence and IFO business confidence survey data this week in Germany, remains positive. Both surveys are likely to stabilize at healthy levels but how long can the likes of Germany drag along the eurozone periphery?

There will be relatively more attention on the meeting of Eurogroup/Ecofin officials, with focus on issues such as enlarging the size of the European Financial Stability Facility (EFSF) bailout fund and development of a “comprehensive plan” to contain the eurozone crisis. Don’t look for any conclusive agreements as this may have to wait until the European Union (EU) Council meeting on 4 February assuming (optimistically given ongoing German resistance) some agreement can even be reached.

Following the success (albeit at relatively high yields) of the eurozone debt auctions last week, sentiment for peripheral debt will face further tests this week in the form of debt sales in Spain, Belgium and Portugal.

The US Martin Luther King Jr. holiday will result in a quiet start to the week for markets but there will be plenty to chew on. This week’s key earnings reports include several banks scheduled to release Q4 earnings. Financials are a leading sector in the rally in equities at present and these earnings will be critical to determine whether the rally has legs.

The US data slate includes January manufacturing surveys in the form of the Empire and Philly Fed, both of which are likely to post healthy gains whilst existing home sales are also likely to rise. This will not change the generally weak picture of the US housing market, with high inventories and elevated foreclosures characterizing conditions. As if to prove this, housing starts are set to drop in December. On the rates front, the Bank of Canada is likely to keep its policy rates on hold this week.

After coming under pressure last week much for the USD will depend on the eurozone’s travails to determine further direction. Concrete evidence of progress at the Ecofin may bolster the EUR further, with resistance seen around 1.3500 but don’t bank on it. The ability of eurozone officials to let down often lofty expectations should not be ignored. In any case following sharp gains last week progress over coming days for the EUR will be harder to achieve.

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