The Dust Settles

May 12, 2010 — Mitul Kotecha

As the dust settles on the massive “shock and awe” package announced over the weekend it is become painfully apparent that markets are not at all convinced that underlying issues surrounding Europe’s woes are on the path to being resolved. Undoubtedly the EUR 750 billion provided by the European Union (EU) and International Monetary Fund (IMF) will go a long way towards fixing the symptoms of the crisis but it will take a lot more action to convince markets that the measures to cut budget deficits, improve productivity and enact structural reforms are being carried out.

As a result of ongoing skepticism EUR/USD dropped to its lowest level since March 2009. The currency pair shows little sign of turning around and over the short-term EUR/USD is likely to test its 2010 low around 1.2510. Market positioning remains heavily short EUR suggesting some scope for short covering but any rebound in EUR/USD is being met with plenty of sellers and the upside is likely to be restricted to around 1.2885.

The size of the EU/IMF package means that financing issues for eurozone peripheral countries will not be a major concern and spreads are likely to continue to narrow against core debt. However, attention has turned to the next step in the process, in particular the path of fiscal consolidation necessary in the months ahead and the negative impact on the economies in Europe that this will entail. As US Fed Chairman Bernanke noted, the package from the EU/IMF is “not a panacea”.

Overall, the measures may have cheapened the long term value of the EUR rather than boost it as it has highlighted the many problems in having a single currency to encompass a wide variety of countries. The stark reality in having differing fiscal policies across the euro region whilst maintaining a single monetary policy has proven to be highly problematic.

At least for now, the economic data in the eurozone is providing some support, though it is questionable how long this will continue. Eurozone GDP grew by 0.2% in the first quarter of 2010 compared to the previous quarter, which was stronger than expected and growth in the second quarter actually looks like it will have picked up from this pace based on the indications from recent monthly data.

Further out, the real damage will begin and in particular economic activity in southern European countries will slow sharply even as the German economy remains resilient due to relatively strong export performance. Deficit cutting measures in Portugal, Spain and Italy will begin to bite into growth later this year and into 2011. The weakness in growth in Europe relative to the US economy, which is likely to perform relaitvely better, will provide further rationale to sell EUR/USD, though at some point markets may just shift their attention back to the burgeoning US fiscal deficit.

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Shock and Awe

May 10, 2010 — Mitul Kotecha

The Greek crisis spread further last week, not only to Portugal and Spain, but in addition to battering global equity markets, contagion spread to bank credit spreads, OIS-libor and emerging market debt. In response, European Union finance ministers have rushed to “shock and awe” the markets by formulating a “crisis mechanism” package with the International Monetary Fund (IMF). The package includes loan guarantees and credits worth as much as EUR 750 billion. The support package can be added to the EUR 110 billion loan package announced last week.

In addition, the US Federal Reserve (Fed) announced the authorisation of temporary currency swaps through January 2011 between the Fed, European Central Bank (ECB), Bank of Canada (BoC), Bank of England (BoE) and Swiss National Bank (SNB) in order to combat in the “the re-emergence of strains” in European markets. Separately, the ECB will conduct sterilised interventions in public and private debt markets, a measure that was hoped would be announced at the ECB meeting last week, but better late than never. The ECB did not however, announce direct measures to support the EUR.

The significance of these measures should not be underestimated and they will go a long way to reducing money market tensions and helping the EUR over the short-term. Indeed, recent history shows us that the swap mechanisms work well. The size of the package also reduced default and restructuring risks for European sovereigns. However, the risk is that it amounts to a “get out of jail free card” for European governments. A pertinent question is whether the “crisis mechanism” will keep the pressure on governments to undertake deficit cutting measures.

The Greek crisis has gone to the heart of the euro project and on its own the package will be insufficient to turn confidence around over the medium term. In order to have a lasting impact on confidence there needs to be proof of budget consolidation and increasing structural reforms. Positive signs that the former is being carried out will help but as seen by rising public opposition in Greece, it will not be without difficulties whilst structural reforms will take much longer to implement. Confidence in the eurozone project has been shattered over recent months and picking up the pieces will not be an easy process.

Some calm to markets early in the week will likely see the USD lose ground. There was a huge build up of net USD long positioning over the last week as reflected in the CFTC IMM data, suggesting plenty of scope for profit taking and/or offloading of USD long positions. In contrast, EUR positioning fell substantially to yet another record low. Some short EUR covering is likely in the wake of the new EU package, but EUR/USD 1.2996 will offer tough technical resistance followed by 1.3114.

The EU/IMF aid package will help to provide a strong backstop for EUR/USD but unless the underlying issues that led to the crisis are resolved, EUR/USD is destined to drop further. Perhaps there will be some disappointment for the EUR due to the fact that the package of support measures involves no FX intervention. This could even limit EUR upside given that there was speculation that “defending the EUR” meant physically defending the currency. In the event the move in implied FX volatility over the last week did not warrant this.

Posted in central banks, Currencies, Economics, Economy, emerging markets, equity markets, Europe, eurozone, Federal Reserve, Financial crisis, Fiscal/Budget, FX, Germany, Greece, IMF, Interest rates, Japan, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , . 1 Comment »

Risk Aversion Back With A Vengeance

May 5, 2010 — Mitul Kotecha

Risk aversion is back with a vengeance as reflected in the rise in equity volatility (VIX), drop in equity markets and rally in US Treasuries.  European peripheral debt markets sold off despite the EU/IMF aid package for Greece, whilst EUR/USD slid below 1.3000.  Various rumours dealt a blow to markets including talk of a sovereign ratings downgrade and a EUR 280 billion bailout for Spain.   The message is clear.  This situation is becoming increasingly dire by the day.  Europe is in big trouble and the whole euro project is under threat of unravelling.  

Concerns about parliamentary approvals, implementation/execution risk, prospects for relatively weaker growth in Europe, as well as contagion to Spain and Portugal, has tempered any enthusiasm towards the EU/IMF bailout package.  In addition, despite the large size of the EUR 110 billion loan package there are growing worries that it will be insufficient to cover Greece’s funding requirements over the next three years.  All of this implies that the EUR will remain under pressure for some time yet.  I have previously spoken about a drop to around EUR/USD 1.25 but the risk is for a much sharper decline is growing.

The USD is the clear winner, spiking to its highest level since May 2009 and is looking well set to consolidate its gains over the short-term despite the fact that net aggregate USD speculative positioning has already reached its highest level since September 2008 (according to the CFTC Commitment of Traders IMM data) in contrast to EUR positioning, which is at a record low.  This is unlikely to stand in the way of further downside for EUR/USD, with the next technical support level seen at 1.2885, which would match the previous lows see in April 2009.

A combination of worries including contagion to Spain and Portugal, policy tightening in China, debt concerns in the UK and Japan, all threaten to undo the positive message from recent positive economic data including further strengthening in Purchasing Managers Indices globally.   The immediate attention remains on Greece and growing scepticism about the ability of Greece to carry out austerity measures in the face of rising domestic opposition, including a nationwide strike today. 

The rout in US and European markets will spill over to Asia, putting equity markets and Asian currencies under pressure.  Another risk currency to suffer is the AUD, which has dropped sharply following the Reserve Bank of Australia (RBA) meeting, in which the Bank indicated that rates were close to peaking.  Speculative positioning has dropped for the past two weeks as longs are taken off but AUD/USD weakness is set to be temporary, with buyers likely to emerge around near term support seen around 0.9001.

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Greece Bailed Out, Euro Unimpressed

May 3, 2010 — Mitul Kotecha

After much debate eurozone ministers along with the International Monetary Fund (IMF), finally announced an emergency loan package for Greece amounting to  EUR 110 billion. In return for the bailout Greece agreed to enhanced austerity measures. The good news is that the package covers Greece’s funding requirements until 2012, and is sufficient to avoid debt restructuring and default. The loan package has also removed uncertainty ahead of bond redemption on May 19th.

One aim of the package was to prevent contagion to other eurozone countries, especially Portugal and Spain, where there has been growing pressure on local bond and equity markets. However, the path ahead is strewn with obstacles and it is too early to believe that the package has ensured medium term stability for the EUR.

The challenges ahead are two-fold, including both the implementation of the measures in Greece in the face of strong domestic opposition and the approval of the loans by individual country parliaments within the eurozone, both of which are by no means guaranteed.

The toughest approval process is likely to be seen in Germany where the government will face a grilling in parliament and a challenge in the constitutional court ahead of official approval of the package. European Union leaders are scheduled to meet on May 7th to discuss the parliamentary approval of loans to Greece whilst German officials meet on the same day.

Implementation risk is also high. Although the Greek government appears to be sufficiently committed, opposition within Greece is growing; various strikes planned over coming days. Aside from union opposition, the scale of the budgetary task ahead is enormous, having never been undertaken on such a large scale in recent history. The sharp decline in growth associated with the austerity measures will make the task even harder.

The EUR bounce on the news has been limited, with the currency failing to hold onto gains. The announcement seems to have triggered a “buy on rumour, sell on fact” reaction, with the size of the loan package falling within the broad estimates speculated upon over the last week. The lack of EUR bounce despite the fact that going into this week the CFTC Commitment of Traders report revealed record net short speculative positioning in EUR/USD, reveals the extent of pessimism towards the currency.

The EUR may benefit from a likely narrowing in bond spreads between Greece and Germany. Given that sovereign risk is being increasingly transferred from the periphery to the core, the net impact on bond markets may not be so positive for the EUR. Over the short-term there will be strong technical resistance on the upside around EUR/USD 1.3417 but more likely the currency pair will target support at around 1.3114.

The Herculean task ahead for the Greek government suggests that markets will not rest easy until there are credible signs of progress. Investors would be forgiven for having a high degree of scepticism given the degree of “fudging” involved in the past, whilst Greek unions will undoubtedly not make the government’s task an easy one by any means. Such scepticism will prevent a sustained EUR recovery and more likely keep the EUR under pressure.

As noted above the divergence in growth for the eurozone economy between Northern and Southern Europe will make policy very difficult. Moreover, the EUR is set to suffer from an overall weak trajectory for the eurozone economy, relative to the US and other major economies. The widening growth gap with the US will also fuel a widening in bond yield differentials, a key reason for EUR/USD to continue to decline to around or below 1.25 by the end of the year.

Posted in Bond markets, central banks, Currencies, Economics, Economy, equity markets, Europe, eurozone, Financial crisis, Fiscal/Budget, FX, Germany, Greece, IMF, Interest rates, Monetary Policy. Tags: , , , , , , , , , , , , , , , , , , . 1 Comment »

For A Few Dollars More…

April 22, 2010 — Mitul Kotecha

…or should I say a few EUR more.   This is what the Greek authorities must be wondering.  Once again Greek worries weighed on equities and risk appetite as a whole.  Although the saga is turning into one big yawn, markets have not had their fill with the bad news coming from this small eurozone economy.  Talks between Greek officials, International Monetary Fund (IMF), European Central Bank (ECB) and European Union (EU) began yesterday but are expected to go on for several days or weeks until a joint text is issued on May 15, just days ahead of a EUR 8.5 billion bond redemption by Greece. 

The talks have done nothing to prevent Greece’s bond yields moving higher, with the yield on 10-year bonds pushing well over 8% whilst the spread with Germany debt also blew out to over 500bps.  The main fear in the market is that Greece will ultimately end up restructuring its debt.  Moreover, contagion fears have dealt a blow to southern European sovereign CDS especially Portugal.  It wasn’t plain sailing for German bonds either, with yesterday’s auction of EUR 3 billion of 30-year Bunds failing to sell the full amount. 

Another casualty of ongoing Greece concerns is the EUR, with the currency under performing other majors and still on its path towards EUR/USD 1.3300 in the near term and onto 1.3150 after.   EUR also looks vulnerable on the crosses and EUR/GBP in particular is one to watch, with the 28 January low around 0.86029 likely to be targeted over the near term.  UK employment data gave some relief to GBP yesterday, with further direction coming from retail sales data today and the next televised leaders’ debate.  

At some point the market will become fatigued with consensus beating earnings and the positive impact on equities will become less marked.  This point is approaching but we’re not quite there yet.  Apple, Morgan Stanley and Boeing did not disappoint, with earnings easily beating forecasts.  Boeing’s earnings in particular helped industrials to be the best performing sector on the S&P 500 although the overall index closed marginally lower.

Earnings today include Amazon.com, American Express, Credit Suisse, Microsoft, Nokia, and PepsiCo.  It is becoming plainly obvious that market expectations for earnings are too pessimistic but as noted above the positive market impact of good earnings is likely to wane. 

On the data front, highlights include March existing home sales, jobless claims and Producer Price Index (PPI).   There will be less focus on PPI given that the Consumer Price Index (CPI) over the month has already been released whilst claims are likely to resume a path lower following the jump over the past couple of weeks.   Existing home sales are likely to post an impressive gain as indicated by firm pending home sales data.   

Overall, it appears that risk appetite is creeping back into the market psyche but the ongoing battle between positive earnings/data versus European/Greek woes suggests that there will be no clear direction for markets.  Improving risk appetite will ultimately win but current conditions will leave currencies trading within well worn ranges, with the exception of the underperforming EUR. In contrast the USD index is likely to remain supported, taking solace from positive data releases.

Posted in central banks, Currencies, Economics, Economy, equity markets, Europe, eurozone, Financial crisis, Fiscal/Budget, FX, Germany, Greece, IMF, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , . Leave a Comment »
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