Sell Risk Trades On Rallies

It seems that every time there is a bounce in risk appetite it quickly dissipates as worries about growth, fiscal deficits, sovereign debt, etc, return to dent sentiment. This was again the case overnight as markets sold off late in the US session, with an early bounce in sentiment proving too fragile to last. This pattern of trading is set to persist for a long while yet, with the overall tone of selling risk trades on rallies remaining in place.

Fears over a double dip global recession have increased since the release of Friday’s disappointing US jobs report even if it is too early to pass judgment based on the basis of one month’s data. Coupled with worries about slowing growth momentum in China, hopes that slower growth in the eurozone could be counterbalanced by firm growth elsewhere are being dashed. The problem is that despite a strong quarter of growth for most economies in Q2 2010 the outlook for the second half of the year is far more uncertain.

European Union officials sought to calm worries about the potential for renewed fiscal crises in the future by agreeing to monitor national budgets more closely and at an earlier stage whilst introducing a wider range of sanctions on excessive deficits. Unfortunately this is akin to the idiom about closing the stable door after the horse has bolted. The steps aren’t going to help resolve the current crisis. Evidence of implementation, execution and results on the deficit cutting front will help however, but this is a process that will take months rather than days or weeks.

A couple of factors may have prevented the EUR from extending losses overnight. 1) Germany announced EUR 80 billion in spending cuts along with 15,000 public sector job cuts. Germany also is pushing for a financial transactions tax on tap of the bank levy. 2) European finance ministers finalised details of the EUR 440 bn Financial Stability Facility which aims to sell AAA rated bonds to make loans to eurozone countries. The only question is the approval process. The statement on the funds operations only said that “national legal procedures to participate in the facility are well on track”. EUR/USD is likely to range between 1.1826 and 1.2110 over the short-term.

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What To Watch This Week

Well so much for a “risk on” week. Market sentiment soured at the end of last week following The US Securities and Exchange Commission (SEC) civil action against Goldman Sachs, in which they accused the bank of fraud. The impact reverberated across markets and risk trades were pulled back as a consequence. Bulls shouldn’t be too downhearted though as the drop in risk trades followed several days of gains and part of the pullback could be attributed to profit taking.

Speculation of similar probes in Europe by financial regulators will cast a shadow over markets early this week. Nonetheless, direction will at least in part come from earnings. So far the run of earnings looks upbeat, with around 83% of the 48 S&P 500 companies reporting, beating analysts’ estimates. Overall profits are forecast to increase by around 30% from a year ago but are on track to easily beat this estimate. Bellwether names including IBM, Apple, Coca-Cola, Boeing, Microsoft, and AT&T report this week.

The meeting between Greek officials, ECB, IMF and EU has been delayed until Wednesday. There is little likelihood of Greece seeing any loan money soon as the need for parliamentary approval in some EU countries and upcoming regional elections in Germany on 9 May will put a spanner in the works. An issue of EUR 1.5bn of 3-month Greek debt tomorrow will act another test of market confidence but the recent widening in Greek debt spreads suggests a less positive reception than the previous sale.

There are also a few central bank meetings to contend with this week including Canada, Sweden, India, Philippines and Thailand. The only Bank likely to hike interest rates out of this bunch is the RBI in India with another hike expected, following closely on the heels of the March move. Canada and Sweden are unlikely to shift policy until at last after the end of Q2 whilst protests in Bangkok, Thailand, and the knock on impact on consumer confidence, have effectively sealed the case for no rate move there.

On the data front, attention will turn to US housing market activity. Markets will be able to gauge further clues to whether recovery in the housing market has stalled. An increase in both existing (Thu) and new home sales (Fri) in March is expected, which may allay some concerns although any improvement is likely to continue to fragile against the background of tight credit and high foreclosure levels.

In Europe, aside from the ongoing Greek sage, sentiment surveys will garner most attention, with the release of the German ZEW (Tue) and IFO (Fri) surveys as well as manufacturing and service sector purchasing managers indices (PMIs) across Europe. On the whole the surveys are likely to reveal some improvement as confidence.

Risk aversion will be slightly elevated at the beginning of this week but strong earnings and improving data will help to prevent too much damage. Consequently Risk currencies will start the week under pressure but any pullback will be limited. Given that speculative positioning in risk currencies such as the AUD, NZD and CAD is well above their three-month average according to the latest Commitment of Traders’ IMM data there will be some scope for profit taking. EUR speculative sentiment has seen some improvement but EUR/USD remains vulnerable to a further pull back to technical support around 1.3302 this week.

Optimism dissipates

Markets have been highly fickle so far this year. Optimism about strong recovery led by China – recall the fact that disappointment from the surprisingly weak US non-farm payrolls report in December was outweighed by strong Chinese trade data – has dissipated. Instead of rejoicing at China’s robust GDP report last week, which revealed a 10.7% rise in the fourth quarter of 2009, investors began to fret about whether China would have to move more aggressively to tighten monetary policy. Fuelling these fears was the release of Consumer price data which showed inflation rising above expectations to 1.9% YoY in China.

If such fears were not sufficient to hit risk appetite, US President Obama’s plan to limit the size and trading activities of financial institutions dealt another blow to financial stocks. The plan followed quickly after the Democrats lost the state of Massachusetts to the Republicans and managed to shake confidence in bank stocks whilst fuelling increased risk aversion. Meanwhile, rumblings about Greece continue to weigh on markets and Greek debt spreads continued to widen even as global bond markets rallied.

Following the US administration’s plans to restrict banks’ activities the fact that the rise in risk aversion was US led rather than broad based led to an eventual pull back in the dollar which helped EUR/USD to avoid a break below 1.40. Risk trades including the AUD came under pressure as risk appetite pulled back. A drop in commodity prices did not help. The AUD was also hit by news that Australia’s Henry Tax Review would look to tax miners in the country. As a result AUD/USD dropped below 0.90 though this level is likely to provide good buying levels for those wanted to take medium term AUD long positions. The one currency that did benefit was the JPY which managed to drop below sub 90 levels.

The aftermath of the “Volker Plan” will reverberate around markets this week keeping a lid on equity sentiment. Meanwhile Greece will be in the spotlight especially its bond syndication. A bad outcome could be the trigger for EUR/USD to sustain a move below 1.40 though it looks as though it may find a bottom around current levels, with strong support seen around 1.4029. The German IFO business survey for January will be important to provide some direction for EUR and could be a factor that weighs on the currency if as expected it reveals some loss of momentum in the economy.

Aside from the Fed the other G3 central bank to meet this week is the Bank of Japan but unless the Bank is seen to be serious about fighting deflation, USD/JPY may remain under downward pressure against the background of elevated risk aversion. Below 90.0 there does appear to be plenty of USD/JPY buyers however, suggesting that further upside for the JPY will be limited. USD/JPY will find strong support around 88.84.

Much will depend on the key events in the US this week including the Fed FOMC meeting and the President’s State of the Union speech. USD bulls will look for some indication that the US government is serious about cutting the burgeoning budget deficit. Also watch out for the confirmation vote on the renomination of Bernanke as Fed Chairman which could end up being close. There is a heavy slate of data to contend with including new and existing home sales, consumer confidence, durable goods orders, the first glance at Q4 GDP and Chicago PMI.

FX Prospects for 2010

There can be no doubt that for the most part 2009 has been a year for risk trades, not withstanding the sell off into year end. The policy successes in preventing a systemic crisis and the massive flood of USD liquidity injected globally kept the USD under pressure for most of the year and the currency became a victim of this success. Risk appetite is likely to improve only gradually over coming months given the still significant obstacles to recovery in the months ahead.  This will coincide with the declining influence of risk on FX markets. 

2010 will not be as straightforward and whilst risk will dominate early in the year interest rate differentials will gain influence in driving currencies as the year progresses. The problem for the USD is that market expectations for the timing of the beginning of US interest rate hikes is likely to prove premature as the Fed is set to hold off until at least late 2010/early 2011 before raising interest rates. The liquidity tap will stay open for some time, and risk trades will still find further support at least in the early part of 2010, whilst the USD will come under renewed pressure.    

The ECB will be much quicker in closing its liquidity tap than the Fed and arguably an earlier reduction in credit easing and interest rate hikes compared to the Fed would favour a stronger EUR.  However, the EUR is already very overvalued and a relatively aggressive ECB policy is unwarranted. Consequently rather than benefiting from more favourable relative interest rate expectations, the EUR could be punished and the EUR is set to decline over much of 2010 following a brief rally in Q1 2010, with EUR/USD set to fall over the year. 

Japan is moving in the opposite direction to the ECB.  FX intervention is firmly on the table though the risk is limited unless USD/JPY drops back to around 85.00. Even at current levels the JPY is overvalued but for it to resume weakness it will need to regain the role of funding currency of choice, a title that the USD has assumed. Efforts by the BoJ to combat deflation will likely help result in fuelling some depreciation of the JPY and it is likely to be the worst performing major currency over 2010, with a move back up to around USD/JPY in prospect.

The issue of global rebalancing will need to involve currencies but the currency adjustments necessary will not be forthcoming in 2010.  USD weakness early in the year will be mostly exhibited against freely floating major currencies which will bear the brunt of USD weakness.  However, the bulk of adjustment is needed in Asian currencies and there is little sign that central banks in the region will allow a rapid appreciation.  China holds the key and a gradual appreciation in the CNY over 2010 suggests little incentive to allow other Asian currencies to appreciate strongly. 

So in many ways 2010 will be one of two halves for currency markets and this has the potential to reignite some volatility in FX markets.  High beta risk trades including the AUD, NZD, NOK and many emerging currencies will see further upside in H1 as the USD falls further.  Gains in risk currencies will look even more impressive when played against the JPY and/or CHF than vs. USD given that they will succumb to growing pressure in the months ahead as their usage as funding currencies increases.

Ongoing rate hikes in Australia and Norway and the likely beginning of the process to raise rates in New Zealand early next year will mean that these currencies will also have the additional support of yield to drive them higher unlike the JPY.  There is a limit to most things however, and eventually the USD will recover some of its lost ground against risk currencies, as it undergoes a cyclical recovery over H2 2010.

AUD and NZD outperformance

Just as the euro looked as though it was showing some signs of rebounding following the battering it received in the wake of the downgrade of Greece’s credit ratings, S&P placed Spain on credit watch negative from neutral, which helped drag EUR/USD all the way down again. Expect more to come as sovereign risk concerns / fiscal deficit remain in focus. EUR/USD was helped by the usual sovereign demand, preventing a test of technical support around 1.4625 but another push lower is likely over the short term.

Despite a tough budget from Ireland yesterday, it alongside the likes of Latvia, Ireland, Hungary and Portugal will remain on the ratings agencies’ hit lists. Eurozone periphery bond spreads have widened sharply against bunds but even larger countries in Europe such as Italy have seen an increase in funding costs. Added to these concerns are the lingering uncertainties about Dubai as reflected in the continued rise in CDS.

In contrast, growth worries are receding quickly in Australia where another robust jobs report was released. Employment rose 31.2k in November, with an upward revision to the previous month, to 27.2k from 24.5k initially. The details looked good too, with much of the jobs increase coming from full time hires (30.8k). The jobless rate fell to 5.7% compared to 5.8% in October. Taken together with the hawkish slant to the RBNZ statement, the data will help keep the AUD and NZD resilient to any sell off in risk trades.

The decision by the RBNZ to leave interest rates unchanged at 2.5% came as no surprise. However, Governor Bollard did shift away from the earlier pledge not to hike interest rates until H2 10 and stated that a hike could come around the middle of 2010. The RBNZ also upgraded its growth forecasts. A rate hike could come even earlier in my view, a factor likely to keep the NZD well supported.

Markets will digest more interest rate decisions today, in the UK and Switzerland. No change is likely from both the BoE and SNB but the issue of QE will remain at the forefront, especially given the split decision by the BoE MPC at the last meeting. As for the SNB the usual concerns about CHF strength are likely to be expressed but the tone of the SNB’s comments are likely to remain dovish, expressing little urgency to begin implementing an exit strategy.

The US data slate is light but does include weekly jobless claims and October trade data. There will be more interest than usual on the claims data given the surprise in last week’s payrolls report. Claims have been on an improving trend declining at a more rapid pace than previous recessions and markets will eye the numbers to determine whether they point to further improvement in payrolls or whether they suggest the November data was merely an aberration.

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