Calm after the storm

After yesterday’s carnage, global equity markets have recovered some of their poise. Whether this is a pause before another wave of pressure or something more sustainable is debatable. It appears that US equities are finally succumbing to a plethora of bad news.  Higher US yields have driven the equity risk premium lower.  Also there’s probably a degree of profit taking ahead of the onset of the Q3 US earnings season.

At the same time valuations have become increasingly stretched.  For example, the S&P 500 price/earnings ratio is around 6% higher than its 5 year average while almost all emerging market price/earnings ratios are well below their 5 year averages.  While strong US growth prospects may justify some or even all of this differential, the gap with emerging markets has widened significantly.

While US President Trump blames an “out of control” US Federal Reserve, it would have been hard for the Fed to do anything else but raise policy rates at its last meeting.  If the Fed didn’t hike at the end of September, bond yields would like have moved even higher than the 3.26% reached on the 10 year US Treasury yield earlier this week as markets would have believed the Fed is falling behind the curve.   However, as US yields rise and the equity risk premium reacts, the opportunity cost of investing in equities rises too.

In the FX world the US dollar could succumb to more pressure if US equities fall further but as we saw yesterday, USD weakness may mainly be expressed versus other major currencies (EUR etc).  Emerging market currencies continue to face too many headwinds including higher US rates and tightening USD liquidity, as well as trade tariffs.  The fact that emerging market growth indicators are slowing, led by China, also does not bode well for EM assets.  Unfortunately that means that emerging market assets will not benefit for the time being from any rout in US assets despite their valuation differences.

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Spain downgraded

Pressure on Spain has intensified in the wake of a two notch downgrade to the country’s debt to just one notch above junk at BBB-. S&P cited “the significant risks to Spain’s economic growth and budgetary performance, and the lack of a clear direction in euro-zone policy”. The slow progress towards a sovereign bailout for Spain will have likely played a role in the decision, a factor that is also weighing on general market sentiment. The debt downgrade may on the margin increase the pressure on the Spanish government to request a formal bailout.

Nonetheless, risk assets including peripheral Eurozone bonds do not appear particularly stressed although it may only be a matter of time before pressure escalates. Italian bond supply today may give some further direction on this front. US Q3 earnings will have some bearing on sentiment too as concerns have grown that they will disappoint. With little on the data front (highlights include Eurozone country September inflation and US trade data) attention will focus on comments from the IMF meetings against the background of growing global growth worries.

Against this background the EUR is likely to continue to drift lower, with the currency set to test support just under the 1.2800 level AUD will have got a boost from the relatively positive September jobs report released this morning, which revealed a 14.5k increase in employment. The positive impact may slightly be mitigated by a rise in the unemployment rate to 5.4% from 5.3%, which also gives further evidence supporting the RBA’s recent rate cut. The data will at least help to alleviate some of the concerns about the jobs market following last month’s surprise drop in employment. My preference is to play AUD via going long positions versus EUR.

More Bad News In Europe

Several pieces of bad news soured sentiment at the end of last week undoing much of the good news since the beginning of the year and dashing hopes of a relatively swift resolution to Eurozone’s ills. S&P ratings agency downgraded nine Eurozone countries’ credit ratings leaving 14 on negative outlook. In particular France and Austria, which lost their triple AAA status while not particularly surprising, comes as a major blow to efforts to resolve the crisis. The downgrade puts at risk the EUR 180 billion in credit guarantees underpinning the EUR 440 EFSF bailout fund.

Separately the breakdown of talks on Greek debt restructuring and criticism by the Euuropean Central Bank (ECB) on a new draft of a treaty to ensure fiscal discipline added to the malaise, with the ECB noting that proposed revisions amount to a “a substantial watering down”. Such criticism will likely be an obstacle to the ECB stepping up its peripheral debt buying potentially threatening any decline in bond yields. It is difficult to see sentiment improving this week, with risk aversion set to remain elevated as Eurozone leaders attempt to restore confidence. In contrast, US data continues to support evidence of economic recovery, albeit gradual and this week’s releases including industrial production and manufacturing surveys will likely add to this.

The EUR slid further at the end of last week reversing earlier gains, as the bad news mounted in the Eurozone. Ratings downgrades, breakdown of Greek debt talks and ECB criticism over watered down fiscal rules, combined to make a dangerous concoction of negative headlines. The news put an end to the EUR’s short covering rally, leaving the currency vulnerable too further declines this week. Speculative sentiment according to IMM data reached another all time low last week (-155k net positions), suggesting that any good news could lead to a strong bounce as short positions are covered.

However, it is difficult to see where such news will come from and even a small expected bounce in the German January ZEW investor confidence survey this week will do little to detract from the negative news on the policy front. A meeting between Merkel, Monti and Sarkozy will be eyed closely as they prepare for a meeting of European Union (EU) Finance Ministers and markets will be looking for aggressive action to turn confidence around. Debt sales in In the meantime EUR/USD will continue to languish but strong technical support is seen around 1.2588.

High Hopes for the EU Summit

Following the knock to the EUR from the S&P ratings news on Eurozone countries yesterday the currency has managed to regain a semblance of stability ahead of the European Union Summit beginning tomorrow. Expectations that the Franco-German deal announced late Monday (Fiscal compact etc) will be rubber stamped at the summit are high and the warning shot by S&P suggests that the stakes are even higher should there be no further progress this week.

Aside from putting the ratings of 15 Eurozone countries on negative watch S&P stated overnight that the EFSF bailout fund could be downgraded too. The EUR however, looks supported ahead of the summit and European Central Bank (ECB) meeting tomorrow, with news of discussions to beef up the bailout fund to two separate entities likely to further underpin the currency. EUR/USD short term support is seen around 1.3330.

The cut in the Reserve Bank Australia (RBA) cash rate piled on the pressure on the AUD, especially as a rate cut was not fully priced in although its weakness was limited by the relatively neutral RBA policy statement. The statement did not support expectations of more significant easing in the months ahead and data this morning in the form of a much stronger than expected Q3 GDP reading reinforced our view that markets are too dovish on Australian interest rate expectations.

Next it’s the turn of the Reserve Bank of New Zealand (RBNZ) but unlike the RBA we do not expect an interest rate cut. The room for policy easing in New Zealand is limited, especially given that inflation is above the Bank’s 1-3% target band. Both the AUD and NZD are highly correlated with interest rate differentials and therefore any shift in rate expectations will have an important bearing. AUD and NZD have benefitted from a widening in yield differentials with the US and are likely to find garner some resilience from this fact over coming sessions.

EUR/GBP has continued to grind lower over recent months while GBP/USD appears to have settled into a range. GBP sentiment has clearly worsened over recent weeks as reflected in the deterioration in speculative positioning in the currency, with the market becoming increasingly short. Data releases have not been particularly helpful, with data yesterday revealing that UK house prices fell in November and retail sales dropped more than expected.

There will be more disappointment, with October industrial production likely to drop today. Our forecast of a 0.8% monthly highlights the downside risks to consensus expectations and in turn to GBP today. The data releases will if anything add to pressure on the Bank of England to embark on more quantitative easing, which will be another factor that restrains GBP over coming weeks. We continue to look for more GBP strength versus EUR but weakness against the USD over the short term. A move to support around GBP/USD 1.5469 is on the cards over the near term.

S&P Spoils The Party

Although stock markets registered gains the rally in risk assets stumbled, with sentiment knocked by news that S&P ratings has placed 15 Eurozone countries on negative watch for a possible downgrade due to “systemic stresses”. Among the 15 were Germany and France. Weaker economic news in the form of service sector purchasing managers indices in China and the US also dented market sentiment.

The Eurozone countries including all six triple A rated governments have a one in two chance of a downgrade within 90 days. Although there has been speculation of a French downgrade the major surprise was the inclusion of Germany in the list. A downgrade of Eurozone countries would hit the ability of the EFSF bailout fund to finance rescue packages for countries give that it is supported by sovereign guarantees from the six AAA rated countries.

Ironically the S&P announcement followed news that German Chancellor Merkel and French President Sarkozy have agreed on treaty changes revealing some progress ahead of the Eurozone summit on 8/9th December. Among the details of the agreement private sector bond holders will not be asked to bear any losses on any future debt restructuring, automatic sanctions for countries that breach the 3% deficit / GDP rule, a “golden rule” on balanced budgets, and an earlier data for the launch of the European Stability Mechanism to 2012.

The “fiscal compact” will be welcomed by the European Central Bank (ECB), with hints by President Draghi that it could be followed by stronger action from the central bank. Although S&P spoiled the party somewhat overnight, markets will go into the EU Summit with high expectations, suggesting that risk assets will find some degree of support. EUR slipped on the S&P news but further losses will be limited ahead of the EU Summit, with markets looking for further concrete actions from Eurozone leaders. EUR/USD will be supported around 1.3260 in the short term.

Risk appetite remains fragile

Fortunately for the USD the situation in the eurozone has become so severe that the problems in the US are all but being ignored. Even in the US, attention on the nomination of the Republican presidential candidate has over shadowed the looming deadline for an agreement on medium term deficit reduction measures.

The Joint Select Committee on deficit reduction is due to submit a report to Congress by November 23 and a final package would be voted on by December 23. A lack of agreement would trigger automatic deficit reduction of $1.2 trillion, a proportion of which would take place in 2012. If this is the case it could potentially tip the economy into recession, necessitating QE3 and consequently a weaker USD.

Reports that the eurozone could fall apart at the seams as countries exit have shaken confidence, yet the EUR has managed to hold above the psychologically important 1.35 level. The strong reluctance of the European Central Bank (ECB) to embark on unsterilized bond purchases and to act as lender of the last resort, suggests that the crisis could continue to brew for a long while to come.

Nonetheless, the EUR found a semblance of support from news that former ECB vice-president Papademos was named new Prime Minister of Greece, the ECB was reported to be a strong buyer of peripheral debt, Italy’s debt auction was not as bad as feared, affirmation of the EFSF’s AAA rating by Moody’s and France’s AAA rating by S&P (following an erroneous report earlier). EUR/USD remains a sell on ralliesup to resistance around 1.3871, with initial resistance around the 1.3665 level.

The underlying pressure over the near term is for further JPY strength in the face of rising risk aversion and a narrowing in the US yield advantage over Japan. Given that the situation in the eurozone remains highly fluid as well as tense, with little sign of resolution on the horizon, risk aversion is set to remain elevated. Moreover, yield differentials have narrowed sharply and the US 2-year yield advantage over Japan is less than 10bps at present.

Against this background it is not surprising that the Japanese authorities are reluctant to intervene aggressively although there are reports that Japan has been conducting secret interventions over recent weeks. However, given that speculative and margin trading net JPY positioning have dropped significantly the impact of further JPY intervention may be less potent. In the meantime USD/JPY will likely edge towards a break below 77.00.

Swiss officials have continued to jawbone against CHF strength, with the country’s Economy Minister stating that the currency remains massively overvalued especially when valued against purchasing power parity. Such comments should be taken at face value but the CHF is unlikely to embark on a weaker trend any time soon.

Although the EUR/CHF floor at 1.20 has held up well while the CHF has lost some its appeal as a safe haven the deterioration in the situation in the eurozone suggests that the CHF will not weaken quickly.

Italy downgrade adds to EUR woes

The USD index remains firm but it remains unlikely that the USD is being bought on its own merits but rather on disappointments in the eurozone. Nonetheless, speculative USD sentiment has turned positive for the first time since June 2010 according to the CFTC IMM data, reflecting a major shift in appetite for the currency. Clearly there are risks to the USD including the potential for more QE3 being announced at this week’s FOMC meeting but this risk is likely to be small.

In contrast, the reversal in speculative sentiment for the EUR has been just as dramatic but in the opposite direction as the net short EUR position has increased over recent weeks, with positioning now at its lowest since June 2010. Sentiment is likely to have soured further overnight following news that Italy’s credit rating was cut by S&P to A from A+ despite the recent passage of an austerity package.

This outweighed any boost to sentiment from what was noted by the Greek Finance Minister as “productive” talks yesterday. Another conference call today is scheduled but the longer markets wait for approval of the next loan tranche the bigger the risk to the EUR. In addition Greek and Spanish T-bill auctions and European Central Bank (ECB) cash operations will be in focus. The EUR remains vulnerable to a test of support around 1.3500.

GBP has continued to slide over recent weeks, having fallen by around 5% since its high just above 1.66 a month ago. However, it has managed to hold its own against the EUR which looks in even more of a sorry state than the pound. The fact that GBP has been unable to capitalise on the EUR’s woes is largely attributable to growing expectations of further UK quantitative easing.

The minutes of the last Bank of England meeting on September 8 to be released on Wednesday will give more clues as to the support within the Monetary Policy Committee for further QE but its likely that the MPC will want to see the next Quarterly Inflation Report in November before committing itself to any further easing. In the meantime, GBP will find it difficult to sustain any recovery, with its drop against the USD likely to extend to around 1.5583 in the short term.

Japan returns from its Respect for the Aged holiday today but local market participants will have missed little action on the JPY, with the currency remaining confined to a very tight range. The inability of USD/JPY to move higher despite the general bounce in the USD index reflects 1) the fact that USD/JPY is very highly correlated with 2 year bond yield differentials and 2) the fact that US yields continue to be compressed relative to Japan. Additionally, risk aversion continues to favour the JPY and combined, these factors suggest little prospect of any drop in the JPY versus USD soon.

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