Pressure, panic and carnage

August 8, 2011 — Mitul Kotecha

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.

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CHF and JPY remain on top

August 2, 2011 — Mitul Kotecha

It’s been a tumultuous few week for global markets. First a debt deal in Europe and then a debt ceiling agreement in the US. In both cases any boost to sentiment has and will be limited. Europe’s debt deal, while comprehensive, left quite a few questions in terms of implementation, scope and mutual country agreements.

In the US the deal to raise the US debt ceiling by $1.2 trillion hammered out between Republican and Democrat party leaders helps to stave off a debt default but is far smaller and less comprehensive in terms of deficit reduction measures than had been hoped for and may still be insufficient to prevent a credit ratings downgrade by S&P and/or more ratings agencies. The deal will prove a disappointment to USD bulls.

Markets in the US have failed to find much to rally them despite the debt deal. Indeed, all that has happened is that attention has shifted back towards economic growth worries in the wake of a disappointing ISM manufacturing index in the US (50.9 in July, a reading which is just about in expansion territory) which follows on from a run of soft data in the US including the Q2 GDP report. Unfortunately data elsewhere is no better as a series of weak manufacturing surveys have highlighted this week.

Weak data and the US debt deal have pushed Treasury yields lower but despite this the USD has rallied, especially against the EUR, which is not only suffering from renewed peripheral debt concerns and weaker growth, but also from a run of disappointing earnings releases in contrast to the US where earnings have on the whole beaten forecasts. The USD may have benefited from a renewed increase in risk aversion and in this respect further US equity weakness may provide the USD with further support.

Whether EUR/USD will extend its recent losses is doubtful, however. Much will depend on Friday’s US July jobs report and if there is another weak outcome as looks likely, speculation of another round of Fed asset purchases could dent USD sentiment. The currencies that remain on top in this environment are the CHF and to a lesser extent the JPY much to the chagrin of the Swiss and Japanese authorities

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EUR to struggle to extend gains

July 5, 2011 — Mitul Kotecha

Once again the USD index failed to break above its 100-day moving average, its third failure to do so over recent weeks. The USD is now trading below its 20- and 50- day moving averages and looks vulnerable to further weakness. However, much will depend on the travails of the EUR and how quickly the boost to this currency fades following last week’s Greek austerity plan approval.

The USD was helped last week by the relative move higher in US bond yields, which saw 2-year yield differentials between the Eurozone and US drop below 100bps for the first time since the beginning of April. Given that the six-month correlation between 2-year bond yield differentials and EUR/USD is at a very high level, it is reasonable to assume that this will remain an important factor driving the currency pair going forward.

The yield differential narrowing seen last week has reversed as German yields have moved sharply higher this week, however. This is in large part attributed to more positive developments in Greece but nonetheless, it has helped to push the EUR higher.

Ratings agencies may yet spoil the party for the EUR, with S&P’s warning that Greece’s debt rollover plans may put the country’s ratings into select default, fuelling some caution. Should ratings agencies downgrade Greek debt to junk it will not only be international investors that will re-think their exposure to the country but the European Central Bank (ECB) could also stop holding Greek debt as collateral for loans although an official from the Bank noted that this would happen only if all the major ratings agencies downgrade Greek debt to default.

Attention is now turning to the implementation risks of austerity measures and asset sales. While Greece’s contribution to eurozone GDP is small, the pain of implanting more budget cuts will push the economy deeper into recession and reveal the stark divergences in growth in the eurozone at a time when the ECB is hiking interest rates.

In reaction to such concerns there is likely to be a series of measures announced over coming days and weeks to boost growth according to Greece’s finance minister. As the S&P comments and implementation/growth concerns suggest, the EUR may struggle to extend gains, especially as the currency is looking increasingly stretched at current levels, with this week’s ECB rate hike largely in the price. Top side resistance for EUR/USD is seen around 1.4598.

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Risk off mood

May 23, 2011 — Mitul Kotecha

A ‘risk off’ tone is quickly permeating its way through the market psyche as tensions surrounding the eurozone periphery reach fever pitch. This is reflected in the sharp jump in equity volatility as indicated by the VIX ‘fear’ gauge. Equity markets and risk trades in general look set to remain under pressure in the current climate.

Moreover, the EUR which is finally succumbing to bad news about the periphery will continue to face pressure over the short-term. Against this background economic data will likely be relegated to the background this week but it worth noting that what data there is on tap, is likely to send a weaker message, with data such as durable goods orders in the US as well as various purchasing managers indices (PMI) data in the eurozone today likely to show some slippage.

The Greek saga remains at the forefront of market attention, with restructuring speculation remaining high despite various denials over the weekend by Greek and European Central Bank (ECB) officials. News that Norway has frozen payments to Greece, whilst Fitch ratings agency’s downgrades of Greece’s ratings by 3 notches and S&P’s downgrade of Italy’s ratings outlook to negative, have all contributed to the malaise afflicting the periphery.

This weekend’s local election in Spain in which Prime Minister Zapatero and his Socialist Party suffered its worst defeat in more than 30 years leading to a transfer of power in the Spanish regions, will lead to concerns about the ability of the government to carry out much needed legislative changes.

It is difficult to see any improvement in sentiment towards the peripheral Europe and consequently the EUR over the short-term. In Greece, Prime Minister Papandreou will attempt to push through further unpopular austerity measures through parliament this week in advance of a 5th bailout tranche of EUR 12 billion scheduled for next month. This comes at a time when opinion polls show the government losing more support and 80% of those surveyed saying they would not accept more austerity measures.

The deterioration in sentiment for the EUR has been rapid as reflected in the CFTC IMM data, with net long speculative positions now at their lowest since 15 February and heading further downhill. Conversely, USD short covering has been significant though there is still a hefty USD short overhang, which points to more USD short covering as EUR sentiment sours.

Nonetheless, the USD still has plenty of risks hanging over it including the fact that it still suffers from an adverse yield differential (note that 2-year Treasury yields have fallen to the lowest since 6 December 2010). Safe haven currencies in particular CHF are the key beneficiaries and notably EUR/CHF touched a record low around 1.2354 and is showing little sign of any rebound.

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US Dollar Facing Battle On US Debt Ceiling

April 14, 2011 — Mitul Kotecha

President Obama, the Fed’s Beige Book and a firm reading for US retail sales provided some temporary relief for the beleaguered USD but this soon gave way to renewed pressure. Obama proposed cutting around $4 trillion from the fiscal deficit over the next 12-years, similar in size to Republican plans, but structured differently. Separately the Beige Book relatively upbeat, noting “widespread” economic gains across sectors. Finally, whilst top line retail sales were slightly softer than forecast ex-autos sales were upbeat, with upward revisions to the past month.

President Obama’s deficit reduction plans sets the stage for a fractious political battle regarding the $14.3 trillion debt ceiling. Having averted a government shut down following a late agreement between Republicans and Democrats the USD will have a much bigger challenge to face in the weeks ahead. Obama has stated his support for raising the debt ceiling but if agreement is not reached by around mid May (or July if temporary measures are introduced), the US government may effectively default.

When will the USD lose its funding currency mantle? The approach of the end of quantitative easing (QE2) by end June 2011 (assuming the Fed sticks to the plan) will be a particularly important period for the USD. Assuming that there will be no QE3 much will depend on how proactive the Fed is in reducing the size of its balance sheet. This remains unclear and judging by the variety of comments from Fed officials over recent weeks, there is plenty of debate within the Fed FOMC about the pace of balance sheet reduction.

St Louis Fed President Bullard (non-voter) maintained his hawkish stance by highlighting his preference for reducing the Fed’s balance sheet rather than hiking interest rates as a first step towards policy normalisation. There will be further clues both in terms of Fed thinking as well as inflation pressures.

Fed speakers including Duke, Kocherlakota and Liang, Plosser, Tarullo, Lacker, Baxter and Evans will give further clues. CPI inflation data will also be in focus, with headline inflation likely to be boosted by higher energy prices but core inflation likely to remain well behaved. Despite Bullard’s comments the majority of Fed officials appear to be taking a more cautious stance, suggesting that the USD will remain under pressure for a while yet.

The EUR continues to capitalise on generally weak USD sentiment despite nervousness about the details of Portugal’s bailout program. More worryingly for the EUR is ongoing speculation about Greek debt restructuring, with S&P ratings agency noting that the risk of Greek debt restructuring was almost one in three and the Zeit newspaper reporting that investors could lose around 50-70% in a restructuring. Although plans to restructure have been denied by the Greek government this has not stopped Greek bond yields from skyrocketing.

Posted in Bond markets, central banks, Currencies, Economics, Economy, Europe, eurozone, Federal Reserve, Fiscal/Budget, FX, Greece, Interest rates, Monetary Policy, Portugal, US, US administration. Tags: , , , , , , , , , , , . Leave a Comment »
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