Extreme Uncertainty

The level of uncertainty enveloping global markets has reached an extreme level. Who would have thought that close to 13 years after its introduction at a time when it has become the second largest reserve currency globally (26.7% of global reserves) as well as the second most traded currency in the world, European leaders would be openly talking about allowing countries to exit the EUR? No less an issue for currency markets is the sustainability of the USD’s role as the foremost reserve currency (60.2% of global reserves). The US debt ceiling debacle and the dramatic expansion of the Fed’s balance sheet have led to many official reserve holders to question their use of the USD. Perhaps unsurprisingly the JPY has been the main beneficiary of such concerns especially as global risk aversion has increased but to the Japanese much of this attention is unwanted and unwelcome.

The immediate focus is the travails of the eurozone periphery. Against the background of severe debt tensions and political uncertainties it is perhaps surprising that the EUR has held up reasonably well. However, this resilience is related more to concerns about the long term viability of the USD rather than a positive view of the EUR, as many official investors continue to diversify away from the USD. I question whether the EUR’s resilience can be sustained given that it may be a long while before the situation in the eurozone stabilises. Moreover, given the now not insignificant risk of one or more countries leaving the eurozone the long term viability of the EUR may also come into question. I believe a break up of the eurozone remains unlikely but such speculation will not be quelled until markets are satisfied that a safety net / firewall for the eurozone periphery is safely in place.

In this environment fundamentals count for little and risk counts for all. If anything, market tensions have intensified and worries about the eurozone have increased since last month. Politics remain at the forefront of market turmoil, and arguably this has led to the worsening in the crisis as lack of agreement between eurozone leaders has led to watered down solutions. Recent changes in leadership in Italy and Greece follow on from government changes in Portugal and Ireland while Spain is widely expected to emerge with a new government following elections. Meanwhile Chancellor Merkel has had to tread a fine line given opposition from within her own coalition in Germany while in France President Sarkozy is expected to have a tough time in elections in April next year. The likelihood of persistent political tensions for months ahead suggests that the EUR and risk currencies will suffer for a while longer.

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Contagion spreading like wildfire

EUR continues to head lower and is is destined to test support around 1.3484 versus USD where it came close overnight. Contagion in eurozone debt markets is spreading quickly, with various countries’ sovereign spreads widening to record levels against German bunds including Italy, Spain, France, Belgium and Austria. Poor T-bill auctions in Spain and Belgium, speculation of downgrades to French, Italian and Austrian debt, and a weak reading for the November German ZEW investor confidence index added to the pressure.

A bill auction in Portugal today will provide further direction but the precedent so far this week is not good. The fact that markets have settled back into the now usual scepticism over the ability of authorities in Europe to get their act together highlights the continued downside risks to EUR/USD. Although there is likely to be significant buying around the 1.3500 level, one has to question how long the EUR will continue to skate on thin ice.

The Bank of Japan is widely expected to leave policy unchanged today but the bigger focus is on the Japanese authorities’ stance on the JPY. Finance Minister Azumi noted yesterday that there was no change in his stance on fighting JPY speculators. To some extent the fight against speculators is being won given that IMM speculative positions and TFX margin positioning in JPY has dropped back sharply since the last FX intervention to weaken the JPY.

However, this has done little to prevent further JPY appreciation, with USD/JPY continuing to drift lower over recent days having already covered around half the ground lost in the wake of the October 31 intervention. Markets are likely therefore to take Azumi’s threats with a pinch of salt and will only balk at driving the JPY higher if further intervention takes place. Meanwhile, USD/JPY looks set to grind lower.

GBP will take its direction from the Bank of England Quarterly Inflation Report and October jobs data today. There will be particular attention on the willingness of the BoE to implement further quantitative easing. A likely dovish report should by rights play negatively for GBP but the reaction is not so obvious. Since the announcement of GBP 75 billion in asset purchases a month ago GBP has fared well especially against the EUR, with the currency perhaps being rewarded for the proactive stance of the BoE.

Moreover, the simple fact that GBP is not the EUR has given it a quasi safe haven quality, which has helped it to remain relatively resilient. Nonetheless, GBP will find it difficult to avoid detaching from the coat tails of a weaker EUR and in this respect looks set to test strong support around GBP/USD 1.5630 over the short term.

Data releases in focus

For a change the markets may actually concentrate on data releases today rather than political events in the eurozone. The October US retail sales report and November Empire manufacturing survey are likely to paint a less negative economic picture of the US. The data will help to dampen expectations of more quantitative easing in the US but we will be able to hear more on the subject from the Fed’s Bullard and Williams in speeches today.

Overnight the Fed’s Fisher poured more cold water on the prospects of further QE by highlighting that the economy is “poised for growth”. While speculative data in the form of the CTFC IMM data shows a drop in USD sentiment to its lowest in several weeks we do not expect this to persist. The USD will likely benefit from the data today and we see the currency retaining a firmer tone over the short term especially as eurozone concerns creep back in.

The vote by German Chancellor Merkel’s party to approve a measure for a troubled country to leave the EUR opens up a can of worms and will hit EUR sentiment. But rather than politics there are several data releases on tap today that will provide some short term influence on the EUR, including Q3 GDP and the November German ZEW survey. FX markets will likely ignore a positive reading for GDP given that the outlook for Q4 is going to be much worse. The forward looking ZEW survey will record a further drop highlighting the risks to Europe’s biggest economy.

T-bill auctions in Spain and Greece may garner even more attention. Following on from yesterday’s Italian debt sale in which the yield on 5-year bond came in higher than the previous auction but with a stronger bid/cover ratio, markets will look for some encouragement from today’s auctions. Even if the auctions go well, on balance, relatively downbeat data releases will play negatively for the EUR.

When viewing the EUR against what is implied by interest rate differentials it is very evident that the currency is much stronger than it should be at least on this measure. Both short term (interest rate futures) and long term (2 year bond) yield differentials between the eurozone and the US reveal that EUR/USD is destined for a fall.

Europe’s yield advantage has narrowed sharply over recent months yet the EUR has not weakened. Some of this has been due to underlying demand for European portfolio assets and official buying of EUR from central banks but the reality is that the EUR is looking increasingly susceptible to a fall. EUR/USD is poised for a drop below the psychologically important level of 1.35, with support seen around 1.3484 (10 November low).

Contrasting US and European data

While the week is likely to commence in a positive mood as political uncertainties in Greece and Italy ease somewhat, there are still plenty of uncertainties that could derail risk appetite. In particular, there has been little progress on agreeing on further details on leveraging the EFSF bailout fund. Moreover, many are looking to the European Central Bank (ECB) to take up the role as lender of the last resort. Indeed, the difficulty of the EFSF debt issue last week to garner demand puts the onus firmly on the ECB.

While it is likely that the ECB will have to step up its bond purchases especially given the heavy bond supply this week from Italy, France and Spain, the ECB is very reluctant to take up this mantle. As a result, peripheral and increasingly core bond market sentiment will remain fragile while the EUR will be vulnerable to a drop lower, especially given how rich it looks around current levels close to 1.38 versus USD. The week will likely be one of selling risk on rallies.

Data releases this week will show some contrasts between the US and Europe. US data will further dampen expectations of more Fed quantitative easing, with October retail sales and industrial production set to register gains and November manufacturing surveys likely to bounce. Several Federal Reserve speeches this week will shed more light on the FOMC’s stance and likely some support for purchases of mortgage backed securities will be reiterated.

In contrast eurozone data will show further deceleration. Industrial production in September is likely to have dropped sharply while the German ZEW investor confidence survey is set to have dropped further in November. Even an expected bounce in eurozone Q3 GDP will do little to stave off recession concerns given that growth in the final quarter of the year will have been much weaker. Banking sector develeraging will only add to growth concerns as credit expansion in curtailed.

In FX markets, the risk currencies will be vulnerable to selling pressure. EUR/USD has rebounded having tested highs around 1.3815 this morning but its gains look increasingly fragile. USD/JPY continues to grind lower, with no sign of further intervention from the Japanese authorities. Elevated risk aversion and the narrow US yield advantage continues to support the JPY making the job of weakening the currency harder. GBP has done well although it has lagged the EUR against the USD over recent days. A likely dovish stance in the Bank of England (BoE) quarterly inflation report will see GBP struggle to extend gains above 1.60 against the USD.

Euphoria fades, risk currencies weaker

The euphoria emanating from last week’s eurozone agreement will likely fade into this week as renewed doubts creep in. Details of how the EFSF bailout fund will be leveraged or how the special purpose vehicle will be utilised have yet to emerge while the firewall to protect countries such as Italy and Spain may still be insufficient given that the use of the European Central Bank (ECB) to provide unlimited support has been ruled out.

With more questions than answers markets will be hungry for further details over coming weeks and until then it is difficult to see risk appetite stretching too far. One indication of such concern was the fact that Italy’s borrowing costs climbed to euro-era highs the day after the European Union (EU) plan was agreed. The G20 meeting on 3-4 November will be eyed for further developments as well as further reaction to the EU agreement.

There are plenty of events to digest this week that could add to any market nervousness. In terms of central banks we do not expect to see any change in policy stance from the ECB, Federal Reserve or Reserve Bank of Australia (RBA) this week but the decisions may be close calls. The ECB under the helm of new President Draghi will be under pressure to ease policy as growth momentum has clearly weakened but the Bank will likely hold off for the December meeting when new growth and inflation forecasts will be released.

The RBA may also take some solace from a better global economic and market climate but the market disagrees having priced in a cut this week. The Fed will look to see how ‘Operation Twist” is faring before moving again but recent indications from some Fed officials suggest growing support for purchases of mortgage backed securities.

On the data front eurozone inflation today will be the key number in Europe while the US jobs report at the end of the week will be the main release in the US. Ahead of the payrolls data, clues will be garnered from the ISM manufacturing data and ADP jobs report. The consensus is for a 95k increase in non-farm payrolls and the unemployment to remain at 9.1% maintaining the trend of only gradual improvement in the US jobs market.

Recent data releases have turned less negative, however, and at the least have helped to alleviate renewed recessionary concerns. Overall, I suspect that markets will come back down to the reality of slow growth and unanswered questions this week, with risk assets likely to lose steam over coming days.

Euro still looks uglier than the dollar

Currency markets continue to vacillate between US debt ceiling concerns and eurozone peripheral debt worries. Despite a lack of agreement to raise the debt ceiling, with House Republicans failing to back a proposal by House speak Boehner, the USD actually strengthened towards the end of the week as eurozone peripheral issues shifted back into focus.

The resilience of the USD to the lack of progress in raising the debt ceiling is impressive and reveals that the EUR looks even uglier than the USD, in many investors’ eyes.

Much in terms of direction for the week ahead will depend on the magnitude of any increase in the debt ceiling and accompanying budget deficit reduction measures. Assuming that a deal is reached ahead of the August 2 deadline it is not obvious that the USD and risk currencies will enjoy a rally unless the debt ceiling deal is a solid and significant one.

Given the limited market follow through following the recent deal to provide Greece with a second bailout, the EUR remains wholly unable to capitalise on the USD’s woes.

A reminder that all is not rosy was the fact that Moody’s ratings agency placed Spain’s credit ratings on review for possible downgrade while reports that the Spanish parliament will be dissolved on September 26 for early elections on November 20 will hardly help sentiment for the EUR. Compounding the Spanish news doubts that the EFSF bailout fund will be ready to lend to Greece by the next tranche deadline in mid-September and whether Spain and Italy will participate, have grown.

Some key data releases and events will also likely to garner FX market attention, with attention likely to revert to central bank decisions including the Bank of Japan, European Central Bank, Bank of England, Reserve Bank of Australia and US July jobs report. None of the central banks are likely to shift policy rates, however.

The risk for the USD this week is not only that there is disappointing result to the debt ceiling discussions, but also that there is a weak outcome to the US July jobs report. An increase of around 100k in payrolls, with the unemployment rate remaining at 9.2%, will fixate market attention on weak growth and if this increases expectations for a fresh round of Fed asset purchases the USD could be left rather vulnerable.

The RBA is highly unlikely to raise interest rates but the tone of the accompanying statement is unlikely to be dovish. The RBA noted the strong emphasis on the Q2 CPI inflation data and in the event it came in higher than expected, a fact that supports my expectation that the Bank will hike policy rates at least once more by the end of this year.

Markets have largely priced out expectations of a rate cut but there is still scope for a more hawkish shift in Australian interest rate markets, which will give the AUD a boost. However, AUD remains vulnerable to developments in the US and Europe as well as overall risk aversion, and a preferable way to play a positive AUD view in the current environment is via the NZD.

EU Deal Boosts Euro But Momentum To Fade

The European Union deal for Greece was clearly on the positive side of expectations and from that perspective helped to buoy sentiment for European assets. The fact that EU leaders managed to work over differences and emerge with a solid deal will help remove some of the uncertainty about Greece’s future and lower the risks of contagion.

To recap EU leaders announced a EUR 109 billion second aid package for Greece. Private bondholders will contribute a target of a further EUR 37 billion via bond swaps or rolling over existing debt for new bonds maturing in 30 years. Investors will have the option to exchange existing debt into four instruments. The aim is to obtain 90% participation from Greek bondholders.

Moreover, it appears that governments will guarantee any defaulted Greek debt offered as collateral until the country can return to the market. Effectively this means that even if ratings agencies declare a default rating on Greek debt, Greek banks may still be able to obtain funding from the European Central Bank (ECB) as the debt is guaranteed by national governments.

Greece, Portugal and Ireland will benefit from lower interest rates on loans and longer maturities. Moreover, the European Financial Stability Facility (EFSF) bailout fund will have a wider scope for bond buying directly from investors. This lets the ECB off the hook to avoid further use of its own bond purchase programme and removes any further impairing of its balance sheet. The idea of a tax on banks was removed, as criticism of the workability of such a plan increased.

The downside of the deal includes the fact that:
1) European tax payers are on the line for a potentially unlimited amount to guarantee defaulted Greek debt,
2) The bondholder programme is only limited to Greece, so there is no contingency should something similar be needed in other countries
3) The participation rate for private bondholders is yet to be known (but will most likely be high).
3) The deal will lead to a default on Greek debt given the programme amounts to a 21% drop in value but a credit event is unlikely to be triggered.
4) Greece still has a highly ambitious privatisation and austerity plan to implement which even some Greek officials have admitted is overly optimistic and at worst could turn into a fire sale of Greek assets.
5) EFSF bond purchases will need the “mutual agreement” of member states which is by no means guaranteed.
6) The fund size is not large enough should Italy and Spain need similar bailouts especially as leaders have stressed that the Greek package will not be replicated for other countries.

The EUR rallied on the outcome of the European talks. However, the EUR has plenty of other worries to deal with including divergence in growth across the eurozone, overly long EUR market positioning, EUR overvaluation, likely growth underperformance versus the US and a likely rebound in general for the USD over coming months especially if the Fed does not embark on QE3 and agrees a deal to raise the debt ceiling. EUR/USD is likely to remain supported in the near term, with near term resistance around 1.4467. I still suspect that the momentum will not last, with EUR/USD looking particularly rich at current levels.

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