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 »

Greece In The Spotlight (again)

April 7, 2010 — Mitul Kotecha

Once again Greek worries are hogging the limelight and although the Greek saga has become a rather tedious affair for markets, concerns are well founded.  The latest issue is whether Greece is willing to adhere to potentially tough measures that would be associated with IMF assistance for the country.  Latest speculation suggests that Greece may side step the IMF to avoid such measures though this was belatedly denied by the Greek authorities. 

Given the huge amount of bonds Greece needs to sell over the coming weeks renewed nervousness does not bode well for a good reception to this issuance. As it is financing costs are rising once again in the wake of a renewed widening in Greek sovereign bond spreads and servicing this debt will add to the economic misery.  Greece has little by way of upside over coming months and years.  Tough and necessary austerity measures mean that sharp growth deterioration is inevitable, deepening recession.

The lack of flexibility for Greece to devalue its way out of its quagmire means much more economic pain with no release valve.   The same applies to the likes of Spain and Portugal.  The overall loser will be the EUR which looks likely to succumb to further weakness in the months ahead; the parity trade remains a prospect. Perversely a weaker EUR may be exactly what is necessary to alleviate some of the pain for Southern European economies though the EUR would need to weaken by much more than we forecast to be of much help.   

Aside from Greek gyrations the overall market tone looks somewhat positive.  The Fed’s dovish minutes of its March 16 meeting in which it marginally downgraded growth and inflation forecasts, highlights that interest rates are unlikely to be raised by the Fed this year. This will keep in place an accommodative policy stance conducive to further improvements in risk appetite.     Moreover, data releases such as the US ISM manufacturing and non-manufacturing surveys, have been generally supportive to recovery,

Easing tensions on China/US exchange rate policy have also helped sentiment as the issue has been put to one side after the US administration delayed the decision whether to officially label China as a currency manipulator.  Pressure from the US Congress suggests that the issue will not be on the back burner for long and the issue of CNY revaluation will likely be a topic at the during the various meetings between US and Chinese officials over coming weeks. 

Nonetheless, the delay in the US Treasury report will work in favour of a Chinese currency revaluation sooner rather than later as China will likely react more favourable to less international pressure to revalue.

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Better Levels To Sell

March 1, 2010 — Mitul Kotecha

It is questionable how long the slight improvement in risk appetite at the beginning of this week lasts given the fickle nature of market sentiment at present and propensity for more disappointment. More than likely any relief will be short-lived given 1) there are still major concerns about fiscal/debt problems in Greece, Spain, Portugal, etc 2) the sharp decline in economic activity that various austerity plans will lead to and 3) rising social/labour unrest due to cuts in spending and hikes in taxes that need to be implemented.

Attention remains firmly fixed on Greece’s woes whilst global growth concerns have reappeared following some disappointing data releases in the US last week as well the decline in China’s manufacturing purchasing managers’ index (PMI) in February, released overnight, which although obscured by the timing of Chinese Lunar New Year holidays, suggests that China’s economy is losing some of its recent strong momentum.

Speculation of a rescue plan for Greece will likely give some support to the beleaguered EUR though it may only end up providing better levels to sell the currency. EU Monetary Affairs Commissioner Rehn is scheduled to meet with Greek Prime Minister Papandreou today against the background of talks about the possibility of EUR 25 billion in aid to Greece using state owned lenders to buy Greek debt. Any aid will likely come with demands for more action to reduce Greece’s yawning budget deficit which will fuel further weakness in economic activity.

A key test of sentiment towards Greece’s austerity plans will be the market reception to an upcoming sale of as much as EUR 5 billion in 10-year Greek bonds. Given the reassurances given by the EU the sale of bonds will likely not be too problematic. As an indication, Greek 10-year bond yields dropped sharply on Friday as sentiment improved.

The bounce in Greek debt was accompanied by a firmer EUR/USD which rebounded to a high of around 1.3667 as markets covered short positions. It’s probably way too early to suggest that the EUR has began a sustainable rally however, and more likely it has settled into a new range, with support around the 2010 low of 1.3444. The latest CFTC Commitment of Traders’ (IMM) data revealed a further increase in net short EUR positioning to a new record low in the week to 23rd February. This highlights both the weight of pessimism on the currency as well as significant potential to rebound.

Conversely, the IMM data reveals that net USD positions are at their highest in almost a year and well above their three-month average, suggesting that USD positioning is looking a bit stretched though its worth noting that positioning is still well off its record high. Nonetheless, with a bailout for Greece in the offing, risk appetite could gain a stronger foothold this week, in turn keeping the USD capped.

As for the EUR, although a lot of bad news is in the price, for the currency to rebound on a sustainable basis it will require fiscal/growth worries to recede. Despite talk of Greek aid, there is a long way to go before Europe’s fiscal/debt problems are resolved.

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What To Watch This Week

February 7, 2010 — Mitul Kotecha

As usual the G7 meeting will leave markets with little to chew on. G7 officials maintained their commitment to stimulus measures and timely exit strategies but there was little of note for FX markets aside from the usual comments about wanting to avoid excess FX volatility. There was certainly know step up in pressure on China to strengthen though a report prepared for the meeting did push for countries with inflexible currencies to make adjustments. Meanwhile US officials mouthed the usual “strong dollar” mantra.

Where does this leave markets this week? Well I must admit my bullish view on risk currencies is clearly suffering after a positive start to the year. The pullback in high beta currencies (those with the highest sensitivity to risk aversion) has been dramatic. I have highlighted many of the factors weighing on sentiment in previous posts and whilst I still think the US dollar will find itself under renewed pressure over coming months the current environment remains conducive to more USD and JPY buying and selling of currencies such as the AUD, NZD, CAD, GBP, NOK, SEK, ZAR etc.

Ironically the US and Japan have arguably more severe deficit/debt concerns than some of the European countries under pressure but as most of Japan’s debt is held domestically there is little worry of a collapse in JGBs. Unlike Japan foreign investors hold over half of US debt but are not yet losing confidence with US Treasuries though this may not last unless there is some tangible sign that the burgeoning US budget deficit is being reduced. For now, attention remains firmly focussed on Greece, Spain, Portugal and to a lesser extent Italy.

Like the G7 meeting the US January jobs report released at the end of last week will give little direction for markets. Although the 20k drop in payrolls and revisions to past months were slightly disappointing the surprise drop in the unemployment rate was better news. This week’s data highlights include the January US retail sales report and December trade balance. The sales data is likely to help allay some concerns about faltering economic recovery, with retail sales forecast to rise over the month despite a likely pull back in autos spending.

How will this play out for currencies this week? Overall, the risk off tone is set to continue though the moves are looking increasingly stretched. The USD, JPY and CHF will remain on the front foot whilst risk currencies will remain under pressure. The EUR is set to continue to struggle against the background of eurozone deficit concerns and after its dive through 1.40 last week 1.35 now looms large. Meanwhile, the AUD may also struggle following the recent reassessment of interest rate expectations after the recent Reserve Bank of Australia (RBA) meeting in which interest rates were left unchanged.

UK markets will focus on the Quarterly Inflation Report from the Bank of England though the political situation may hold some interesting implications for GBP if polls continue to show that the gap between the governing Labour party and Conservative opposition continues to narrow. Prospects of a hung parliament will hardly hold any positive implications for GBP, a prospect which could limit any potential for GBP to recover ahead of May elections. The drop below 1.60 for Cable (GBP/USD) could extend further, especially as the BoE has kept the door open to further asset purchases if needed.

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