The Global Currency Trading Trend

07/02/2010 12:01 am EST

Focus: FOREX

After the major market shakeout through May over European debt fears, we have begun to see a slightly better attitude when it comes to risk. Granted, financial markets have priced in a decent chance of a double-dip recession for advanced economies later this year. The economic data, on the other hand, has been mixed, but does not yet support anything that bad. We remain in the midst of the transition from stimulus power to private power. Risk, as a result, is being weighed down by uncertainty and will remain prone to a high degree of volatility as markets re-price more aggressively with each new release. The epicenter of Europe remains mired in tall risk concerns of a full-blown debt crisis and the more likely outcome of further government rating downgrades and fiscal tightening.

We recently noted that market pricing of the economic risks has become significantly divorced from the current tracking of the data itself. Either the economic data needs to deteriorate to match the signals coming from equities and commodities, or we should expect some improved sentiment in markets in the second half of the year. We've highlighted US employment and Asian trade figures as two key indicators of global growth momentum, and on cue, stronger US weekly claims and a phenomenal April export result for China helped improve market sentiment after the disappointing May payrolls figures.

The issue we see the market going through right now is trying to appropriately price the transition from the stimulus sugar high to the complex carbs of sustainable private demand. The sugar high that energized the global economy and global markets since the second quarter of last year is now fading. This was something we last highlighted in the November global markets report. Updating the key chart here, it continues to support our focus on the transition from the first to the second half of this year as the major event for global markets this year. This may show the various impulses working through the US economy, but similar impulses can be shown for all major economies. Europe's slower recovery and institutional weaknesses when it comes to multiple fiscal authorities within one currency union have simply made them the first most-vulnerable area to focus on.

We think ultimately there needs to be a meeting in the middle between economic forecasts and market levels. The market may be overpricing the risks in the second half of the year given at some point, central banks will need to hold their nose and deliver additional stimulus. But clearly economic forecasts need to appreciate that steep declines in equities and commodities and credit tightening in Europe do have real implications for future investment and employment decisions. We do need to keep some perspective here though as the re-tightening we have seen in US money markets, for example, would need to get much worse before it had a significant drag on GDP. By our measures of credit tightness to GDP, the rise in LIBOR is enough to potentially shave half a percentage point off of US residential investment growth in the second half of 2010, but only up to one-tenth of one percentage point off of total GDP growth. The risks remain on fears of what we may yet see, not any cataclysmic results due to what we have already seen. But credit impacts the economy only with a two- to three-quarter lag as investment decisions are altered when credit cannot be retained. So the economic evidence will not be forthcoming immediately.

Euro Woes

The risk factors here remain centered on Europe. The renewal of concerns over the Spanish banking system highlights one vulnerability. While the markets have shown some relief with the final agreement on the EUR 440 billion European Financial Stabilization Fund (EFSF), the unfortunate truth is that the ultimate danger of a sovereign debt crisis is that it bleeds into the domestic banking sector. Cutting off credit to the private sector is the larger concern and one that the EFSF cannot help with. Even though the markets may be signaling that European deficits need to be cut, and even European leaders this week have said Portugal and Spain in particular need to reduce their planned 2011 deficits even further, we may not yet be done with shifting private sector liabilities onto the public sector balance sheet. This cannot be paid for with the EFSF directly, but would show up with the increased issuance needs of Spain.

The other risk is rating downgrades. With the crossholdings of debt across Europe, repairing the banking sector will be a slow process. Lowering deficits will take some time as the eventual rise in yields will mean higher debt service costs and weaker economic prospects mean plans are still prone to slippage. Greece is unlikely to default or restructure soon, but this remains likely about two to three years out. All of this implies further rating downgrades will likely be in the pipeline, both weighing on sentiment and the euro and reinforcing higher default premiums in fixed income.

The peripheral European economies are most at risk, but France, Italy, and Spain—the second, third and fourth largest euro zone economies—are all at risk themselves with varying vulnerabilities of debt, deficit, and interest costs. The biggest risks here in the market lie in the likely response of the euro. Over the last six months, our weighted euro zone sovereign credit rating index has fallen by 0.2 points, while the euro has fallen from 1.50 to 1.20. A one-notch downgrade of France or two-notch downgrade of Spain would imply a further 0.07-point drop in our index, with the potential to pressure the euro towards 1.10. Market distress by a thousand paper cuts is the more valid concern at the moment rather than expecting another extreme black swan event like the subprime crisis.

Inflation Risks Remain to the Downside

Outside of all of these risks, we should be certain to keep our eyes on the broader fundamentals still bearing down on global markets. Budget deficits trend with output gaps, and both can generally be expressed as the average growth in the economy in the preceding years. So budget deficits around the world will improve as economies improve, but there is no magic pill to cut government deficits without any adverse impacts on the economy. So the G10 space will continue to be split between countries with high deficits and low interest rates like the US and Europe versus the better-performing areas like Canada and Australia, which can support higher interest rates because of their better fiscal positions. Deficits reflect economic weakness, but all restrain the ability of rates to move higher until inflation and the economy have finally recovered.

At the same time, those same output gaps correlate nicely with changes in inflation and bond yields. Economists may have a hard time figuring out precisely how much slack there is in the economy at any given moment. But what is clear is that we remain near levels that continue to pose downside risks to inflation and can keep yields low for long in spite of issuance fears. Is a fiscal risk premium likely to remain in the US and Europe? Yes, because this is the current group of profligate spenders where markets fear rating downgrades, financing questions, and potentially higher inflation. Interestingly though, the correlations here show that eventually higher inflation and lower budget deficits will go hand in hand, but this is only natural and not part of some nefarious plot.

So as emerging market economies continue to barrel ahead and only selectively increase interest rates, this continues to provide some support for global demand and markets. But the real support that can offset the above risks would be further easing from G3 central banks. Reflating consumer prices remains a remote possibility, so in the mean time, reflating balance sheets must continue in order to increase the levels of credit and spending that can be supported globally. If the economic data does eventually come into line with the current pullback in markets, then the Fed and ECB will find ways to introduce new stimulus into the economy and provide yet another boost to the support for risky assets. For the time being, however, the market continues to try and price uncertainty rather than facts. As a result, we would generally not fully buy into its fits of pessimism, nor be inclined to wade into its moments of hopeful optimism as we have at the moment.

By the Staff at ActionForex.com

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