The Fed’s future path still seems more bullish than the European Central Bank. If so, the yiel...
Don’t Trust This Euro Rally
01/24/2011 11:20 am EST
The EUR finished out the past week at two-month highs against the USD and posted strong rebounds on the crosses as well. The EUR recovered even after EU finance ministers failed to deliver a concrete long-term debt resolution mechanism (see more below), postponing a likely plan until late March. While there has been some movement on the part of Germany to show greater willingness to provide assistance to the periphery, the German government remains insistent that other EU countries will need to shoulder more of the cost as well.
This raises the question of how highly indebted countries like Belgium, Italy, and Spain will be able to come up with their shares of any support package, and this is the source of our skepticism on the sustainability of the EUR recovery. German data has continued to surprise to the upside with ZEW and IFO surveys all pointing to further strength in the core, and this has also provided the euro with support.
But core euro zone strength was never really the issue, but rather how the periphery will muddle through. On that count, we still have serious doubts that major debt restructurings (i.e. defaults) can be avoided in several of the peripheral nations. In that sense, we view the recent unwinding of bearish EU bets (e.g. short EUR, long sovereign CDS, short peripheral bonds) as a temporary position adjustment, rather than the end to the European debt crisis. Similarly, we think the fears of an ECB tightening phase are overblown and that even uber-hawk and potential next ECB president Axel Weber this week downplayed the risks from inflation and called current policy appropriate. We prefer to use current EUR strength as an opportunity to establish more fundamental short EUR positions for an expected decline in the weeks ahead.
Has Europe’s Sovereign Crisis Turned a Corner?
At this time last week, the market was looking forward to euro zone officials taking decisive steps toward creating a permanent solution to the sovereign debt crisis. However, two meetings of EU officials passed with no resolutions agreed upon. In fact, German finance minister Wolfgang Schaeuble said that the calm that has descended on the peripheral bond markets in recent weeks meant there was less urgency to make changes to the current European Financial Stability Facility (EFSF).
It seems likely that there will be no progress on a permanent solution until the EU council meeting scheduled for March 24-25. Then officials may agree to an extension of the EFSF fund, which currently stands at EUR440 billion. The timing of this meeting is important since it comes just before a state election in Germany on March 27. Only after this can the German Parliament debate proposals for a permanent bailout facility.
Even though it may seem like Europe’s debt problems have been pushed down the road, the market has given Europe the benefit of the doubt. The euro has extended its rally this week and looks fairly comfortable above 1.3500. Investment flows into the safety of German bunds have also fallen, which has pushed up bond yields. The spread between German and US two-year government debt has widened to its highest level since November 2009, which could fuel EUR/USD gains back up to 1.4000.
The single currency may have yield on its side, but the path to 1.4000 could be bumpy. There has been a shift in the discussion of Europe’s sovereign debt crisis away from bailouts and towards default (in Greece’s case) and bank sector nationalization in Spain.
Reports that Germany was working on a plan to provide Greece with a loan to buy back its bonds in a restructuring that could apply haircuts to senior bond holders was swiftly denied. If this is true, it would suggest that the EU is taking the first steps towards fiscal unity, which flaunts the fiscal sovereignty rule in the European constitution. However, officials may not be willing to take such drastic action yet, even if it does sound like a sensible long-term solution to Greece’s problems. The cost to insure Greek debt for five years has fallen this week, suggesting that restructuring could bring some certainty to investors and actually reduce risk for investors holding Greek debt. If you know for certain that you could be subject to a haircut, then you can price Greek debt accordingly.
Spain, meanwhile, is working on recapitalizing its troubled Caja banks. The financial position of the 17 domestic lenders is precarious at best. They are scheduled to report all of their non-performing loans and property holdings by January 31. This could cause market jitters, especially if their liabilities are larger than the approximately EUR50 billion the market is expecting.
NEXT: China Rate Policy, UK GDP Data, Gold and Silver at Key Buy Levels|pagebreak|
Fears of Aggressive China Tightening May Soon Unwind
China’s pace of economic growth accelerated above expectations (Q4 real GDP y/y printed +9.8% versus expected +9.4% in Dec.), which was also reciprocated in Dec. industrial production (+13.5% y/y versus expected +13.4%) and Dec. retail sales (+19.1% versus expected +18.7%). The markets’ reaction to positive China data surprises, however, was negative. Fears of a potential ramp up in PBOC tightening measures gripped financial markets with the brunt of the impact hitting commodities —gold declined -1.7%, WTI crude oil fell -2%, and silver lost around -4% post data release.
Commodity currencies experienced concurrent declines as AUD/USD fell sharply below parity to lows around 0.9835, and USD/CAD soared to highs around 1.0030. However, the commodity market selloff should be taken with a grain of salt as speculation for more aggressive PBOC rate hikes are likely to be just that: Speculation. Steadying inflation—December consumer prices y/y declined to 4.6% from a prior 5.1%, as did producer prices to 5.9 % from a prior 6.1%—may balance out added tightening pressures from faster-than-expected growth and is likely to see policy direction stay the path of a moderate tightening cycle.
Accordingly, we think the post-data commodity currency selloff may be overextended. AUD/USD fell off a proverbial cliff from highs around 1.0075 but was met by strong demand ahead of the 0.9825 range lows. The pair has been consolidating within a 0.9800/1.0025 range since Jan. 6, 2011. Above 0.9825 may provide good value for longs on persistent sideways price action. Aussie crosses have also corrected lower on the back of China tightening speculation. AUD/CHF is currently testing key support into 0.9450 and warrants bringing stops to cost as protection against a sharp upside correction, as we believe this to be a possibility when rate realities begin to set in over rate expectations.
A Chilly Fourth Quarter for the UK
The strength of the UK’s economic recovery faces its most severe test on January 25 when GDP data is released for the fourth quarter of 2010. Market analysts expect the quarterly growth rate to dip to 0.5% from 0.7% in the third quarter and a whopping 1.2% in the second quarter. But the risks are to the downside.
The trade deficit increased over the quarter, which will hit growth; also, economic data released so far has shown a divergence between different sectors of the UK economy. The manufacturing sector has come back with a bang, and the PMI manufacturing index reached a multi-year high of 58.3 in December. In itself, this is good news. However, the manufacturing sector is only a small portion of the UK’s economy; a far more important sector is consumption, and there, the figures are looking grim.
Retail sales have been on a downward trajectory since October, culminating in a dismal 0.8% monthly decline in sales in December, a record drop. Although part of the decline was due to the coldest weather in a century hitting the UK, the hike in sales taxes on January 1 suggests that retail sales will not pick up anytime soon. On another note, rising fuel and food costs also depressed retail sales at the end of 2010, which puts more pressure on the Bank of England. The minutes of the latest Bank of England meeting will be released on January 26, which should give us some idea of where the debate is heading within the monetary policy committee: To hike or not to hike?
As mentioned, there is a chance that expectations for the UK’s economic growth are overdone. If we get a weak GDP reading this week, then we could see a sharp reversal in long sterling positions. We were wary about the sustainability of growth in the UK, and wrote in our Q1 2011 outlook that we thought 1.6000 would be a tough resistance level for GBP/USD to break through; so far, it looks that way.
Precious Metals May Enter Q1 2011 Predicted Buy Zones
While the correction in gold and silver has taken a few weeks longer than predicated in our 1Q 2011 precious metals outlook, that correction has still come nonetheless. The unwinding since the turn of the year has been treacherous, especially for silver, the “poor man’s gold,” but ultimately, little has changed fundamentally. Much of this price action can be attributed to a reduction of long positioning since the “doomsday” scenario appears to be off the table. In the short term, the market believes troubles in both the US and EU have abated, primarily due to rising US 2011 GDP estimates based on the 2% reduction of the social security tax and EU official’s willingness to discuss a permanent solution and/or changes to the European Financial Stability Facility (EFSF). However, this euphoria is unlikely to last forever, and Wednesday’s FOMC interest rate decision may provide a spark in renewed interest for precious metals—the Fed is likely to reaffirm their view to keep interest rates “low for an extended period of time.” We believe gold and silver may trade down into the $1300-$1325 and $26-$27 regions this week, respectively, and could be an attractive area to establish a bullish bias over the coming weeks and months. Alternatively, buying a dip in XAU/EUR between EUR970-980, for those who prefer to remove the USD variable, could also be an idea.
By Brian Dolan, chief currency strategist, FOREX.com
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