The Fed’s future path still seems more bullish than the European Central Bank. If so, the yiel...
Forex Traders Avoiding the Risk Trade
06/13/2011 10:15 am EST
As stocks and commodities continue to struggle, traders will watch the ongoing debate over US debt, the controversial new bailout for Greece, and monetary policy decisions from several central banks.
Risk assets (stocks and commodities) continue to slide lower after topping out in early May on signs the global recovery was losing steam. Incoming data continues to highlight a slowdown in major developed economies, and the main question is whether this is only a temporary soft patch, or the start of a more ominous deceleration in growth.
Optimists can point to temporary factors—like the surge in energy prices—as the cause for recent weakness in demand, and express confidence that growth will pick up shortly. Pessimists, on the other hand, highlight structural drags on growth—like high unemployment and the exit from fiscal stimulus and imposition of austerity measures—as the roots of a more pronounced slowdown.
The reality lies somewhere in between, where temporary factors intensify the effects of the structural constraints on growth, but the overall trajectory is clearly one of slowing. This suggests to us that the pullback in risky assets has further room to run.
For the time being, the pullback in risk assets appears moderate and orderly, but there are plenty of potential developments that could trigger a much more severe collapse in risk markets.
The game of chicken being played over Greek debt (see below) has the potential to trigger another financial and liquidity crisis that seems unlikely to remain confined to European shores. A resolution is needed before the June 23-24 EU summit in Brussels, and possibly before the June 20 finance ministers conclave.
The debate in the US on raising the debt limit, now with less than eight weeks to go until the August 2 Treasury deadline, is another potential show stopper.
An exodus of investors from emerging markets appears to be underway, and we would note the MSCI Emerging Market Index has dropped out of the daily Ichimoku cloud.
Sentiment also appears to be building that China is at risk of a real estate bubble bursting, though timing that is extremely difficult. And all of these events are playing out against the backdrop of a deceleration in major economies.
Looking ahead, we anticipate further declines on a gradual basis, but we are on alert for event risks to trigger a much more severe collapse. Finally, we would note that the S&P 500 last week closed below the daily Ichimoku cloud (bearish), and this past week registered a close below the weekly Kijun line (bearish), suggesting potential lower to the weekly cloud top, currently at 1175.
We will continue to look for opportunities to get short risk assets on remaining strength. In concrete terms, we think shorts in AUD, CAD, and NZD against the USD and JPY from just above current levels offer attractive opportunities.
NEXT: ECB Gives the Market a Reality Check|pagebreak|
ECB Gives the Market a Reality Check
The euro finished the week on a lull, breaking through the key 1.4500 mark on the back of 1) a less- hawkish-than-expected ECB, and 2) fears that private investors will take a hit if Germany gets its way over negotiations for a second bailout for Greece.
The ECB may have signaled a rate hike in July by using the words “strong vigilance” during its press conference on Thursday, but rather than cause the currency to surge, the opposite thing happened and the euro dropped back below the critical 1.4500 mark.
The market concentrated on the ECB staff macroeconomic predictions. While growth for this year was higher, inflation for next year was revised lower to a range between 1.1% and 2.3%, much closer to the ECB’s 2% target.
While interest rates have been a major driver of the euro in recent months, the growth story is coming back to the forefront. Even Germany, the currency bloc’s economic powerhouse, is not immune to the global moderation in growth. The Bundesbank expects a sharp drop in Germany’s growth rate between this year and next from a stellar 3.1% in 2011 to 1.8% next year.
With the ECB looking set to take its time over interest rate normalization, the interest rate premium that has been driving the single currency may start to be priced out as the chance of further rate hikes after July starts to moderate. European interbank lending rates fell after the ECB’s press conference, but the outlook for monetary policy in the Eurozone really depends on how well the global economy weathers the current malaise in growth. If growth picks up again later this year, the ECB may continue to hike rates.
However, the fact that EUR/USD has only managed to stay above 1.4500 for brief spells of late suggests the currency is at risk of a longer-term contraction. While we don’t expect an imminent collapse, above 1.4850 now looks remote and we believe the downside is protected above 1.4000.
Germany Risks Raising ECB’s Ire
Markets hate uncertainty, but that hasn’t stopped the ECB and Germany from staging a very public disagreement over how to bail out Greece. Without extra funds, the troubled southern European nation may have to default next month after the first bailout, which was due to last until mid-2012, was shown to be woefully inadequate.
The markets may have given the various branches of power within the EU the benefit of the doubt that a mutually agreeable solution to the Greek crisis would be found, but as D-day for Greece approaches, it is losing faith. This is likely to weigh on the single currency for the foreseeable future and has sent the cost to insure Greek debt against default to fresh record highs.
Germany wants private bondholders to share in the burden of further aid to Greece to the tune of EUR 30 billion, or roughly 50% of the extra funds that are needed. However, haircuts or maturity extensions on bonds are totally unacceptable to the ECB for a viable reason.
Credit ratings agencies have said that if Germany gets its way and maturities on Greek debt are extended—possibly by seven years—then this would constitute a default and credit ratings would be adjusted as needed. And it would not just be Greece who would suffer; Portugal and Ireland would also be at risk.
This is problematic for the ECB, which holds in excess of EUR 75 billion of peripheral debt on its balance sheet through its securities markets program, as well as holding more Greek and Irish debt as collateral in return for loans to these nations’ troubled banking sectors. Multiple rating downgrades would hit the ECB’s financial viability and possibly unleash a financial crisis just at the time that it would have limited means to support the currency bloc’s economy.
Right now we are at the loggerheads stage, and in the next few weeks, it will be interesting to see who wins out in the fight. Although Germany is the currency bloc’s paymaster, pushing for a technical default won’t help matters. Not only will it hurt the ECB, it will also hurt the European banking sector with exposure to peripheral debt. Banks in Germany and France with big exposures to the periphery may require bailouts from their governments, so if Berlin gets its way, it may well end up shooting itself in the foot.
A decision has to be made by June 24, when EU leaders hold their monthly meeting. If further aid is not agreed upon, then a default beckons for Athens.
NEXT: No Surprises Expected from Bank of England, Bank of Japan|pagebreak|
Slim Chance of BOE Rate Hike
The BOE remained on hold last week, as expected. We’ll have to wait until June 22 for the minutes to see how the newest member of the MPC, Ben Broadbent, voted. Overall, we think that there wasn’t much change in the views. Growth is slowing and inflation remains elevated, leaving the BOE between a rock and a hard place.
Signs that growth disappointed in the second quarter continued last week when production data for April fell. Manufacturing, which has been the success story of the UK’s recovery, fell sharply by 1.5% for the month. While there was probably some disruption caused by the bank holidays, there is little doubt that the UK economy is fairly anemic at this stage of the recovery.
This was confirmed when the National Institute of Economic and Social Research (NIESR) released its latest GDP data, which showed the economy rose by a miserable 0.4% in the three months to May. The NIESR said that UK growth remains “subdued” and it does not think that GDP will reach its pre-recession peak until 2013.
This makes the BOE less likely to hike rates any time soon. While domestic factors argue for a weaker pound, in reality, the direction of sterling will continue to depend on the US and the Federal Reserve’s extremely accommodative monetary stance along with the ECB and the Greek debt crisis.
No Major Changes Expected from Bank of Japan
On Tuesday, June 14, the Bank of Japan (BOJ) will conclude its two-day meeting and announce its monetary policy stance and economic assessment. As recent surveys such as the April METI survey and PMI surveys have indicated that production is expected to rebound in May and June, it gives evidence to the BOJ that economic activity may be picking up. With monetary policy already extremely loose with near-zero interest rates, an upgrade to the economic assessment may reduce the immediate need for additional easing measures.
The International Monetary Fund (IMF) earlier this week said that more asset purchases by the BOJ could ease deflation and boost growth as the economy is still facing headwinds from the March earthquake. The IMF suggested that the BOJ could accelerate and expand its existing program of purchases of private assets such as corporate bonds, commercial paper, and ETFs, as well as lengthen the average maturity of government bond holdings.
While the Bank of Japan is not expected to take any drastic measures, a small expansion of its asset purchase facilities may be likely. Small tweaks are not likely to see much of a reaction in the currency markets, with the risk of a large increase in additional purchases likely to weigh on the yen.
Technically, USD/JPY has moved back above the psychological 80.00 figure with significant support around the May lows of about 79.50 to the downside. A rally may face immediate resistance around the 80.90-81.00 area, which is where the daily ichimoku cloud base, Kijun line, and 21-day simple moving average (SMA) can be found.
Above this level, we may see a move towards the 55- and 100-day SMA’s, which currently converge around the 81.90-82.00 area as the next level of resistance. Should the pair see a sustained break below the 79.50 area, a move towards 78.50 may materialize.
By Brian Dolan, chief currency strategist, FOREX.com
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