US, Euro Debt Drive Down Risk Assets

11/21/2011 11:00 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Look for new headlines about US debt problems to further detract from risk sentiment in the weeks ahead, posing more downside risk for world currencies but potentially offering good short-side opportunities.

Eurozone headlines have continued to dominate recent market action, but we think that may soon shift as the so-called US deficit-reduction Supercommittee (SC) appears headed for a stalemate. The latest comments from SC panelists suggest the two sides remain far apart on a package of spending cuts and revenue increases, but the SC may still meet over the weekend if no agreement is reached Friday. While we agree that in Washington, it’s usually “darkest before the deal,” our base-case expectation remains that deadlock will ensue as the November 23 deadline comes and goes.

If no agreement is reached, as we expect, then we would look for credit ratings agencies to voice concern on the outlook for US sovereign ratings, potentially with Fitch joining Moody’s and S&P indicating a negative outlook (S&P cut US ratings following the debt-cap debacle in July).

While there are many potential outcomes, including partial deals, two-step processes, etc., we think global financial markets may respond in negative fashion similar to the debt-ceiling debate reaction, which saw the S&P 500 collapse by over 18% in late July/early August.

It won’t be based on the fiscal issues involved, but rather on the lack of political cooperation inhibiting any long-term stabilization in US deficits or debt levels. Additionally, mandatory across-the-board spending cuts triggered by a deadlock, while not set to take effect until 2013, will further weigh on the outlook for the US and global recoveries. We would expect back-up plans galore to be floated in the aftermath of a SC deadlock, likely meaning a new legislative drama begins on the other side of the Atlantic into the end of the year.

Absent a deal, we think risk sentiment is ripe for a further plunge, with the US dollar (USD) potentially seeing strong safe-haven demand despite potential ratings concerns. Most likely, though, in our view, the Swiss franc (CHF) and Japanese yen (JPY) will be the bigger winners if risk comes off sharply.

Alternatively, should a last-minute package be reached, risk sentiment is likely to improve significantly given the low expectations for a result.

ECB Digs in Against Sovereign Bailouts

Even as the market chorus calling for a European Central Bank (ECB) backstop for sovereign borrowers grows louder, the ECB appears to be digging in against using its balance sheet to stem the contagion.

The euro stabilized somewhat at the end of the week on reports that the ECB might consider lending to the International Monetary Fund (IMF), which would in turn provide funding to endangered Eurozone governments. But comments from ECB President Draghi on Friday, in which he declared that the ECB would stay focused on its inflation mandate and called on politicians to find a solution, suggest the ECB/IMF initiative will not materialize.

Germany remains adamant in its opposition to allowing the ECB to provide unlimited lending, and until there is some further crisis in credit markets, we don’t see Berlin relenting.

Meanwhile, the Eurozone economic outlook continues to deteriorate, intensifying the negative feedback loop where weak growth aggravates debt burdens, which raises credit costs, adding further to debt burdens, and on and on.

Spanish elections on Sunday were expected to see the conservative opposition People’s Party win a landslide victory on a platform of additional austerity measures. While the market reaction to the elections may be briefly positive for the EUR and Spanish debt, we think it will be extremely short-lived as the reality sets in that further austerity will do nothing to alleviate the negative debt dynamics in Spain and elsewhere, bringing markets back to the view of toxic Eurozone government debt.

We would also note that the British press on Friday revealed a leaked report from the German foreign ministry which indicated policymakers should prepare for additional orderly defaults beyond Greece, likely meaning Italy, Spain, and others.

We don’t think this bodes well for Eurozone credit markets in the near term, but we’ll also be looking to see exactly how much Italian/Spanish debt the ECB bought in this past week. If they stepped up purchases to significantly more than the sub-EUR 10 billion of recent weeks, it may provide some further stabilization. Lastly, we would look for the ECB debate to come to a head around the next EU summit on December 9.

NEXT: Risk Assets Still Vulnerable

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Risk Assets Still Vulnerable

Continuing on from the sections above, we’ll begin by looking at EUR/USD, where price this past week has closed just below the daily Ichimoku cloud bottom at 1.3531, but importantly has held above the weekly cloud base at 1.3408, which coincides with the 76.4% retracement of the recent 1.3150-1.4250 advance.

If the 1.3405/1.3410 level fails on a daily closing basis, we would look for additional declines to the 1.3150 prior lows initially. While that support holds, there is scope for some further consolidation/correction, but we think the 1.3750/1.3800 area offers a good short-entry opportunity.

Consistent with the weak outlook for EUR, the S&P 500 has broken down out of a sideways triangle consolidation at about 1235 and may in fact be leading FX. The daily Tenkan line is poised to cross down below the Kijun line, generating only a weak sell signal at the moment as price remains above the 1168 daily cloud top. The weekly Kijun line comes in at 1215, coincident with the November 1 low, suggesting to us that a drop below the 1210/1215 level may trigger a sharper decline in the weeks ahead.

The CRB commodity index has also fallen below trend line support for the advance since early October (last at 312.20), but it has held above the daily cloud base at 310.00 for the time being. The daily Tenkan and Kijun lines should see a bearish crossover shortly, and with price inside the cloud or possibly below, a medium to strong sell signal may be generated.

We would also note the sharp rejection of WTI crude oil prices from above $100/barrel and a similar failure in gold from the $1800 area. Gold prices have dropped back into the daily cloud, and a close below the $1703 Kijun line may signal a test of the $1676 cloud base initially.

Overall, we continue to favor using rebounds in risk assets as an opportunity to get short risk. In FX, we will focus on opportunities to short risk currencies like EUR, AUD, CAD, and NZD on remaining strength against safer-haven FX like the USD, CHF, and JPY, though we must caution on intervention risks in those last two currencies.

Finally, we would note the US Thanksgiving holiday this Thursday, which also typically sees reduced market interest on Friday as well. While a holiday-shortened week heading into the final weeks of the year may see further market consolidation/sideways drift, we will be alert for potential risk-asset breakdowns amid lethargic markets.

By Brian Dolan, chief currency strategist, FOREX.com

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