Euro Summit Casts Doubt on Risk Assets

01/30/2012 9:55 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The first EU debt summit of 2012 is the key focal point for the week ahead, and wide-ranging impact is expected for a host of assets including EUR/USD, equities, commodities, and more.

Eurozone debt markets continued to show signs of further stabilization as Greek/private sector bondholder (private sector investors, or PSI) negotiations continued to stumble along with repeated promises that a deal was soon to be reached, possibly over the weekend.

The debt swap deal is a prerequisite to Greece receiving the next EU/IMF aid installment and avoiding a disorderly default. The details of the debt swap deal are reported to be a haircut of around 70% on existing bond holdings and an average interest rate of around 3.75% on the new Greek debt.

The key to avoiding a default event and potential market disruption will be the degree of PSI participation and whether the swap can plausibly be called "voluntary."

On that count, the outcome is significantly more questionable, as a participation rate of 90%+ is likely needed to avoid triggering credit default swaps and unleashing another wave of banking sector losses. So the details will matter, and if a deal is reached, depending on its terms, there could be a volatile Sunday open.

Government bond yields in Spain and Italy dropped back significantly as one sign of calmer investors, but Portuguese yields surged to record highs over 14%, suggesting Portugal will be the next target of market angst.

To be sure, following a Greek debt deal (if there is one), markets may simply revert to longer-term solvency concerns of the larger EU countries in a "buy the rumor/sell the fact" type of reaction. After all, Greece was never the real threat to EU financial stability.

See related: Key Misconceptions About Euro Debt

On that front, the EU summit is expected to ratify the fiscal compact on budget deficits and surveillance, which will lock EU countries into austerity for years to come. The typical pattern has been for EUR, and risk assets generally, to appreciate going into such meetings, only to then relapse as the summit’s outcomes are deemed insufficient to stem the crisis.

I think we could be looking at a similar scenario yet again, as the fiscal pact does little to alter current debt burdens and consigns most EU members to weak growth. In response, EU leaders are pledging to also develop growth strategies at the summit, but I’m a little more than skeptical, as fresh fiscal stimulus does not seem likely. We’ll have to see what they ultimately come up with, but I’m not optimistic and would not be surprised by another post-summit wave of disappointment.

Technically, EUR/USD has now reached back to a key resistance zone in the 1.3220-1.3250 area, which I highlighted in last week’s update. 1.3220 was the breakdown level from last December and 1.3245/1.3250 is 38.2% of the decline from roughly 1.4250-1.2620 since late October.

However, positioning is still excessively short, with Commitment of Traders (COT) data from the Commodity Futures Trading Commission (CFTC) showing the largest net-short EUR futures position on record as of Jan. 24, so a further short-squeeze can’t be ruled out.

While I favor using current EUR levels to establish shorts for a resumption of the move lower, I can’t exclude further gains, so I would exit on strength over the 1.3320/1.3330 broken trend line support turned resistance.

See related: How to Short the Euro with Less Risk

EUR/USD was set to close last week above the daily Ichimoku cloud base at 1.3186, potentially signaling a move to the top of the cloud at around 1.3600.

NEXT: Fed Policy Surprise Hits US Dollar Hard


What the Fed Did and Didn’t Say

The FOMC this past week delivered a bit of a surprise by indicating that rates would remain exceptionally low until late 2014, extending their prior time frame from mid-2013. The Fed also lowered its 2012 GDP forecast to 2.2%/2.7% from November’s forecast of 2.5%/2.9% and noted that significant downside risks to the recovery remained.

The “low-rates-for-longer” pledge hit the USD sharply and sent gold prices soaring, but what the Fed didn’t say was that it was actively considering additional asset purchases, or QE3. True, Bernanke said it was still an option in his press briefing, but that doesn’t mean it’s close to being adopted yet.

As such, the pronounced USD weakness following the Fed events may not be sustained. I would note that broad commodity indexes (CRB) and stocks did not express the same QE3 euphoria that FX did, with gold being the exception.

Bernanke will appear before the House Budget Committee on Thursday, Feb. 2. I would expect Republican members to grill him over any plans to further expand the Fed’s balance sheet with additional asset purchases, a major source of irritation to them.

Bernanke will surely defend the Fed’s independence and its dual mandate, but in doing so, he may also indicate that QE3 is not currently under active consideration. If so, the USD could see a sharp rebound. This should not be the usual Fed appearance before a Congressional committee.

In addition to the EU Summit and Thursday’s Bernanke testimony, this week sees a number of key data points. Also, this week will see month-end portfolio hedging flows, some of which may have helped drive Friday’s USD slump.

Given outsized gains in US stock/bond valuations relative to other G10 markets, we expect overall USD selling to persist through Tuesday, other events being equal, typically culminating at the 1600GMT London fixing. In particular, our proprietary model suggests the strongest USD selling against CHF, CAD, AUD, and JPY, with slightly less strong USD sell signals against GBP and EUR.

On Wednesday, China will a release pair of critical manufacturing sector PMIs, with the January national PMI forecast to dip back into “contraction-type” levels at 49.6 after 50.3. Later on Wednesday in the US, the ADP January employment report will give us a first sense of how Friday’s US non-farm payrolls (NFP) report may play out. Friday will also see non-manufacturing PMIs out of China.

See related: The Best News Events for Forex Trading

By Brian Dolan, chief currency strategist,

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