The US debt ceiling remains unresolved at this late date. The market's response over the past week to Europe's new initiatives is poor as peripheral, including Spain and Italian, bond yields and spreads over bunds widened considerably. Yet as investors, we must look ahead.
There are five key events next week that will be on radar screens, leaving aside the US debt ceiling debate and rating challenge.
The same two issues continue to vie for dominance in the global capital markets. On one side, there is the unresolved European debt crisis. The ink is not even dried on Greek 2.0 in the sense that government's need to ratify the agreement and implementation must begin, and already it is evident that to bring Greek debt burden to more sustainable levels a Greek 3.0 will be needed at some point. On the other side is the brinkmanship tactics in the US over raising the debt ceiling and agreeing on a longer term strategy to put the US on a more sustainable fiscal path. On Monday and Tuesday the dollar suffered; Wednesday and Thursday the dollar has come back
The US debt ceiling debate continues. The House vote, initially slated for today, has been postponed. President Obama's advisers and the the executive branch's Office of Management and Budget were urging a veto of it in any event as it provided for a six month fix only. Such a short term fix would not have been sufficient to prevent a downgrade of US triple A rating. A Reuters poll found 30 of 53 respondents expect at least one of the three major rating agencies to downgrade the US and the policy market, www.intrade.com shows 82.5% expect S&P to cut the US rating by the end of 2013.
Yet the dollar is mixed today as some of the downside pressure has eased. Problems with the new European initiative are becoming clearer. For taking grave risks, including the first default by developed country in 60 years, which as Moody's noted, will serve as a template for Ireland and Portugal, there is little substantive reduction of Greek's debt burden. The optimists assume about a 24 percentage point reduction, leaving it with more than twice the Maastricht and Stability Pact target of 60% of GDP. Hence the ink is hardly dried, the agreement yet to be ratified and already one must be cognizant of the need for Greek 3.0.
The stalemate in Washington has eclipsed the Greek tragedy to be the main driver of the foreign exchange market. The US dollar has sold off hard as a credit downgrade and possible default looms closer. The Aug 2 deadline seems rather soft as indications suggest US government revenues rose recently more than projected and outlays were less than expected.
The euro rose to its best level since July 5 and key resistance is now seen in the $1.4580-$1.4600 area. Initial support is seen near $1.4450, but the technical tone is likely to remain positive provided the $1.4360-$1.4400 area remains intact.
After staring into the abyss, and reducing risk, investors anticipating a new European initiative spent most of last week putting risk back on. The details of the European initiative were less important in the first instance than the fact that a new initiative was to be taken.
My general sense is that European officials have bought some time, but the sense of closure is unlikely to last until the end of the quarter.
There are two key elements. One is about Greece and the other is about the new flexibility of the EFSF.
The Bank of Japan held a private briefing with a small group of analysts from leading financial institutions in their NY rep office. The Director-General of the Research and Statistics Department led the presentation. Must of the discussion was a summary of what has happened. There was little new or fresh here, but more interesting was some forward looking observations which may be important for international investors.
First, Japanese auto makers are expected to return to pre-crisis output levels sooner than initially expected. In April, it was hoped that production would be restored by the end of the year. Now the BOJ expects it to occur sometime in the July-Sept period.
The optimism of a resolution of the European crisis, especially after Merkel and Sarkozy presented a united front were squashed by Eurogroup head Juncker who first seem to let it slip that a selective default in Greece might take place.
On Monday, in this space, I suggested the euro would head to $1.4300, sterling $1.42 and the dollar toward JPY78.50. The dollar has held up a little better against the yen (today's low JPY78.61), but the euro hit $1.4295, the week's high and sterling hit $1.62 today--before the fireworks--disappointing flash PMI and Juncker. The flash PMI was 50.4 in manufacutring and 51.4 in the service sector. Risk is that the rime between the flash and the final, there is more economic slippage. UK retail sales were above expectations at 0.7%, after a -1.3% print in May.
While there has been some talk of a Swiss sovereign wealth fund, it might raise more problems than it solves. Companies facing an adverse currency shock typically have two strategies. The first is boosting productivity which helps blunt the loss of competitiveness induced by the over-valued currency. The second is to increase foreign direct investment to diversify operations away from strong currency area.
The Swiss franc's function as a safe haven has been put on steroids by the global debt crisis in general and the European debt crisis in particular. There is speculation that over time it is likely to move to parity with the euro. Indicative pricing in the options market can shed some light on the issue.
In basketball, with 5-person teams, the crowd is often referred to as their "sixth man". (My webmaster, an Ann Arbor Native, would like us all to take a moment and realize this year marks the 20th anniversary of the Fab Five) Ahead of tomorrow's summit, there are numerous proposals being floated that involve modifications to the EFSF and different schemes for private sector participation.
It is not yet clear how the dust will settle, or even if an agreement, which Merkel warned yesterday would not spectacular, is even sufficient for the dust to settle for long. Speculation of some agreement has helped lift the euro, peripheral bonds, and generally has underpinned the risk appetite in recent days. This leaves the market vulnerable to disappointment or a "buy the rumor sell the fact" type of activity.
Embattled officials in both the US and Europe appear to be making the right noises and this has served to spark a further recovery in most major and emerging market currencies. The dollar has traded on both sides of yesterday's range against the yen. Although it has recovered the JPY79 area is now offering resistance. Elsewhere the Canadian dollar is extending yesterday's gains scored on the back of a central bank statement that brought forward rate hike expectations. Reports that CNOOC is to buy failed Calgary oil company for $2.1 bln may be providing incentive ahead of the Bank of Canada's monetary policy report.
Between the looming US debt ceiling and the European debt crisis, the Japanese yen has been largely sidelined. Over the past three sessions, for example, the dollar has been confined to a JPY78.80-JPY79.30 range. The implied 3-month volatility is hovering near 10%, a level that it is has rarely traded below since the financial crisis began around 4 years ago.
Nevertheless, something interesting is being played out. Margin traders--the famed Mrs Watanabe-- at the Tokyo Futures Exchange--have amassed a large short yen position. There are about 900k short yen contracts as of today and about 364k are short yen against the dollar. This is the largest short yen long dollar positions since 2006.
The US dollar has begun the new week on a strong note, although there appears to have been little progress on the debt ceiling talks. The European debt crisis is simply eclipsing the US debt situation as there seems to be a a consensus that at the last minute US politicians will find a resolution. The European debt situation is seen a more intractable.
The key event of the week is the Thursday European summit, but Merkel is already indicating that if there isn't a deal, she won't be attending. The stress test results were not very satisfying and this has kept pressure on the peripheral bond markets and bank share prices. Of note, Spanish 10-year yields are making new euro-era highs near 6.30%. There is speculation that LCH Clearnet, a key clearer/platform for trading European bonds may increase the margin required on Spanish bonds due to the volatility. And Italy is flirting with the 6% level. Moody's warns that the new austerity measures, approved last week, will hurt regional finances.
The week will finish with a bang. European bank stress test results, and what might be the softest headline CPI reading since Q2 last year, the Empire state survey, where the forward looking new orders component may be the most important component, and the ongoing US debt talks.
Press reports have suggested that 10-15 European banks will be found to need more capital. Spanish cajas are likely candidates. Given the focus on the sovereign aspects of the crisis, the stress tests will most likely not have a big impact on the markets. However, the risk seems asymmetrical for greater potential to have bad news than good news.
Officials from Japan and Switzerland have stepped up their rhetoric protesting the price action that has propelled their respective currencies sharply higher. Contrary to market anxiety the risk of intervention remains low and lower for the SNB than the BOJ.
The BOJ has a track record of being more interventionist. Many market participants continue to focus on levels that would trigger BOJ intervention. In our assessment this is mistaken.
Capital markets have been buffeted by a number of different forces and volatility is rising. Here is my sense of their significance.
1.Misunderstood Bernanke: I think the market misunderstood Bernanke to the extent that he was understood to break any new ground or signaled an increased likelihood of QE3. He essentially repeated the main thrusts of the FOMC statement and minutes. Although his text his the same today, look for him to find opportunities in the Q&A to balance the perception. Bar to QE3 remains high. Risk of deflation has ended.
The main feature today is the euro's strong recovery after falling through the 200-day moving average yesterday and Moody's cutting the Irish rating to below investment grade. Today is a new day. The combination of stronger than expected Chinese data, which eases fears of a hard landing, ongoing talk that the the ECB is buying sovereign bonds for the second day in a row (won't be confirmed/refuted until early next week) and weak euro shorts has lifted the euro from the $1.3950 area seen in Asia to a little above $1.41 in the European morning.
With some positive headlines coming from Europe, including talk of ECB bond purchases after 15 week hiatus, and the US trade figures, the euro bounced to about $1.4020, but selling into bounces is still the most likely course as a resolution of the European debt crisis remains elusive.
The US trade deficit for May came in well above expectations at $50.2 bln. The consensus was for a shortfallIt is the widest deficit since Oct 08. In real terms, which is what is used for GDP calculation purposes, rose to $47.8 bln from $43.9 bln in May. The average monthly shortfall in Q2 (April and May) is just shy of $46 bln, closer to $44 bln.
The European debt crisis and the policy paralysis continues to dominate the capital markets. The euro has been driven lower, breaking below the 200-day moving average in Europe for the first time since January 12th today, before recovering following respectable bill auctions in Italy and Greece and talk that the ECB broke a couple month hiatus and intervened bought sovereign bonds. The euro bounce is unlikely to be sustained. Look for the $1.4000-$1.4050 area to now denote upper end of range.
European officials are promising a new strategy shortly and of course in this environment can the new IMF head say anything but that it is not presently talking about a second Greece aid package. European officials are not ready. They do not appear to know what to do.
Tolstoy tells us in the first line of Anna Karenina that "Happy families are all alike; every unhappy family is unhappy in its own way." This is directly applicable to Europe. It is easy to tar all (growing) peripheral countries with the same brush, but that risks over simplification and the faulty analysis may generate poor investment decisions.
Given recent developments in the European debt and derivatives market many policy makers and observers see the problem as one of contagion. The unresolved Greece 2.0 assistance is weighing on sentiment and dragging down the other peripheral countries.
There is one main force in the capital markets today and it is European debt crisis. The crisis is becoming deeper and broader. Deeper in the sense that the Greek 2.0 is looking more difficult and some reports suggest that if the rating agencies will declare nearly any "voluntary" private sector participation as a "stressed exchange" and therefore at least partial default (selective default), European officials might has well consider bolder action now. Broader, in the sense that pressure is building on Spain and especially Italy.
These forces are evident in the sovereign bond markets, CDS and financial shares. Italy and Greece have bill auctions this week and Italy also has bond auctions. This is of course
The key take away from this week is not the weakest US jobs data in nine months. After all, it was well appreciated that for a number of reasons the US economy has lost some momentum in H1. Even the Federal Reserve has acknowledged this. Nor is the take away from the week that European officials have yet to design a way to get the private sector to participate in aiding Greece without taking the risk that the rating agencies would recognize the scheme as a distressed exchange and give Greek bonds a default rating. With the next tranche of aid to be handed over, there is plenty of time--a couple months at least, for Europe to figure a way to square the circle.
The US dollar is generally little changed against most of the major currencies, with the notable exception of the euro and Swiss franc, against which the greenback is recouping some of yesterday's losses.
The word cues in Trichet provided yesterday is suggestive of another rate hike in Q4. The issue is whether Trichet delivers it at his last meeting or Draghi delivers it early in his tenure.
The euro's recovery yesterday appeared to have coincided with Trichet's announcement that it was suspending its collateral rules for Portugal. This should not have been surprising. The ECB had done the same for Greece and, following Moody's decision to slash Portugal's debt rating below investment grade, it had little choice but to do the same for Lisbon.
Republicans and Democrats in the US Congress are having a difficult time agreeing on changing a law that will allow the federal government to pay for what it has already spent. However, there does seem to be bipartisan support for giving American companies a tax holiday to repatriate funds that have been kept abroad. The discussion has been taking place for the better part of the first half, but recently more attention has been given to it by policy makers, business leaders and economists.
Economists at some of the largest investment banks conclude that such a tax break would be materially beneficial to the dollar and U.S. asset markets. Some have gone so far as to compare it favorably to QEIII. As often seems to be the case, the risk is that the advocates of a corporate tax holiday and their allies and benefactors in Washington and Wall Street typically embellish and exaggerate the implications.
We identify two main forces that have driven the euro-dollar exchange rate in recent months. The first is the divergent monetary policy trajectories, with the Federal Reserve easing policy through the end of June, while the ECB today delivered its second rate hike in the cycle that began in Q2. We expect the ECB to hike rates at least a couple of more times before the Federal Reserve raises its Fed funds target.
The second force is the European debt crisis, where the EU/IMF have failed to contain, let alone provide closure, to the crisis that began eighteen months ago.
The US dollar is holding on to yesterday's gains as the market awaits the key events of the week: the ECB meeting and press conference and the US jobs data--for which the imprecise ADP data will serve as the proxy today ahead of tomorrow's national report.
While yesterday's free-fall in peripheral European bonds has moderated today, helped perhaps by a solid reception to the Spanish bond auction, pressure is still evident in the credit-default swaps market. Portual 5-year CDS is moving above 1000 bp today, which in the past has been an important threshold.
Many have long suspected that Greece, Ireland and Portugal are ultimately manageable given the relatively small size relative to the euro zone GDP and institutional capacity of the EFSF. Spain was the real challenge. Yet the price action in recent days warns that beyond Spain, Italy looms even larger.
Over the past five sessions, Italian bonds have under-performed their Spanish counterparts. The current 10-year Italian bond yield has risen 14 bp to Spain's 1 bp. Until now, the Italian and Spanish bonds had performed roughly equally over the past year. The market still see Spain as a bigger risk but than Italy, but the difference is narrowing. Spain is paying 48 bp more Italy on 10-year bonds and 31 bp more on 2-year borrowing. Spain's 5-year CDS is quoted just above 301 while Italy is near 215.
There is only one story today in the capital markets. As European officials continue to debate private sector participation in Greece's second package, Moody's seemingly caught the market off-guard by slashing Portugal's rating 4-notches late yesterday--keeping it on negative watch and warning it may need a second aid package as well. The market reacted to it in the expected ways in the US afternoon, but Asia seemed to shrug it off. Europe has ignored Asia and followed the US lead.
In recent posts, I have suggested that Ireland will not be able to go back to the capital markets next year as its assistance program assumed. The government denies this, which they must. Today the focus is on the logic that Moody's used to downgrade Portugal can apply to Ireland as well. Moreover, while Moody's is the first to rate Portugal below investment grade, the other rating agencies may follow suit.
The Mexican peso is losing ground against the dollar today for the first time in seven sessions. The peso's heavier tone is consistent with the generally heavier tone among emerging market currencies today. Concerns about global growth, with softer than expected PMI readings from China and Europe, concern that China may still hike rates, and the uncertainty facing a second aid package for Greece may all be conspiring to spur some profit-taking in the peso.
During this run, the peso appreciated 2.3% against the dollar, the most in Latin America, and better than most emerging market currencies, save the Hungarian forint and Polish zloty. Part of the peso surge seems to be a function of market positioning. Throughout most of June, and actually beginning back in late April, the net speculative position at the IMM had been reduced and stood at its lowest level since last September. This coincided with the sharp cut in cetes holdings by foreign investors. Speculative players appeared to have been chasing the peso higher last week, as risk appetites returned following the successful Greek austerity vote.
The recent pattern is holding. Fridays tend to be trend days. There is often some albeit limited follow through on Mondays before consolidation phase sets it. The foreign exchange market is in that consoldiative phase that began yesterday.
The euro found support near $1.4460 and looks to probe higher in North America today. Still the uncertainties surrounding Greece 2.0, softer service sector PMI reading may prevent the euro from moving convincingly above the down tend line on the daily and weekly charts, drawn off the early May and early June highs (coming in now near $1.4520). Still, talk of Asian reserve manager demand and anticipation of an ECB hike on Thursday may limit the downside.
The US dollar is mixed against the major and emerging market foreign currencies. It is largely consolidating the losses suffered in recent sessions as the Greek government survived a vote of confidence and parliament approved a new austerity program in the face of public protests.
This led to the EU approval of the next tranche of aid under the plan developed last year. The IMF is expected approve its disbursement on July 8th even though next year's funding of Greece has yet to be determined, and this had been previously cited as one of the pre-conditions. In this case, as we suggested, the IMF appears willing to accept the EU's commitment/intention in lieu of a hard plan.
The dollar is mixed today, but is set the finish the week on soft footing. The euro's resilience is notable today in the face of the disappointing news stream. However, it has not convincingly violated the downtrend line (connecting the early May and early June highs) and comes in near $1.4540-50 today.
The short-term momentum indicators I use to monitor intraday price action suggests there it is likely to rise above there today, perhaps on the back of a disappointing ISM report.