The Trend is Your Friend

The US dollar appears to be shining as a safe haven.  The Swiss remain committed to their peg and the weakness of consumer confidence and new threats of deflation can only harden the SNB's resolve.  Comments form one SNB member that it will diversify reserves into sterling and yen does not appear to be helping those currencies.  Surely Japanese officials who have boosted the intervention war chest by JPY15 trillion cannot be pleased that the SNB not only deflected speculative flows toward the yen, but will buy yen itself, aggravating Japan's challenges.

Another Yen Update

Today is first time in two weeks that the US dollar has been above JPY77 and thus far the penetration is minor. Although no doubt Japanese officials and corporate Japan would prefer a weaker yen, given the concerns about the impact of the success of the SNB in blocking hot flow entering Switzerland, the stability of the yen must be partly welcome.

Even if one does not monitor developments in the options market, the fact that the gap between the volatility of the euro (3-month) and yen is now at the highest level since late 2008/early 2009 illustrates the extent of the euro debt crisis and the reluctance of the market to risk BOJ intervention.

Bundestag Approves, but Agenda Shifting

As widely anticipated the German Bundestag approved the EFSF reform plans.  The euro recovered fully from the sell-off in the US session yesterday that had brought it to almost $1.35 early in the Asian session.  However, that was largely before the vote and subsequently the euro half a cent.  Initial support is seen near $1.36, but the near-term range appears to be $1.35-$1.37.  Next week promises to see broader range, as ECB meeting and US jobs data provide fodder along with the purchasing manager reports. 

Even though the Bundesrat votes tomorrow on the bill and a few other countries have yet to vote, the agenda is already shifting.  The discussion now is not so much on the EFSF reforms that were agreed upon on July 21, but how to increase its efficiency.  A new structure maybe in place, EFSF2.0, but the funding is too small to be the proverbial bazooka that is needed for confidence as much as capability. 

US Durable Goods Orders--Another Point for Good Q3 GDP

Today's durable goods orders data lends credence to our projection of fairly robust Q3 US GDP after the dismal 0.8% expansion in H1.

The durable goods report is the third important piece of data that should encourage economists to look for something close to what is regarded as trend growth in the US (2.5%-3.0%). The sharp rise in July personal consumption expenditures and the smaller real trade deficit were the other two pieces.

Dollar Remains Heavy

The US dollar remains soft, near yesterday's lows.  The main developments today include somewhat higher than expected German state reports.  They follow on the heels of the relatively firm M3 and private lending figures and suggest that market talk of a 50 bp rate cut by the ECB is over the top.  As noted previously, the ECB is likely to focus more on liquidity provisions, which may include a 12-month refi operation, renewed buying of covered bonds and some adjustment to the rate corridor.  A 25 bp rate cut may also be delivered, and this would seem primarily as a way to help avoid Draghi having to cut rates at his first meeting in Nov at the helm. 

With the Greek parliament approving the new property tax, it is increasingly likely that Greece will get the next tranche of aide from the EU/IMF.  Finland is likely to approve EFSF reforms today, even though the collateral for Greek 2.0 has not yet been worked out.  Still, there does seem to be renewed hope that European officials will take some bold steps.  The rub is that those bolder measures are unlikely before Nov.  The risk is that many will confuse the calendar effect (month/quarter/fiscal half year and year end) with an important shift in sentiment. 

Fox News: GDP Growth Will Boost the Dollar

Tuesday's Markets

Asian stocks staged their biggest rally in since April 2009 after hitting 16-month lows yesterday.  Wall Street's sharp gains on Monday, encouraged by favorable noises from Europe and action in the US Senate to avoid an imminent closure of the government and a repeat of last month's farce.  The dollar  has been confined to yesterday's trading ranges against the euro, Swiss franc and yen.  The initial attempt to take sterling higher succeeded, but only to fail in front of $1.56.  The dollar-bloc which has been the most beaten up over the past week have risen through yesterday's highs.  The price action underscores the consolidative/corrective tone as participants await fresh developments. 

There are two important votes today.  The first is in Greece where parliament votes on the new property tax.  The government has a a 4 seat majority, but there have been six MPs who have threatened to vote against the measure.  A defeat by the government would likely be euro negative as it would put at risk the Troika's return and approval of the next tranche of aid. 

ECB Appears Focusing on Liquidity Measures

There has been some speculation in the markets over the past week or so that the ECB may begin reversing the April and July rate hikes as early as next month. The October 6 ECB meeting is Trichet's last before Draghi takes the reins.

Pricing from the OIS market suggest EONIA rates will remain low and this is achievable through either a ECB rate cut or continued safe haven inflows into the short-end in Europe. ECB member Mersh called the speculation over a 50 bp cut "wild", according to news accounts. However, given the dismal flash PMI readings and its correlation with GDP, the market is aware that the ECB can indeed cut rates next week, even though Trichet did not use the "normal" word cues to suggest it.

Crisis and Instability: Searching for Terra Firma

Give me a lever long enough and a fulcrum on which to place it and I shall move the world.- Archimedes

 

Last week, Europe’s nuclear research organization, CERN, announced that it believes that it has found some sub-atomic particles (neutrinos) that moved faster than the speed of light. Assuming that its findings are confirmed, the speed of light, which has been regarded for more than a century as a cosmic constant and the ultimate speed limit in the universe, may lose its special significance.

Monday Blues

Asian equities took hard the failure of the G20/IMF/World Bank to produce anything concrete.  The MSCI Asia-Pacific Index fell nearly 2.5% to new 16-month lows.   This comes on top of the 7.1% loss last week.    Foreing investors have been persistant sellers of Asian equities this month.  Between South Korea and Taiwan alone the outflow is near $4 bln.  Indonesia and Thailand account for another $1 bln outflow.  Out of the more popular markets in the region, only India has recorded inflows this month. 

Europe opened weak but has recovered smartly.   The markets were already recovering when Germany reported a fairly resilient IFO.  The main catalyst for the recovery seems to be some sense that Greece will get its next tranche of aid and Europe is moving to substantially increase the firepower of the EFSF, even though it may not take place until November.   

CNBC: Greek Default Rumor

The Pain in Spain

Spain appears to have dropped off radar screens. In part, a disorderly outcome of the Greek crisis continues to be threatened. Italian bond yields and CDS prices have risen above Spain's. Yet, ironically, earlier this week, Spain's central bank warned that its banking problems are bound to get worse.

Spain's 5-year CDS is trading at new record highs today near 440 bp. Before the ECB agreed to buy Spanish bonds as part of the controversial sovereign bond purchase scheme, the CDS hit 429 bp. Within two weeks of the ECB's decision, the CDS had fallen to 330 bp (Aug 15).

Freaky Friday

Much like the 1976 classic (forget that Lindsay Lohan remake nonsense), there is a heightened sense of financial crisis today and the initial G20 statement does little to ease market anxiety.  Early gains in the major currencies against the dollar have largely been reversed, though sterling and the Australian dollar are holding on to modest gains just before the opening of the North American session.  European equities have been unable to sustain earliy upticks.  Price action on Friday's is often in line with underlying trends and it could be ugly even though hourly momentum indicators show stretched conditions. 

One sign of the financial stress is that the German 2-year yield has fallen to new record lows, below 35 bp for the first time.  With the US 2-year yield largely flat, the German move has resulted in a further shift in the 2-year differential.  At a 16 bp, the German premium is the smallest of the year.  There is in creased talk that the ECB will have to respond to the pressures in a way the new dollar swap lines/auction failed to do. 

Two Brakes on Dollar Bulls

The market is talking about the possibility of two official measures and that is helping stabilize the major foreign currencies at lower levels.  The first is talk that the Federal Reserve could cut the interest rate on the swap lines by 100 bp, which would essentially lower the rate to the Fed funds rate.  It would help boost liquidity and make it easier to secure dollar funding.

Fed Twists, Markets Shout and Some Thoughts on Currency Levels

The Federal Reserve announced Operation Twist and rather than increase investors appetite for riskier assets, the market has sought the security of the US dollar and to a lesser extent the Japanese yen. Equities have dropped dramatically, but the impact of the Fed's plans is clear as the US Treasury curve continues to flatten with the long end rallying in anticipation of the Fed's purchases.

It did not help matters that the euro zone flash Purchasing Managers survey was dismal. The manufacturing PMI fell to 48.4 from 49.0 in Aug and the non-manufacturing PMI dropped to 49.1 from 51.5. The composite reading of 49.2 is the first below 50 and lowest since July 2009. Although it is not in most base line forecasts yet, the risks of a new contraction in Europe is rising, even while it appears Q3 will be near trend (2.5%-3.0%) in the US.

Ready to Twist or Shout?

Contrary to my expectations, the US dollar is headed into the conclusion of the FOMC meeting bid though within recent ranges.  I had expected some position adjusting given the extensive dollar longs built over the past couple of weeks, especially against the euro.  

There are couple of factors that might help explain the dollar's general tone:

Short Note on Euro Zone Success: Ireland?

More on Ireland Here

That said, it is remarkable that Irish 10-year yields have completely decoupled from Greece. At the beginning of the year, the 60-day correlation between Irish and Greek 10-year yields was above 0.90. Today, the correlation stands at -0.42. At the same time, Irish 10-year bonds yields have become significantly more correlated with German bund yields. That 60-day rolling correlation is near 0.85 today. As recently as late July, Irish 10-year bonds were inversely correlated to bunds (-0.90). This is not to say that Ireland is a safe haven, but...

With speculation still running high that Greece will be forced into a disorderly default and possibly leave EMU, the euro zone problems seem to be intensifying. S&P moved to cut Italy's credit rating yesterday and Moody's is expected to follow suit in the coming weeks. Spain's credit rating also looks particularly vulnerable especially in light of recent comments by rating agencies in light of the regional deficit overshoot and downgrade of a few of the largest regions.

Market Takes Italy Downgrade in Stride, FOMC Injects Caution

The euro completely recovered from the down draft sparked by S&P one notch cut in Italy's sovereign debt rating.  S&P was already at the lower end of the rating agencies and many expected Moody's to move first.  Moody's says it needs another month or so to work through its review.   The euro had dropped a cent from the announcement through the Asian low, but rallied a full cent in the European morning.   

There is some risk that correction to the 10 cent drop in the euro from Aug 29 through Sept 12 is not complete.  Last week saw the first leg up of the correction, which met the 38.2% retracement near $1.39, never closing above there.  The push down Friday and yesterday has faltered just below $1.36 and that could be the re-test on the lows and the beginning of the next leg higher.  Initial resistance is seen near $1.3760 or maybe yesterday's high near $1.3785. 

Week's Key Events Lie Ahead

The US dollar firmed on Friday and those gains have been extended today.   The short-covering advance of the euro last week, helped by the Franco-German support for Greece to remain in the euro and than the new quarterly dollar auctions, ran out of steam.  The longer the euro holds below $1.3720 now, the more likely it is to retest last week's low near $1.3500.  Sterling, for its part has already taken out last week's low, slipping to about $1.5685.   Japanese markets were closed and this helped keep the dollar in a narrow 25 tick range against the yen.  The greenback is also bids against most of the active emerging market currencies. 

There are five key events this week:

The Dollar and Gold

One theme that has captured the imagination of many investors has been the debasement of paper money and the dramatic rise in gold prices. Gold has risen 27.6% in dollar terms thus far this year (24% in euro terms, which reflects 3% euro appreciation net-net against the dollar). However, the funding pressures in Europe seems to be reversing this relationship.

Investors have been tracking the changing preferences of US money markets, which is divested or cut the tenor of European bank paper. Banks have seen the basis swap--the cost of swapping from euros to dollars--rise sharply. This week two banks borrowed dollars from the ECB's facility. There are a number of other ways the dollar funding pressure can be documented.

Thursday's Thoughts

The US dollar is slightly firmer as Thursday's European session gets under way.  The dollar peaked on Monday and has drifted lower this week.  Asia consolidated and Europe appears poised to take the dollar lower.   If the euro does rise above the $1.3780-$1.3800 area, the next corrective objective is near $1.39.   Sterling appears to have bottomed yesterday near $1.57 and despite expectations of a soft retail sales report, it is outpeforming the euro.  Support on the cross comes in near GBP0.8680.    The dollar has been confined to a 18 tick range against the yen centered on JPY76.71. 

Thought on Russia's Repo Rate Cut

Russia cut its repo rate yesterday (25 bp to 5.25%), the first cut in 15 months. It is tempting to put it in the context of Turkey and Brazil's recent rate cuts. However, we see Russia's move in slightly different terms. It seems to be more of a technical response to the tighter ruble liquidity than a bona fide move to ease monetary policy.

There are a number of factors, including less central bank dollar and euro sales last month (lowest since January) as well as global issues, that has drained liquidity from the banks. Evidence of this needs was seen in this week's auction for the placement of excess government budget funds. The auction for RUB20 bln was oversubscribed 5-fold. Usually the bid-cover is closer to 2:1.

What to Look for if the Market Wants to Challenge the SNB

Since Sept 6, when the SNB surprised the world by putting a floor under the euro at CHF1.20, the market has not deigned to challenge it, despite the continuing pressure in the euro zone debt markets, where spreads continue to widen and CDS prices continue to rise. This is true for banks, many corporates, along with sovereigns. So while the conditions that led to the Swiss franc;'s overshoot remain in place, euro-Swiss has been in narrow ranges above the CHF1.20 floor.

The market will likely eventually challenge the SNB's resolve. What are some of the potential signs that the market is beginning to gear up for such a test?

Turn Around Tuesday--Half Right

The euro and sterling did recover in late US yesterday and into the Asian session today.  The euro reached $1.3696, close to the initial objective of $1.37 and sterling rose to $1.5870, close but shy of the $1.59 initial target.  However, neither currency was able to sustain the gains through the European session. 

French bank shares have come under new pressure and the concerns are extended from a downgrade to perhaps the need for recapitalization.  That gets tricky because if the government has to bear the burden, it would risk its AAA status and this is important, not just for France, but for the potential knock-on impact on the EFSF AAA bond rating. 

Table Being Set for Turn-Around Tuesday

Often it seems that when the currency markets are trending, Friday is a trend day in the sense that the dollar moves in the direction of the underlying trend.  Monday then often sees some follow through in that same direction but runs out of steam and Tuesday reverses the near-term trend.  This pattern seems to be playing itself out again now.  

The markets seemed to be looking into the abyss.  Rumors of an imminent and un-managed Greek default.  A German hawk on the ECB resigned, perhaps, some feared, leaving the doves in control.  French banks and Italy are rumored to be facing a imminent downgrade.

No Stark Future

Three developments from last week will influence the global capital markets in the period ahead: the Swiss National Bank’s decision to aggressively prevented further appreciation of the franc; the resignation of Jurgen Stark from the European Central Bank, following on heels of the resignation of Axel Weber earlier this year; and the strong suggestion of greater monetary and fiscal response by the US. On balance, these drivers will likely continue to fuel a recovery in the US dollar.

Swiss Miss?

The Swiss National Bank has signaled a willingness to keep the euro above CHF1.20. It is willing to sell unlimited amounts of Swiss francs to ensure this. There has been some speculation in the media and markets that in addition to intervening in the swaps market, the SNB has also intervened in the options market.

ECB Gives an Inch, BOE Doesn't; and Bernanke?

The BOE and ECB left rates on hold as the vast majority expected.  The ECB's new staff forecasts shave the lower end of its growth forecasts for this year and next and Trichet sounds significantly more neutral than hawkish.  However, by noting that rates remain accommodative, at his second to last ECB meeting, Trichet did not move very far.  

There was no signal of a rate cut at next month's meeting, which means that barring some major deterioration in the credit or economic environment, the ECB is on hold.  This means that when Draghi takes over at the helm, he will not be in a position to establish his anti-inflation credentials by raising rates early in his tenure as so many had expected.  Instead, it is more likely that his first move, the first decision by a ECB president from a southern/debtor country will be to cut rates, even if not until next year.

Swiss National Bank and Other Surprises

The Swiss National Bank had to act.  I don't just say this because they have surprised the market today, but even in yesterday's post, it seemed clear that if it did not act, it would lose credibility and would increase the challenge of coping with a strong franc.  As of yesterday, the Swiss franc had recouped about 50% of its losses since the SNB began flooding the market with liquidity.

News that Swiss inflation slipped to 0.2% year-over-year in August, the lowest since late 2009 left more than a whiff of deflation in the air.  The SNB also reported that is reserves jumped in Aug to CHF253.4 bln from CHF182 bln in July, reflecting its intervention in the swaps market.

Poor Start to Important Week

This is an important week in terms of market levels and central bank meetings.  At least six G10 central banks meet for policy decisions (Australia, Canada, Sweden, euro-zone, UK, and Japan) and several emerging markets (Poland, Malaysia, South Korea, Indonesia and the Philippines).   In addition, US President Obama is expected to propose some fiscal support--like extending the payroll savings tax cut and unemployment benefits and an infrastructure bank/public works project and the German Constitutional Court is expected to make a ruling that will reinforce the German parliament's role in allocation of euro zone aid deals. 

These events take place amid an intensification of the euro zone debt crisis and sufficiently poor U.S. economic data to keep the market expected additional stimulus from the Federal Reserve later this month--with extending maturities of its current balance sheet (so-called Operation Twist).  

Second Verse Same as the First

The news stream continues to push the edges of the narrative outline here earlier.  US mired in slow growth, but not contracting (here in Q3).  A fiscal and monetary response is likely to be forthcoming in the next few weeks. The euro zone slowed dramatically and Q3 is off to a poor start.  Fiscal policy is off limits as the austerity regime remains in control.  

ECB may soften its stance but is unlikely to cut rates and the ascension of Draghi would seem to make it more difficult.   Japan's recovery is meeting international headwinds and the new government looks a lot like the old.   The MOF's capex survey warns that Q2 GDP is likely to be revised down to -0.5/-0.6% from -0.3% initially.