Sunday, November 28, 2010

FX: Irish euro relief proved temporary

FX: Irish euro relief proved temporary

Irish euro relief proved temporary
The Irish application for EU/IMF funding did temporarily reverse the euro sell-off.
However, after the Green Party announced that it would leave the Irish government
coalition after the budget and EU/IMF negotiations, calling for an election to be held
early next year, investor concern about political risks in Europe rose and the euro
depreciation trend quickly returned – catalysed by rating agencies downgrading Ireland
further. After having rebounded to near 1.38 against the dollar, the euro has lost almost
4% to trade back below 1.33, and it is difficult to see what could turn sentiment around in
the short term. Certainly, the lesson from the spring crisis seems to be that if it is a
political response that will reverse sentiment, it probably needs to be one that exceeds
expectations and not just meets expectations. Two of the potential responses that have
been mentioned is either financial support for Portugal, or an expansion of the European
Financial Stability Fund (EFSF) to remove any speculation about the adequacy of
available funds. For now, however, pressure is on the euro and a continued depreciation
cannot be ruled out – even as we remain dollar negative in the medium term, as reflected
in our 12-month 1.50 forecast. Importantly, short euro positions do not yet appear
crowded and hence, positioning therefore does not yet appear be a limit to further
downside (one of our favourite position indicators, the 1M vol adjusted risk reversal, is
currently trading 1.6 std below its average compared with 3 std last spring).

Resilient global risk sentiment supports the Scandies…
Since late October, when the European fiscal crisis began escalating again, the MSCI
world equity index is actually unchanged – supported by improving economic data (as
witnessed by recent US and European PMIs). In other words, despite all the worries about
the fiscal situation in Europe, risky assets have so far not seen a major sell-off - though
the gains in the run-up to the Fed’s QE2 announcement have been reversed. This is not
least important for the Scandies, which continue to trade closely with risk sentiment. As
we have previously witnessed, the Scandies will only benefit from increased concern
about the eurozone peripherals as long as global risk sentiment is not affected. That is,
despite low fiscal deficits, low debt levels and sound balance of payments, we do not
consider the Scandies to be true fiscal safe havens, as liquidity is simply too low and long
positions too crowded. However, as long as a major sell-off in risky assets does not
materialise, the Scandies should have further appreciation potential. Not least considering
that the Riksbank is expected to hike rates in December and that the market, going into
2011, should become convinced that Norges Bank will reinitiate its hiking cycle. In FX
Strategy: SEK – Time to go long we look at ways to position for a stronger Swedish

…and leaves upside pressure on USD/JPY
Resilient risk sentiment not only supports the Scandies, but is also yielding upside
pressure on USD/JPY. The important channel here is relative interest rates. As long as a
major sell-off in risky assets is avoided, US yields are likely to remain above pre-QE2
levels and therefore, USD/JPY likely to trade well above its late October 80.22 low. We
expect USD/JPY to trade around 83 in the short term before a longer-term uptrend is
expected to materialise later in 2011.
Full report: FX: Irish euro relief proved temporary

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