Wednesday, January 19, 2011

Forex Weekly: After several months of EUR weakness on the back of national and corporate funding worries

Review: 10th – 16th January 2011
Recap · After several months of EUR weakness on the back of national
and corporate funding worries – the EUR bounced back on rumors of
additional state help for ailing European sovereigns
· BoE leaves rates unchanged as market expectations for a
mid-2011 rate hike grow. This week's UK figures could be explosive
for Sterling.
· Equities/bond yields/US Dollar
correlation breaking down going into 2011 – possibly a sign of a
nascent recovery in the US
· Australian floods unlikely to have long term impact on AUD
pairs as impact on future production seems to be manageable despite
the severe hit to infrastructure across the Queensland territory.

*A new year begins, yet the same challenges remain*
Over the course of 2010, the prime theme that has
affected FX markets (as well as all other asset classes) has been the
transfer of private debt into public hands. The huge bailouts provided to
dozens of banks, insurance companies and even car makers over the course of 2009
and 2010 are being burdened by the public which has in turn led to extremely
large deficits in several G20 nations. The net effect of government
intervention was a sharp increase in budget deficits in most developed nations
including the US, UK, Japan and the Euro-zone. The crisis that enveloped Greece in April
and then  later spread to other peripheral European nations was largely due to
investor concern about the ability of small countries to maintain sustainable
levels of economic growth whilst implementing savage budget cuts. Price action
in the FX market has reflected this theme very clearly with the Euro falling to
1.18 against the Dollar – its lowest level since its launch in 1999. More
broadly, we are seeing a clear trend of large debt burdens weighing on growth
prospects in developed nations while countries that have largely avoided the
effects of the financial crisis have found that they do not require severe fiscal
adjustment. This has created a divide whereby some nations are
attempting to loosen monetary policy in order to stimulate growth and employment
(US, UK, Japan, Switzerland, EU) while others are desperate to tighten policy
to combat inflation expectations and prevent asset price bubbles (Australia,
China, Canada, New Zealand, Scandinavia). This type of fundamental divergence
has increased demand for currencies that are entering tightening phases at
the expense of currencies still languishing with ultra-low rates.

In 2011, the focus will remain on how the most
fiscally troubled nations handle their path of adjustment. The risk of
a sovereign default in Europe remains elevated despite the huge safety
net put in place by European policymakers and the IMF. Other factors such as
inflation and unemployment will also be very important in 2011. Central banks have a
primary remit to control inflation but given the economic environment since
the passing of the financial crisis, many central bankers are feeling political
pressure to maintain ultra-low interest rates in the interest of generating
economic growth. So far, this has not helped to alleviate large levels of
unemployment but thankfully, inflation has been kept under control. Some evidence
suggests that several central banks are drifting away from their traditional
inflation orientated remits over to GDP targeting, if this proves to be true,
then 2011 could bring excessive inflation in all such countries. In this
scenario confidence in the Dollar, Euro and the Yen would be severely hit.

Financial markets have began 2011 with a correlation
breakdown: equity prices, bond yields and the US Dollar are broadly
higher since the start of the year – for optimists, these types of asset
price changes tend to signal recovery and the end to persistent weaknesses in the US

Expectations of policy tightening by the Fed at some point in 2011
have increased although most market participants would agree that tighter
monetary policy is some distance away given the importance of ultra-low yields
for US companies, the US Treasury and possibly most important of all, for US
homeowners, still saddled with huge debt overhangs and undermined by a
weak labour market recovery.

Our research suggests that Emerging Market countries have conducted a
record amount of FX intervention in Q4 2010. In broad terms, EM
currencies appreciated against USD at the end of 2010 but to a lesser degree when
compared to its G10 counterparts. This could be an indication of clandestine
market operations by several central banks. Going forward, we feel that FX
intervention will be an extremely hot topic as we are likely to see
the highly touted "currency wars" continue. The more market participants move
on from sovereign debt concerns in Europe and thus feel comfortable to take
risk-tolerant investment decisions, the higher the pressure on EM currencies. A
'race to the bottom' in the FX arena is very plausible given the over-importance
being assigned to export-led growth in both developed and developing

The Euro reached a monthly high against CHF and bounced back sharply
against USD as speculation that European authorities will soon be
bolstering the current safety net beneath fiscally troubled sovereigns in
peripheral Europe. The news sparked a frenzy of short-covering as ECB members
clarified their personal stances and also cementing expectations of changes to
the current EFSF programme. German Finance Minister Wolfgang Schaeuble
said the euro zone countries are working on a "comprehensive package", which
may be agreed by February or March, to solve the bloc's debt crisis.

Market participants are now expecting a range of potential adjustments to be
announced at the EU leaders' summits on Feb 4th and March 24th.
Currently, liquidity facilities add up to €750bn:
€440bn (EFSF), €60bn (ESM) and €250bn (IMF). There is a caveat
in that only €260bn of the EFSF can be used for funding due to credit
enhancements to preserve its own AAA rating. It seems that in today's post-crisis
financial markets the bond lifeguards need a lifeline of their own. Despite
this, the EFSF has ample resources to cover all funding needs in their entirety
for Greece, Ireland, Portugal and Spain up to the end of 2013. However,
the fund wouldn't stretch to covering the additional burden of more bank
redemptions in Spain or the introduction of a fresh candidate for EFSF funding e.g.
Italy. A larger IMF share is unlikely as this would require additional funding
by the US given the fact that the majority of IMF funding comes from the US –
we see a very low likelihood of this scenario because the political landscape
in the US is heavily geared towards domestic issues including the future state
of public finances.

The Euro benefitted last week from a series of upbeat auctions that
removed sovereign default fears if only for the time being. Spain and
Portugal auctioned 5yr and 10yr bonds and received a very strong take up by

The news bolstered the Euro but further medium-long terms gains may be
difficult to achieve because the policy response to such high debt
levels in Europe is still ongoing. As mentioned previously, 2011 contains
several funding humps which is likely to lead to the same concerns about EUR/EU
viability and solvency.

Last week, the big focus in the UK was on the
scheduled interest rate decision by the BoE. Persistently high
inflation and fears of imminent rises in inflation expectations led some market
participants to price in a small chance of an early rate hike in the UK. Such a
rash move was not forthcoming however as the BoE held rates at 0.5% and the APF
was also left unchanged at £200bn.

Inflationary pressures have lingered in the US for over 2 years but
further pressure has come from a 2.5% rise in VAT and an acceleration
of commodity price increases; contradictory to what the BoE believed
would occur over the course of 2010. BoE members were repeatedly confident of
spare capacity in the UK economy being able to soak up the inflationary
pressures and commodity prices were expected to
stabilise. In every MPC meeting since June 2010, BoE member Andrew
Sentance has voted to raise interest rates due to worries about price pressures.

Financial markets are now pricing in a strong chance of a hike as early as May.
It would be too early to say the BoE has lost control of inflation
expectations but the continued increase in medium-long term inflation
measures should be a big worry for the MPC committee. BoE minutes from last
week's meeting will be published on January 26th with Sentance and Posen
likely to have been the dissenters. Posen, an arch-dove could have
been persuaded to change his stance which would symbolise a significant
strengthening of the hawkish camp and thus provide fertile ground for
a sustained Sterling rally in Q1, Q2.

The counter argument suggests that inflation is primarily being driven
by temporary factors such as a rise in VAT, high commodity prices and
past depreciation of Sterling. By stripping away these factors reveals that
underlying price pressures remain low despite the growing consensus on the
contrary. Given the UK's currently weak labour market and worryingly low wage growth
compared to previous recessions, suggests a decision to hike may not be as easy
as the theory suggests. Overall we see the BoE coming under severe pressure
in 2011 as calls for higher rates to tame actual and expected inflation are
countered by calls to maintain ultra-loose rates to facilitate a strong recovery
and to maintain razor thin bond yields – quite possibly a pivotal factor if
the coalition government expects to reduce the overall debt-to-GDP ratio
within the next 4-5 years in accordance with the acute debt reduction programme
ongoing in the UK.

The Yen was broadly flat last week – largest move was
against EUR as EUR (-3.46%) strength was all pervasive. Interestingly,
Japanese authorities announced plans to buy more than 20% of a bond offering by
the EFSF, expected later this month. This echoes Chinese aspirations to
ramp up bond purchases of troubled EU nations. This move potentially suggests
that the ills facing Europe are transitory in nature i.e. the higher bond
yields offered by peripheral nations are a good investment opportunity at low bond
prices rather than a risky bet on a region that is likely to fail.

The Aussie Dollar gyrated as record flooding in Queensland reached a
point whereby Australia's GDP was likely to be affected
significantly. AUD pairs traded on knee-jerk reactions as RBA's McKibbin suggested floods
could knock up to 1% from Australia's GDP in 2010. Bear in mind that broad market
expectations were for a 0.2-0.3% effect.

Latest damage estimates do not indicate an effect on rate expectations
at RBA's next meeting. Australia as a country may have significant
damage and clean up costs but in our view, not enough to augment monetary policy.
The effect on Australian CPI is likely to be upward as crops and other
commodities suffer a fall back in supply. GDP will likely be negatively affected
by the floods in Q4 2010 and Q1 2011. However, this effect should be
temporary and reconstruction efforts will generate significant growth moving on from
Q2 2011, offsetting the initial drop.

Preview: 17th - 23rd January 2011
Looking ahead: · Europe is again at the centre of attention as recent
news of an expansion of the EFSF stirs ranging expectations as to what extent
European authorities will intervene this time around
· Several interest rate decisions in the G20 – Canada, South
Africa and Brazil are the highlights
· Bond auctions are rife across all durations – event risk is
fairly high. Failed auction could occur as market participants stand
back to see how policymakers react to the growth in funding demand in
peripheral Europe
· Macro data flow is heavy, especially in the UK. UK figures
include CPI, unemployment and retail sales. With macro data (more
specifically, inflation) being in the spotlight, event risk for GBP pairs is

Mildly higher
US yields are supporting the Dollar for the time being – as equities
hit fresh highs it is seemingly the case that improvement in the US economy is
pushing yields higher rather than discontent with US debt. The big focus now
is Q4 earning season which begins this week with Alcoa and Intel reporting.

Further strength in equity markets on the back of good earnings results should
add confidence to the already burgeoning recovery. At the open this week,
equity markets in the US, UK and Europe are all at, or close to, 3 year

Six central
banks are scheduled to announce rates: Canada, Brazil, Poland, Turkey,
South Africa and Mexico. Most interest is on Canada and Brazil. We expect
the RBB to hike 50bp while Canada should stay on hold.

In the bond auction space, this coming week will see lots of supply with one main
event being the 10yr & 13yr auctions in Spain on Thursday. Primary market
activity will also be quite intense in the T-bill market with all
active issuers (except for Italy) issuing. Greece and Spain are due to issue
T-bills on Tuesday. Spain will also auction €3bn of 10yr bonds on Thursday.
Given the good auctions we saw last week in Spain and Portugal, we see a strong
chance of the same result this time round.

For Europe, the next few weeks are key. European finance ministers will meet
several times over the next few weeks and changes to the current EFSF programme are
very likely. Below is a summary of the possible changes that we think are
currently on the table.
1. Lowering the EFSF's lending rate – this measure would make it easier for countries to manage
their fiscal targets but will not relieve the requirement to balance primary
2. Lengthening the duration of the EFSF – would be a help as this would allow sovereigns to
extend duration of loan repayments and provide access to cheaper financing for longer.
The downside here is that investors may lose patience with constantly
increasing levels of financial support and may not want to increase the duration
of exposure to the European periphery.
3. Increasing the overall size of the EFSF via greater funding from Europe and IMF – almost a

Some analysts are expecting €500bn worth of additional funding.
Although the Eurogroup and Ecofin meet early this week, they are unlikely to detail
a permanent crisis management facility this soon given the range and
complexity of the issues involved. The Feb 4th and March 24th
leaders' summits seem like more apt announcement dates. Comments
from attending finance ministers should clarify the likely measures to be introduced
but by the same token (and from past experience) we could see an inconsistent
flow of commentary from the myriad of ministers likely to have a comment.
Getting lost in translation may be the understatement of the week! Therefore,
headline risk remains considerable this week.

No comments: