05/15/2011 - Larger risk retreat now looks to be underway

Larger risk retreat now looks to be underway

After last week’s rout in risk assets (commodities, stocks and JPY-crosses)/rebound in the USD, we were largely constructive on the move, viewing it as only a positioning-driven correction within a larger uptrend. Price movements in the past week, however, have now convinced us that a larger trend reversal lower is likely taking place. While there are plenty of individual stories and themes playing out, we prefer to focus on the strength of the global recovery as the primary driver. And here, we think recent data points to moderating global growth, as Asia shows signs of decelerating (see below) and major developed economies appear set to languish as austerity measures increasingly take hold. German factory orders and Eurozone industrial production both declined MoM in March, suggesting that the strong 1Q growth in the Eurozone is unlikely to be sustained. Anecdotally, we continue to hear market talk of sizeable leveraged names (hedge funds) exiting long risk/growth trades and turning more bearish. Additionally, a quarterly Bloomberg News survey also revealed a decidedly bearish shift in sentiment among global investors for the months ahead. Lastly, the impending wind-down of the Fed’s QE2 asset purchase program is cited by many as feeding in to expectations that US rates may rise and stocks may fall, though we don’t ascribe recent risk asset strength to QE2 at all. We will continue to look to incoming data for what it suggests about the strength of the global recovery and to inform our view of risk sentiment.

We think positioning is still a factor, but recent sharp declines in major currencies and commodities suggest that a potentially significant portion of the excess has been worked off, meaning the pace of declines may moderate in the week ahead. Still, we don’t think positioning is anywhere yet near short “risk” assets, so we will look to use rebounds in any consolidation periods as an opportunity to re-sell key commodities, and major currencies/ buy USD on dips. Please note, this is a reversal of the view we suggested in last week’s update. Technically, we are getting trend reversal signals in many major markets: The CRB commodity index has dropped below the daily Ichimoku cloud; WTI crude oil and silver have both dropped into the cloud, but so far are holding above the base (hopefully offering room for a rebound); Gold is lagging and holding well above the 1435/36 cloud top, possibly signalling it will play catch-up (see below); EUR/USD has dropped into the cloud; and the USD index has tested the bottom of the cloud from below. These developments suggest that there may still be some bounce left in certain commodities and currencies/pullback in the USD, but that another week like the last two would trigger unambiguous signals of an even larger reversal lower in risk assets/higher for the USD in the weeks ahead.

The UK leads the “soft patch” in global growth

Last week’s Inflation Report delivered what many had expected– a downgrade to the UK’s growth forecast for 2011. The Bank of England’s central projection for growth this year is between 1.8 per cent and 3.5 per cent. This is below the Bank of England’s February forecast of 2 – 4 per cent. 

Inflation was revised higher, which was also expected. But the Bank surprised the market with its interest rate forecast. Its projections were based on interest rates rising to 1 per cent by the end of the year. This surprised the market since investors had been pricing out the prospect of any rate hikes this year after a spate of weaker data including first quarter GDP that was below the growth rate of Greece. 

The Bank’s signal last week suggests that rates may be increased as early as August and then again at the end of the year. But with growth essentially flat since the third quarter of 2010 and PMI survey data for April pointing to the slowdown extending into Q2, we think that rates may remain on hold for some time yet. 

Interestingly, in the aftermath of the Inflation Report Short Sterling futures, which measure interest rate expectations, have not had a significant move, suggesting that the market is not convinced the Bank will raise rates at all this year. 

There are two reasons for this. Firstly, the outlook for growth has deteriorated. Austerity measures have just started to take hold and household incomes are likely to remain constrained for some time yet. That is bad news for the UK economy as it relies heavily on consumption and services to grow.

Secondly, the fall in commodity prices has the potential to affect UK inflation rates more so than in the US because the Bank of England looks at headline inflation, which includes energy and food prices. So if oil prices continue to come off then we could see CPI rates decline in the coming months. There is a caveat to this: processed food prices. They have risen strongly in recent weeks and have the potential to keep upward pressure on inflation for some time to come. 

Putting that concern to one side, weak growth and the potential that inflation has peaked do not support higher rates. While the UK economy faces strong headwinds in the medium-term, if the Bank holds off on raising rates that may boost growth as we move into 2012. So there is a chance that this soft-patch is a temporary bump in the UK’s economic profile. 

Sterling had a volatile week falling back from 1.6500 – the high post the Inflation Report - and closing the week below 1.6200, the lowest level since the start of April. The economic outlook is particularly cloudy, which makes it hard to predict the direction of sterling. We think the risk is for another down-move, with 1.6500 the high for now. Below 1.6180 – the top of the Ichimoku cloud, GBPUSD is no longer in a technical uptrend and we may see down to 1.6000.

The euro gets hit as sovereign crisis enters its second act

Since last summer the euro has shrugged off sovereign debt concerns. It brushed off the Irish bailout in November, and within days of the Portuguese bailout EURUSD was in touching distance of 1.5000. But since last week the prospect of a second bailout for Greece and a new phase of the crisis have spooked investors. 

It appears that the market is starting to discount sovereign concerns, which makes it unlikely that EURUSD will move back to the 1.5000 level in our opinion. EURUSD closed last week on a weak note, below 1.4190 – the top of the Ichiomku cloud and the end of the EURUSD technical up trend. Below 1.4150 we may see a sharp decline to the 1.3950/60 zone, which is also the bottom of the Ichimoku cloud chart.  

The decline in the euro is not only down to sovereign concerns. The single currency is also weakening along with other risky assets and it is moving inversely to the dollar, which has strengthened 4 per cent against its major trading partners since the start of May.

As risk aversion and the dollar re-bound grips markets then the euro will remain under pressure. However, we don’t anticipate the single currency to go down in a straight line. The ECB still seems committed to normalising interest rates at a quicker pace than the Federal Reserve and strong growth figures for the first quarter of this year have kept interest rate expectations elevated.

Right now there are another two ECB rate hikes priced in by year-end. This seems excessive when the peripheral economies are struggling and Portugal returned to recession in Q1, but unless we see a dramatic slowdown in inflation or overall growth rates then the ECB may hike rates again in July. If interest rate differentials do start to drive FX markets once more then the euro is the sure winner.

However, we believe that sovereign concerns may run for some time yet after Germany said it would not agree to extend more aid to Greece until the conclusion of an IMF audit in June on how well Athens is complying with the conditions of the first bailout. While Germany remains unwilling to pledge extra financial help to Greece then the euro may be on the back foot. After all, this time last year the euro was in free-fall when Germany and other nations failed to agree on the first rescue package.

Asian growth outlook subdued

This week, the People’s Bank of China (PBoC) raised banks’ reserve requirement ratio (RRR) by 50bps effective May 18. This is the fifth time this year the PBoC hiked the RRR which has reached a record high of 21%. This comes after an abundance of Chinese economic data was released on Wednesday. The data showed that while inflation ticked down slightly in April to 5.3% y/y from the previous 5.4%, it remains at elevated levels which is likely to be concerning to policymakers. Additionally, new yuan loans for April rose by much more than anticipated to 739.6B from the prior 679.4B, also an alarming indicator. This suggests that the PBoC may continue to tighten to withdraw liquidity and control inflation. As the world’s second largest economy and major consumer of commodities, expectations of continued tightening by China may keep pressure on risk sentiment as the policy measures are likely to weigh on growth. This can be seen by a lower than forecast April industrial production to 13.4% y/y (cons. 14.6% prior 14.8%) and an unexpected drop in retail sales to 17.1% y/y (cons. 17.6% prior 17.4%). As noted by PBoC Governor Zhou, “there is no limit to how far the required reserve ratio can be raised”.

On Thursday, Japan will release its first quarter GDP which is expected to show a contraction of -0.5% q/q from the prior -0.3%. The decline is largely due to the March 11 earthquake and a second consecutive quarter of negative GDP would confirm a recession. Recent indicators suggest significant deterioration in the Japanese economy with the most notable being a sharp drop in March industrial production by -15.3% m/m from the prior +1.8%. Weakness is expected to persist for some time and the expectations are for continued contraction before a recovery materializes. The Bank of Japan is set to meet next week and is not expected to make any changes at its policy announcement on Friday though the risk is for board members to support Deputy Governor Nishimura to increase asset purchases. While markets are risk averse, yen crosses are likely to remain under pressure, however the downside in USD/JPY may be limited as the threat of intervention lingers, suggesting more pronounced weakness may materialize in non-JPY dollar pairs.

Is gold about to lose its luster?

As we head into next week it appears that gold is setup for a potential ‘Wile E. Coyote’ moment. When analyzing other products that typically have a positive correlation with gold we’ve noticed a few startling technical developments. Of late, RSI has proven its value as a ‘leading indicator’ as it has preceded the actual move in multiple other markets. When focusing on a Silver chart, the daily RSI broke below long-term trendline support on May 2nd, meanwhile price broke below its corresponding trendline on May 4th. The USD index’s daily RSI broke higher one day in advance to price and the EUR/USD’s daily RSI confirmed the break below channel support in real-time.

Now as we turn our technical emphasis to gold, the daily RSI broke below trendline support on May 4th, however price has yet to break below its analogous trendline. On Monday this key support level rises to $1476 and if other markets serve as any precedent, it may only be a matter of time before gold bulls realize they have run off a cliff and there’s nothing left to support them. Should this long-term trendline give way, the downside could be swift and treacherous. Since the beginning of 2009, the 150-day sma has kept the overall bull market intact. Thus, we would expect it to provide support once again should it be tested. On Monday the 150-day sma should be around $1405 as it currently rises about $1 a day.

Key data and events to watch in the week ahead

United States: Monday – May Empire Manufacturing, Mar. Net TIC Flows, May NAHB Housing Market Index, Ben Bernanke Speaks Tuesday – Apr. Housing Starts, Building Permits, Industrial Production, Capacity Utilization Wednesday – FOMC Meeting Minutes, Fed’s Bullard Speaks Thursday – Weekly Jobless Claims, Apr. Existing Home Sales, Leading Indicators, May Philadelphia Fed. Index, Fed’s Dudley, Fisher and Evans to Speak Friday – Fed’s Dudley to Speak

Eurozone: Monday – EZ Apr. CPI, Mar. Trade Balance Tuesday – EU Finance Ministers Meet, German May ZEW Survey Wednesday – ECB’s Stark, Constancio & Bini Smaghi Speak Thursday – ECB’s Trichet, Tumpel-Gugerell Speak Friday – German Apr. Producer Prices, EZ Mar. Current Account, EZ May preliminary Consumer Confidence, ECB’s Mersch to Speak

United Kingdom: Monday – May Rightmove House Prices Tuesday – Mar. DCLG UK House Prices, Apr. CPI, RPI Wednesday – BOE MPC Minutes, Apr. Jobless Claims, Mar. Weekly Earnings, ILO Unemployment Rate Thursday – Apr. Retail Sales figures, May CBI Trends

Japan: Monday – Mar. Machine Orders, Apr. Domestic CGPI, Apr. Consumer Confidence Wednesday – Mar. Tertiary Industry Index Thursday – 1Q preliminary GDP figures, 1Q Housing Loans, Mar. Capacity Utilization, Mar. final Industrial Production, Apr. Nationwide and Tokyo Dept. Store Sales Friday – BOJ Target Rate, Mar. All Industry Activity Index

Canada: Monday – Mar. Manufacturing Sales, BOC Governor Carney Speaks Tuesday – Mar. Int’l Securities Transactions Wednesday – Apr. Leading Indicators, Mar. Wholesale Sales Thursday – BOC’s Carney & Lane to Speak Friday – Apr. CPI, Mar. Retail Sales

Australia & New Zealand: Monday – NZ May Performance Services Index, AU Mar. Home Loans Tuesday – RBA May Minutes Wednesday – NZ 1Q Producer Prices, AU Westpac Consumer Confidence, AU May DEWR Skilled Vacancies, AU 1Q Wage Cost Index Thursday – NZ May ANZ Consumer Confidence Index, NZ Budget, AU Feb. Weekly Wages Friday – NZ Prime Minister Key Speaks, NZ Apr. Credit Card Spending

China: Tuesday – Apr. Actual FDI

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06/19/2011 - Immediate Greek debt crisis looks to be averted

Immediate Greek debt crisis looks to be averted

The short-term risk that Greece will not receive the next installment of the original EUR 110 bio EU/IMF bailout, needed by early July to roll over maturing government debt, is close to being resolved favorably. EU officials have indicated their funding will be available, contingent on the Greek parliament passing additional austerity measures this weekend. And the IMF has relaxed its stance, indicating it will accept EU governments’ assurances that funding for Greece will be available in 12 months rather than a concrete long-term financing arrangement. So the risk this weekend, then, is that Greek lawmakers are unable to agree on a combination of tax increases and spending cuts that satisfy more stringent EU conditions on additional aid. In light of Greek politics, we think this is no small risk. However, Friday’s Greek cabinet reshuffle suggests to us PM Papandreou will achieve the necessary majority to pass the measures. Failure to do so would trigger a government debt default within days or weeks, rendering the Greek banking system insolvent and triggering an inestimable wave of contagion throughout Europe, potentially unleashing another global financial crisis in the process. So failure is not an option, and for this reason we think the measures will pass and the immediate crisis will be averted. The EUR may see further upside in this case, but we do not expect strength much beyond the 1.4450/4500 area in the current environment.

Even with Germany relenting in its demand for private sector burden-sharing on Greek government debt, we think the long-term solvency of the Greek state remains in doubt, and we don’t think we’re alone. Even if Greece does adopt additional austerity measures, there’s no guarantee they’ll be successful in implementing them and achieving deficit reduction goals. The overall Greek debt load continues to increase and with negative growth, investors are right to question whether Greece will ever be able to pay off its debt, meaning a default will continue to loom, though further out on the horizon. And it’s not just Greece or the periphery. Late headlines on Friday that Moody’s has placed Italy’s ratings on review for a possible downgrade underscore the widespread over-indebtedness of major Eurozone economies. With growth on the continent having peaked earlier this year, the debt headwinds are likely to continue to weigh on the single currency. In this light, we would favor using any relief rallies in EUR as an opportunity to get short, highlighting the 1.4450/4600 area as the preferred level for a multi-week decline. Our view is invalidated on a daily close above 1.4710/20.

Global recovery still being marked down

While Greece dominated the headlines this past week, investors remain increasingly cautious over the strength of the global recovery, and we won’t lose sight of that bigger picture. We think this is most evident in overall commodity weakness, which persisted even with the relatively favorable Greek/EU news at the end of the week. The CRB index has dropped back to lows last seen in May and may be set to break down further. We think next week’s reaction in risk markets (stock and commodities) will be exceptionally telling: in light of the ostensibly positive news out of Greece and Europe, we’ll interpret a failure of risk assets to stabilize and test higher as an indication of further risk aversion and downside ahead. In FX, JPY-crosses have not seen a significant rebound, as one would expect if risk sentiment were improving. Indeed, US Treasuries remain nearer to recent highs and the USD index looks set to finish the week above the daily Ichimoku cloud, potentially signifying an intensifying period of risk aversion ahead. We’ll be focused on recent lows in stocks, commodities and JPY-crosses as triggers to further weakness.

Euro’s fate rests with China

At one point last week it looked like the Eurozone was going to descend into chaos. The political situation was deteriorating and the prospect that the various branches of authority could not agree on whether private investors should shoulder some of the burden of further bailout funds for Athens threatened to lead to a disorderly default that could rock the entire financial system. 

This weighed on the single currency, which threatened to break below 1.4000. However, as we move into a fresh week there is a sense of calm. The EU along with the IMF have suggested that the next round of bailout funds will be available to Greece, which will stave off default next month when coupon payments and bond redemptions come due. 

So the euro managed to avoid a Friday sell off and closed the European session comfortably above 1.4300 on Friday. This was also fuelled by signs that Germany would not push for private investors to accept a 7-year extension on their Greek debt holding, thus preventing a default, a credit downgrade and contagion to other parts of Europe.

But while the long-term solutions such as private sector involvement still have to be decided, the FX market is happy enough to hold euro as short-term disaster has been avoided. But we would not get too complacent. 

The Chinese premier Wen Jiabao is visiting Europe next week and the currency bloc needs his support (both political and financial) to see it through this sovereign crisis.

The last time that China pledged to support Europe and buy EFSF rescue bonds in January (we don’t know how much they actually bought) the euro rallied from a 1.3000 low. So, support from China could see further upside in the euro towards 1.4500.

However, any stern words or signs that China is not going to continue to purchase EFSF bonds along with the debt of Greece, Portugal and Spain may see a sharp reversal. 

There are also some important data releases in the Eurozone next week. In Germany there is the IFO – a measurement of industrial sector sentiment. Although this survey remains at elevated levels compared to its long-run average, analysts expect it to moderate in June, adding to evidence that growth in Europe’s largest economy has passed its peak. 

The final readings of the Eurozone PMI surveys are also released at the end of this week. The market is currently looking for a sharp downward revision to both the services and manufacturing surveys. Signs that the Eurozone is going through a summer malaise like the US is euro negative in our view, so watch out. 

The outlook for the single currency remains cloudy and next week is littered with event risk, which requires a nimble strategy and tight stops. In EURUSD, resistance lies at 1.4340 – the base of the Ichimoku cloud and end of the technical downtrend. This pair is in a technical uptrend above 1.4505. 

New boy at MPC shows his colors

The minutes of this month’s MPC meeting are released on Wednesday and the markets will be eagerly waiting to see how the swing of voting has been affected since the departure of arch-hawk Andrew Sentance at the end of last month.

His replacement Ben Broadbent, a former Goldman Sachs economist, hasn’t given much away, but at his Treasury Select Committee hearing although he sounded concerned about inflation and especially commodity prices, he seemed to agree with the MPC’s actions so far. Thus, it seems likely that Broadbent voted with the majority and the Governor Mervyn King to keep rates on hold.

With another member sitting on the fence the camp voting for rate hikes will be weakened, making a rate hike this year look increasingly unlikely. Added to this, it was reported last week that retail sales data was incredibly weak in May, falling 1.6 per cent. This is worrying for an economy that relies on the consumer and the service sector for approx. 60 per cent of its output.

While Europe has been grabbing the headlines, the UK has been benefitting and the Gilt market rallied last week after attracting safe haven flows caused by the Greek debt crisis. 2-year Gilt yields fell more than 10 basis points on the week.

It will be interesting to see how the Gilt market reacts to the public finances figures released on Tuesday. The fiscal year got off to a bad start in April when borrowing surged to GBP10bn, above last year’s figure of GBP7.3bn.

However, as activity on the High Street and in factories starts to slow, tax receipts are inevitably going to fall, which will weigh on the borrowing figures for as long as this economic malaise lasts. The markets think that government borrowing will surge to GBP 16.5bn, above last year’s GBP13.4bn. 

This may call into question the government’s target to cut borrowing by 15 per cent this year. Signs of slippage in the fiscal plans will most likely hurt Gilts, pushing yields up for all the wrong reasons. It is also sterling negative in our opinion. 

Any strength in sterling we think is a selling opportunity, especially versus the Swiss franc. This pair has cracked fresh multi-year highs already in recent weeks, but it could have further to go especially if the Eurozone debt crisis rages on. We think any rallies above 1.6250 in cable are unsustainable. Support comes in at 1.6020 – the 200-day simple moving average.

Soft patch to keep Fed policy on hold

On Wednesday June 22, the FOMC will conclude a two-day meeting and announce its stance on monetary policy. It is unlikely that the Fed will make any material changes to the previous assessment as the U.S. economy appears to be trudging along. Recent data indicate that the economy appears to have hit a soft patch as highlighted by this week’s disappointing May industrial production and recent negative surprises in regional data such as June Empire Manufacturing which fell to -7.79 (prior 11.88) and the June Philadelphia Fed index which dropped to -7.7 (prior 3.9). Moreover, the most recent BLS monthly figures suggest a slowdown in the pace of hiring and uptick in the unemployment rate. We believe that Fed Chairman Bernanke is likely to underscore the sluggishness of the economy but maintain the view that growth may pick up in the second half of the year, ignoring another round of QE. Chairman Bernanke will give his second press conference following the release of the FOMC statement and we would anticipate the Q&A session to include discussion on events in the European periphery and the risks posed to the domestic economy.

What are precious metals secretly telling us?

Fundamentally the commodity market continues to be driven by the many of the same factors: uncertainty surrounding the European Union and sovereign debt crises, completion of QE2 and political bickering regarding the debt ceiling in the United States, geopolitical concerns in the Middle East and North Africa, reconstruction efforts in Japan, Australia and New Zealand and the current global low interest rate environment beginning to come to end. While a tremendous amount of headline risk exists, gold and silver are likely to be torn between those who perceive it as another “asset class”, thus trading in-line with risk and those who believe its “flight-to-safety” play. However, when we compare the two, their relative performance appears to be hinting a material change may be underway.

While both precious metals are typified as safe havens and hedges against inflation, silver accounts for a much larger share of industrial demand than gold. Consequently, it will tend to out-perform gold as the global economy recovery takes hold and under-perform once the economy slows (best seen by looking at the gold/silver ratio). Thus, it can be a great proxy for ‘risk’, as a lower gold/silver ratio promotes risk taking and a higher ratio suggests risk aversion. This is predominantly explained by silver’s typically lower margin requirement and greater volatility in the futures markets.

Interestingly, at the end of April the ratio made a fresh 28-year low around 31 and then saw a sharp rebound higher, briefly touching 45, before settling around current levels of 43. Historically, an inverted gold-to-silver ratio has tended to coincide and even occasionally lead the S&P500. Therefore, the recent outperformance of gold relative to silver suggests we are potentially at a huge turning point for risk overall as reality begins to set in and the prospects for growth are not quite as rosy as they once appeared. While we cannot rule out a possible correction back towards 36-38 in the short-term, we believe a longer-term bottom may be in place. Subsequently, we envision a substantial shift in the way investors perceive ‘risk’ as we head into 2H of 2011.

Key data and events to watch next week

United States: Monday – Treasury Secretary Geithner Speaks Tuesday – May Existing Home Sales Wednesday – Apr. House Price Index, FOMC Rate Decision, Bernanke Speaks at Fed Press Conference Thursday – May Chicago Fed Nat Activity Index, Weekly Jobless Claims, May New Home Sales, Fed’s Evans Speaks Friday – May Durable Goods Orders, 1Q Final GDP Figures

Eurozone: Monday – EU Finance Ministers Meet, German May Producer Prices, EZ Apr. Current Account, 1Q Labor Costs Tuesday – German June ZEW Survey Wednesday – EZ Apr. Industrial New Orders, Jun. EZ Consumer Confidence Thursday – German Jun. Manufacturing & Services PMI, EZ Jun. Manufacturing, Services, & Composite PMI Friday – EU Leaders Conclude Two-Day Summit in Brussels, German Jun IFO Surveys, May Retail Sales

United Kingdom: Monday – Jun. Rightmove House Prices Tuesday – May Public Sector Net Borrowing, Jun CBI Trends Wednesday – BOE Releases MPC Minutes Thursday – May BBA Home Loans, Jun. CBI Sales Friday – BOE Governor King Hold Press Conference

Japan: Monday – May Trade Balance, April Final Leading and Coincident Index, Cabinet Office Monthly Economic Report Tuesday – Apr. All Industry Activity Index Thursday – BOJ’s Morimoto Speaks

Canada: Tuesday – May Leading Indicators, Apr. Retail Sales

Australia & New Zealand: Monday – NZ 1Q Manufacturing Activity, NZ Jun. Performance of Services Index, Prime Minister Key to Speak, NZ. May Credit Card Spending Tuesday – RBA’s Board June Minutes Wednesday – NZ 1Q Current Account, Deficit-GDP Ratio, AU Apr. Westpac Leading Index Thursday – AU Apr. Conference Board Leading Index

China: Friday – MNI Business Condition Survey

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