06/12/2011 - Risk retreat continues, may accelerate

Risk retreat continues, may accelerate

Risk assets (stocks and commodities) continue to slide lower after topping out in early May on signs the global recovery was losing steam. Incoming data continues to highlight a slowdown in major developed economies, and the main question is whether this is only a temporary soft patch or the start of a more ominous deceleration in growth. Optimists can point to temporary factors, like the surge in energy prices, as the cause for recent weakness in demand, and express confidence that growth will pick up shortly. Pessimists, on the other hand, highlight structural drags on growth, like high unemployment and the exit from fiscal stimulus and imposition of austerity measures as the roots of a more pronounced slowdown. The reality lies somewhere in between, where temporary factors intensify the effects of the structural constraints on growth, but the overall trajectory is clearly one of slowing. This suggests to us that the pullback in risky assets has further room to run.

For the time being, the pullback in risk assets appears moderate and orderly, but there are plenty of potential developments that could trigger a much more severe collapse in risk markets. The game of chicken being played over Greek debt (see below) has the potential to trigger another financial and liquidity crisis that seems unlikely to remain confined to European shores. A resolution is needed before the June 23-24 EU summit in Brussels, and possibly before the June 20 finance ministers conclave. The debate in the US on raising the debt limit, now with less than 8 weeks to go until the Aug 2 Treasury deadline, is another potential show stopper. An exodus of investors from emerging markets appears to be underway, and we would note the MSCI Emerging Market Index has dropped out of the daily Ichimoku cloud. Sentiment also appears to be building that China is at risk of a real estate bubble bursting, though timing that is extremely difficult. And all of these events are playing out against the backdrop of a deceleration in major economies. Looking ahead, we anticipate further declines on a gradual basis, but we are on alert for event risks to trigger a much more severe collapse. Finally, we would note that the S&P 500 last week closed below the daily Ichimoku cloud (bearish), and this past week registered a close below the weekly Kijun line (bearish), suggesting potential lower to the weekly cloud top, currently at 1175.

We will continue to look for opportunities to get short risk assets on remaining strength. In concrete terms, we think shorts in AUD, CAD, and NZD against the USD and JPY from just above current levels offer attractive opportunities.

The ECB gives the market a reality check

The euro finished the week on a lull, breaking through the key 1.4500 mark on the back of firstly, a less hawkish than expected ECB and secondly, fears that private investors will take a hit if Germany gets its way over negotiations for a second bailout for Greece.

The ECB may have signaled a rate hike in July by using the words “strong vigilance” during its press conference on Thursday, but rather than cause the currency to surge the opposite thing happened and the euro dropped back below the critical 1.4500 mark. The market concentrated on the ECB staff macro-economic predictions. While growth for this year was higher, inflation for next year was revised lower to a range between 1.1 per cent and 2.3 per cent, much closer to the ECB’s 2 per cent target.

While interest rates have been a major driver of the currency in recent months the growth story is coming back to the fore. Even Germany, the currency bloc’s economic powerhouse, is not immune to the global moderation in growth. The Bundesbank expects a sharp drop in Germany’s growth rate between this year and next from a stellar 3.1 per cent in 2011 to 1.8 per cent next year.

With the ECB looking set to take its time over interest rate normalization then the interest rate premium that has been driving the single currency may start to be priced out as the chance of further rate hikes after July starts to moderate. European Inter-bank lending rates fell after the ECB’s press conference. But the outlook for monetary policy in the Eurozone really depends on how well the global economy weathers the current malaise in growth. If growth picks up again later this year then the ECB may continue to hike rates.

However, the fact that EURUSD has only managed to stay above 1.4500 for brief spells of late suggests the currency is at risk of a longer-term contraction. While we don’t expect an imminent collapse, above 1.4850 now looks remote and we believe the downside is protected above 1.4000.

Germany risks raising ECB’s ire

Markets hate uncertainty but that hasn’t stopped the ECB and Germany staging a very public disagreement over how to bailout Greece. Without extra funds the troubled southern European nation may well have to default next month after the first bailout that was due to last until mid-2012 was shown to be woefully inadequate.

The markets may have given the various branches of power within the EU the benefit of the doubt that a mutually agreeable solution to the Greek crisis would be found, but as D-day for Greece approaches it is losing faith. This is likely to weigh on the single currency for the foreseeable future and has sent the cost to insure Greek debt against default to fresh record highs.

Germany wants private bondholders to share in the burden of further aid to Greece to the tune of EUR30bn or roughly 50 per cent of extra funds that are needed. However, haircuts or maturity extensions on bonds is totally unacceptable to the ECB for a viable reason.

Credit ratings agencies have said that if Germany gets its way and maturities on Greek debt are extended - possibly by 7 years - then this would constitute a default and credit ratings would be adjusted as needed. And it would not just be Greece who would suffer; Portugal and Ireland would also be at risk. 

This is problematic for the ECB, which holds in excess of EUR75bn of peripheral debt on its balance sheet through its Securities Markets Program as well as holding more Greek and Irish debt as collateral in return for loans to these nations’ troubled banking sectors. Multiple rating downgrades would hit the ECB’s financial viability and possibly unleash a financial crisis just at the time that it would have limited means to support the currency bloc’s economy. 

Right now we are at the loggerheads stage. The next few weeks will be interesting to see who wins out in the fight. But although Germany is the currency bloc’s paymaster, pushing for a technical default won’t help matters. Not only will it hurt the ECB it will also hurt the European banking sector with exposure to peripheral debt. Banks in Germany and France with big exposures to the periphery may require bailouts from their governments, so if Berlin gets its way it may well end up shooting itself in the foot.

A decision has to be made by June 24 – when EU leaders hold their monthly meeting. If further aid is not agreed then a default beckons for Athens.

Slim chance of a rate hike from the BOE

The BOE remained on hold last week as expected. We’ll have to wait until the 22 June for the minutes to see how the newest member of the MPC Ben Broadbent voted. Overall, we think that there wasn’t much change in the views: growth is slowing and inflation remains elevated – leaving the BOE between a rock and a hard place.

Signs that growth disappointed in the second quarter continued last week when production data for April fell. Manufacturing, which has been the success story of the UK’s recovery, fell sharply by 1.5 per cent on the month. While there was probably some disruption caused by the bank holidays, there is little doubt that the UK economy is fairly anemic at this stage of the recovery.

This was confirmed when the National Institute of Economic and Social Research released its latest GDP data that showed the economy rose by a miserable 0.4 per cent in the three months to May. The NIESR said that UK growth remains “subdued” and it does not think that GDP will reach its pre-recession peak until 2013. 

This makes the BOE less likely to hike rates any time soon. While domestic factors argue for a weaker pound, in reality the direction of sterling will continue to depend on the US and the Federal Reserve’s extremely accommodative monetary stance along with the ECB and the Greek debt crisis.

No major changes expected from Bank of Japan

On Tuesday June 14, the Bank of Japan (BOJ) will conclude its two-day meeting and announce its monetary policy stance and economic assessment. As recent surveys such as the April METI survey and PMI surveys have indicated that production is expected to rebound in May and June, it gives evidence to the BOJ that economic activity may be picking up. With monetary policy already extremely loose with near zero interest rates, an upgrade to the economic assessment may reduce the immediate need for additional easing measures.

The International Monetary Fund (IMF) earlier this week said that more asset purchases by the BOJ could ease deflation and boost growth as the economy is still facing headwinds from the March earthquake. The IMF suggested that the BOJ could accelerate and expand its existing program of purchases of private assets such as corporate bonds, commercial paper and ETFs as well as lengthen the average maturity of government bond holdings. While the Bank of Japan is not expected to take any drastic measures, a small expansion of its asset purchase facilities may be likely. Small tweaks are not likely to see much of a reaction in the currency markets with the risk of a large increase in additional purchases which may weigh on the yen.

Technically, USD/JPY has moved back above the psychological 80.00 figure with significant support around the May lows of about 79.50 to the downside. A rally may face immediate resistance around the 80.90-81.00 area which is where the daily ichimoku cloud base, Kijun line and 21-day SMA can be found. Above this may see towards the 55 and 100-day SMA’s which currently converge around the 81.90-82.00 area as the next level of resistance. Should the pair see a sustained break below the 79.50 area, a move towards 78.50 may materialize.

Crude oil searching for direction

Following the epic May 5th collapse which saw WTI record its 2nd largest USD denominated daily loss, crude oil prices have stabilized as market participants have been in search of direction. The June 8th OPEC meeting was expected to be the compass for oil markets as speculation of an increase to production targets ramped up ahead of the committee’s decision. Such rumors were proved false as OPEC ministers agreed to disagree. Production quotas were left unchanged and the oil market compass seemingly pointed north. WTI crude oil rallied to highs above $102/bbl and Brent to highs just above $120/bbl on the back of heightened concerns that supply would tighten even further. On Friday, however, crude oil prices sharply reversed as reports of increased Saudi production to 10mb/d soothed supply concerns stemming from Libyan production losses--WTI dipped back below $100/bbl and Brent below the $119/bbl level.

However, recent consolidation ranges remain intact – around $95/105 in WTI and $108/120 for BCO – suggesting further sideways price action may be in store, at least until range limits are upended. At the moment, a downside break for crude oil is seemingly more likely as risk appetites have turned sour on concerns that the U.S. economic recovery may be losing steam and fears of hard landing for China. However, a more granular look at Saudi Arabia’s reported output increase suggests range bound conditions may persist. Saudi oil production is estimated to be around 9.1mb/d, an increase to 10mb/d would result in an additional +0.9mb/d which only replaces roughly half of Libya’s approximate 1.8mb/d output loss. Definitely better than nothing but Saudi’s output increase does not seem to be a game changer and it seems the oil market’s search for direction may drag on a little longer.

Key data and events to watch next week

Unites States:

Monday – Fed’s Lacker and Fisher Speak

Tuesday – May PPI, May Advance Retail Sales, April Business Inventories

Wednesday – May CPI, June Empire Manufacturing, April TIC Flows, May Industrial Production

Thursday – Weekly Initial & Continuing Jobless Claims, May Housing Starts & Building Permits, 1Q Current Account, June Philadelphia Fed

Friday – June Univ. of Mich. Consumer Confidence, May Leading Indicators

Euro-zone:

Tuesday –EU’s Barroso, Ciolos, Barnier, Rehn, Merkel and Sarkozy speak, ECB’s Draghi speaks

Wednesday – EZ April Industrial Production, EU Parliament votes on Draghi’s ECB Candidacy

Thursday – EZ May CPI, EZ 1Q Employment, EU’s Van Rompuy speaks

Friday – EZ April Trade Balance, EU’s Merkel and Sarkozy speak

United Kingdom:

Monday – May RICS House Price Balance, BOE’s Weale speaks

Tuesday – May CPI, May Retail Price Index, May Nationwide Consumer Confidence

Wednesday – May Jobless Claims & Claimant Count Rate, April ILO Unemployment Rate, BOE’s King speaks

Thursday – May Retail Sales

Japan:

Monday – April Machine Orders

Tuesday – 2Q BSI Larger Manufacturing & All Industry, BOJ Interest Rate Announcement, April Capacity Utilization, April Industrial Production

Wednesday – May Machine Tool Orders

Thursday – May Tokyo Condo Sales

Friday – BOJ May Meeting Minutes, May Nationwide & Tokyo Department Store Sales

Canada:

Tuesday – 1Q Capacity Utilization Rate

Wednesday – April Manufacturing Sales, Canada’s Flaherty speaks, BOC’s Governor Carney speaks

Thursday – April International Securities Transactions

Friday – April Wholesale Sales

Australia & New Zealand:

Monday – NZ May REINZ House Sales

Tuesday – NZ May Food Prices, AU May NAB Business Conditions & Confidence, NZ & AU 3Q Manpower Survey

Wednesday – RBA’s Stevens speaks, NZ 1Q Retail Sales, AU April Westpac Leading Index, AU June Westpac Consumer Confidence, AU June Inflation Expectations, AU 1Q Dwelling Starts

Thursday – NZ’s English speaks, NZ 2Q Westpac Consumer Confidence, NZ May Business PMI, AU May New Motor Vehicle Sales, NZ 1Q Manufacturing Activity

Friday – RBNZ Governor Bollard speaks

China:

Tuesday – May PPI, May CPI, May Retail Sales, May Industrial Production, May Fixed Assets Investment

Thursday – April Leading Economic Index

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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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