01/23/2011 - EUR rebound is fundamentally suspect

EUR rebound is fundamentally suspect

The EUR finished out the past week at two month highs against the USD and posted strong rebounds on the crosses as well. The EUR recovered even after EU finance ministers failed to deliver a concrete long-term debt resolution mechanism (see more below), postponing a likely plan to late March. While there has been some movement on the part of Germany to show greater willingness to provide assistance to the periphery, the German government remains insistent that other EU countries will need to shoulder more of the cost as well. This raises the question of how highly indebted countries like Belgium, Italy and Spain will be able to come up with their shares of any support package, and this is the source of our skepticism on the sustainability of the EUR recovery. German data has continued to surprise to the upside with ZEW and IFO surveys all pointing to further strength in the core, and this has also provided the Euro with support.

But core Eurozone strength was never really the issue, but rather how the periphery will muddle through. On that count we still have serious doubts that major debt restructurings (i.e. defaults) can be avoided in several of the peripheral nations. In that sense, we view the recent unwinding of bearish EU bets (e.g. short EUR, long sovereign CDS, short peripheral bonds) as a temporary position adjustment, rather than the end to the European debt crisis. Similarly, we think the fears of an ECB tightening phase are overblown and that even ueber-hawk and potential next ECB president Axel Weber this week downplayed the risks from inflation and called current policy appropriate. We prefer to use current EUR strength as an opportunity to establish more fundamental short EUR positions for an expected decline in the weeks ahead (see the Weekly Strategy).

Has Europe’s sovereign crisis turned a corner?

This time last week the market was looking forward to Eurozone officials taking decisive steps towards creating a permanent solution to the sovereign debt crisis. However, two meetings of EU officials passed with no resolutions agreed. In fact, the German Finance Minister Wolfgang Schaeuble said that the calm that has descended on the peripheral bond markets in recent weeks meant there was less urgency to make changes to the current European Financial Stability Facility (EFSF).

It seems likely that there will be no progress on a permanent solution until the EU council meeting scheduled for 24-25 March. Then officials may agree to an extension of the EFSF fund, which currently stands at EUR440bn. The timing of this meeting is important since it comes just before a state election in Germany on 27 March. Only after this can the German Parliament debate proposals for a permanent bailout facility. 

Even though it may seem like Europe’s debt problems have been pushed down the road, the market has given Europe the benefit of the doubt. The euro has extended its rally this week and looks fairly comfortable above 1.3500. Investment flows into the safety of German bunds has also fallen, which has pushed up bond yields. The spread between German and US 2-year government debt has widened to its highest level since November 2009, which could fuel EURUSD gains back up to 1.4000. 

The single currency may have yield on its side, but the path to 1.4000 could be bumpy. There has been a shift in the discussion of Europe’s sovereign debt crisis away from bailouts and towards default in Greece’s case and bank sector nationalization in Spain.

Reports that Germany was working on a plan to provide Greece with a loan to buy back its bonds in a restructuring that could apply haircuts to senior bond holders was swiftly denied. If this is true, it would suggest that the EU is taking the first steps towards fiscal unity, which flaunts the fiscal sovereignty rule in the European constitution. However, officials may not be willing to take such drastic action yet, even if it does sound like a sensible long-term solution to Greece’s problems. The cost to insure Greek debt for five years has fallen this week, suggesting that restructuring could bring some certainty to investors and actually reduce risk for investors holding Greek debt. If you know for certain that you could be subject to a haircut then you can price Greek debt accordingly. 

Spain meanwhile is working on recapitalizing its troubled Caja banks. The financial position of the 17 domestic lenders is precarious at best. They are scheduled to report all of their non-performing loans and property holdings by 31 January. This could cause market jitters, especially if their liabilities are larger than the approximately EUR50bn the market is expecting.

Fears of aggressive China tightening may unwind soon

China’s pace of economic growth accelerated above expectations (Q4 Real GDP y/y printed +9.8% vs. expected +9.4% in Dec.) which was also reciprocated in Dec. Industrial Production (+13.5% y/y vs. expected +13.4%) and Dec. Retail Sales (+19.1% vs. expected +18.7%). The markets’ reaction to positive China data surprises, however, was negative. Fears of a potential ramp up in PBOC tightening measures gripped financial markets with the brunt of the impact hitting commodities – gold declined -1.7%, WTI crude oil fell -2%, and silver lost around -4% post data release. Commodity currencies experienced concurrent declines as AUD/USD fell sharply below parity to lows around 0.9835 and USD/CAD soared to highs around 1.0030. However, the commodity market selloff should be taken with a grain of salt as speculation for more aggressive PBOC rate hikes are likely to be just that – speculation. Steadying inflation - December consumer prices y/y declined to 4.6% from a prior 5.1% as did producer prices to 5.9 % from a prior 6.1% - may balance out added tightening pressures from faster than expected growth and is likely to see policy direction stay the path of a moderate tightening cycle.

Accordingly, we think the post data commodity currency selloff may be overextended. AUD/USD fell off a proverbial cliff from highs around 1.0075 but was met by strong demand ahead of the 0.9825 range lows – the pair has been consolidating within a 0.9800/1.0025 range since 1/6/11. Above 0.9825 may provide good value for longs on persistent sideways price action. Aussie crosses have also corrected lower on the back of China tightening speculation. AUD/CHF is currently testing key support into 0.9450 highlighted in the Jan. 4th Weekly Strategy and warrants bringing stops to cost as protection against a sharp upside correction as we believe this to be a possibility when rate realities begin to set in over rate expectations.

A chilly fourth quarter for the UK

The strength of the UK’s economic recovery faces its most severe test on25 January when GDP data is released for the fourth quarter of 2010. Market analysts expect the quarterly growth rate to dip to 0.5 per cent from 0.7 per cent in the third quarter and a whopping 1.2 per cent in the second quarter. But the risks are to the downside. 

The trade deficit increased over the quarter, which will hit growth; also economic data released so far has shown a divergence between different sectors of the UK economy. The manufacturing sector has come back with a bang, and the PMI manufacturing index reached a multi-year high of 58.3 in December. In itself, this is good news. However, the manufacturing sector is only a small portion of the UK’s economy, a far more important sector is consumption, and there the figures are looking grim. 

Retail sales have been on a downward trajectory since October culminating in a dismal 0.8 per cent monthly decline in sales in December, a record drop. Although part of the decline was due to the coldest weather in a century hitting the UK, the hike in sales tax on January 1 suggests that retail sales will not pick up anytime soon. On another note, rising fuel and food costs also depressed retail sales at the end of 2010, which puts more pressure on the Bank of England. The minutes of the latest Bank of England meeting will be released on 26 January, which should give us some idea of where the debate is heading within the Monetary Policy Committee: to hike or not to hike? 

As mentioned, there is a chance that expectations for the UK’s economic growth are overdone. If we get a weak GDP reading next week then we could see a sharp reversal in long sterling positions. We were wary about the sustainability of growth in the UK, and wrote in our Q1 2011 outlook that we thought 1.6000 would be a tough resistance level for GBPUSD to break through; so far it looks that way.

Precious Metals may enter Q1 2011 predicted “Buy zones” next week

While the correction in gold and silver has taken a few weeks longer than predicated in our 1Q 2011 Precious Metals Outlook, it has still come nonetheless. The unwind since the turn of the year has been treacherous, especially for the “poor man’s gold”, but ultimately little has changed fundamentally. Much of this price action can be attributed to a reduction of long positioning since the “doomsday” scenario appears to be off the table. In the short-term, the market believes troubles in both the U.S. and E.U. have abated, primarily due to rising U.S. 2011 GDP estimates – based on the 2% reduction of the Social Security tax and EU official’s willingness to discuss a permanent solution and/or changes to the European Financial Stability Facility (EFSF). However, this euphoria is unlikely to last forever and Wednesday’s FOMC interest rate decision may provide a spark in renewed interest for precious metals – Fed is likely to reaffirm their view to keep interest rates “low for an extended period of time”. We believe gold and silver may trade down into the $1300-25 and $26-27 regions next week and could be an attractive area to establish a bullish bias over the coming weeks and months. Alternatively, buying a dip in XAU/EUR between €970-80, for those who prefer to remove the USD variable, could also be an idea.

Key data and events to watch next week

Unites States:

Tuesday – Nov. S&P/CaseShiller Home Price Index, Jan. Consumer Confidence, Nov. House Price Index, Jan. Richmond Fed Manufacturing Index, Weekly ABC Consumer Confidence

Wednesday – Weekly MBA Mortgage Applications, Dec. New Home Sales, FOMC Interest Rate Decision

Thursday – Dec. Chicago Fed Nat Activity Index, Dec. Durable Goods Orders, Weekly Initial Jobless & Continuing Claims, Dec. Pending Home Sales

Friday – 4Q Employment Cost Index, 4Q advance GDP, Jan. Univ. of Mich. Confidence

Euro-zone:

Monday – EZ, French and German Jan. Advance PMI, EZ Nov. Industrial New Orders

Tuesday – French Dec. Consumer Spending, French Jan. Business Survey Overall Demand, German Feb. GfK Consumer Confidence Survey, EU's Barroso and Van Rompuy Speak

Wednesday – French Dec. Jobseekers, ECB's Stark Speaks

Thursday – EZ Jan. Business Climate Indicator, EZ Jan. Confidence Readings, German Jan. preliminary CPI, ECB's Bini Smaghi and Tumpel Gugerell Speak, EU's Van Rompuy Speaks

Friday – EZ Dec. M3, German Chancellor Angela Merkel Speaks

United Kingdom:

Tuesday – 4Q advance GDP, Nov. Index of Services, Dec. Public Finances

Wednesday – BOE Minutes, Dec. BBA Loans for House Purchase, Jan. Hometrack Housing Survey

Thursday – Jan. CBI Reported Sales

Japan:

Monday – Dec. Supermarket Sales

Tuesday – Jan. BOJ Interest Rate Announcement

Wednesday – Dec. Corp Service Price Index, Jan. Small Business Confidence, BOJ Monthly Economic Report

Thursday – Dec. Merchandise Trade Balance

Friday – Dec. Jobless Rate, Jan. Tokyo CPI, Dec. National CPI, Dec. Retail Trade

Canada:

Tuesday – Dec. Consumer Price Index

Wednesday – Nov. Teranet/National Bank HPI

Australia & New Zealand:

Monday – AU 4Q Producer Price Index

Tuesday – AU Nov. Conference Board Leading Index, AU 4Q Consumer Prices, NZ Dec. Performance Services Index

Wednesday – NZ Dec. Credit Card Spending

Thursday – AU Nov. Westpac Leading Index, RBNZ Interest Rate Announcement, RBNZ’s Governor Bollard Speaks

China:

Friday – Jan. MNI Business Condition Survey

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