03/13/2011 - EU competitiveness pact may disappoint

EU competitiveness pact may disappoint

Without the final details in hand as of late Friday afternoon, we can’t be sure of the ultimate reaction, but price moves ahead of the release of the EU pact suggest markets are going to be underwhelmed. The draft of the pact suggested that no concrete rules will be established and that individual governments will operate on a ‘best efforts’ basis to rein in debts and deficits and stimulate growth. The only enforcement mechanism will be discussions between member states. If the final pact follows these outlines, markets are more likely, in our view, to voice disapproval. Indeed, in the run-up to Friday’s summit, peripheral-EU bond spreads widened to near crisis peaks from last year, suggesting many still expect defaults and restructurings to follow. Alongside threats to the global recovery emanating from MENA and China, and now Japan, we think the downside for the Euro is vulnerable and we will view a break below the 1.3730/50 daily Kijun line/weekly low/21-day mov. avg. as an indication of a Euro likely headed back toward 1.3500/50 in the near-term. Should the pact contain more disciplined measures, then we would expect to see some further recovery in the single currency, but think it should remain below 1.4000, as growing risk aversion limits the upside.

Fallout from Japanese earthquake

The massive earthquake and tsunami in Japan on Friday undermined risk sentiment further and this led to JPY-strength as JPY-shorts were rapidly covered. There has been talk of Japanese repatriation of funds to cover insurance costs, but we think this is likely overstated and that risk aversion is the better explanation. The tragedy there is still unfolding, with additional earthquakes registering through Friday night, and no estimates of damage costs are available at the moment. However, given the largely agricultural nature of the affected region, we don’t think the impact to Japanese GDP will be especially severe, but that’s not saying much as Japanese growth already turned negative in 4Q. While we think the near-term pressure will remain on USD/JPY, we don’t think the pair will test the pivotal 80.00 level and seems most likely to find a base in the 80.50/81.50 area in coming weeks. We think the MOF will seek to avoid a further surge in the JPY which would add fresh burdens to the Japanese recovery. The BOJ is meeting at the start of next week and may announce emergency measures such as additional asset purchases, which could see the JPY weaken sooner. The government will also likely soon pursue a supplementary budget to pay for clean-up and reconstruction, and this may revive fears over the size of Japan’s debt burdens and also cause the JPY to weaken.

Spain gets a wakeup call 

There are growing signs that the market is losing patience with the EU authorities who have failed to come up with a credible, long-term solution to the region’s sovereign debt crisis. As EU leaders gathered for a summit in Brussels at the end of last week, the markets had low expectations that an effective solution would be found. Bond yields spiked to euro-era records for Ireland and Portugal; Spain and Italy were not immune either as the risk premium to hold their government debt also increased. 

The downgrade of Spain’s sovereign credit rating by Moody’s to Aa2 from Aa1 at the end of last week focused the markets’ attention back on Europe’s troubled banking sector. A third round of bank stress tests is scheduled to be conducted in the next few months. On 18th March the EU authorities will publish the macro economic scenarios and the sample of banks that will undergo the tests. This is key for the market as it will determine whether the tests are strong enough to really give a true snap shot of the bad debts and recapitalization needs of some of Europe’s most troubled lenders, particularly the Spanish Caja banks. More details will follow in April when the stress test methodology is disclosed and then in June when we finally get the results.

There is no doubt that the EU authorities have made a hash of dealing with their financial problems. It has taken three rounds of stress tests to try and make sense of the bad debts still swimming in Europe’s financial system.

Investors will only be happy once they know exactly how bad the problems are. When the US published devastating results of their bank stress tests in 2009 it was greeted warmly by the markets and led to a stock market rally. Investors will only be happy to hold assets from Europe’s periphery if they can accurately calculate the risk of doing so. Right now they are guessing that things are worse than the authorities are saying, hence bond yields are rising to unsustainable levels. If the truth was out there then bond yields may even start to moderate. Until the full extent of the debt crisis is known there can be no remedy. If the results of the tests are published in June, then a solution is unlikely to be found until the end of the year.

By that time Portugal is most likely to have applied for bailout funds, while Spain just about avoids doing so. But there is a lot of pressure on the larger of the two Iberian nations. Although debt issuance in 2011 is only about 80 per cent of what it was in 2010, Spain still has to tap the markets for an enormous EUR600bn or more for the rest of this year. Doing so at the same time as the bank stress tests are taking place could test investors’ patience. If Spain’s banks require significantly more capital than the EUR 20bn the Spanish authorities have disclosed then its debt could be significantly harder to sell to foreign investors who have already been cutting back on their exposure to the weaker Eurozone states.

The euro has brushed off sovereign debt woes in the past, but they are increasingly weighing on the single currency. It fell back to the 1.3800 level versus the dollar at the end of last week, and the key 1.4000 resistance level is unlikely to be broached for the time being. Technically EURUSD is still in an uptrend above 1.3535 – the top of the Ichimoku cloud, but it has fallen sharply and if we don’t get a bounce somewhere between 1.3600 and 1.3700 then we could see a sharper decline over the coming months, especially versus the greenback.

Central banks expected to maintain policy rates

Several central banks will meet to determine policy in the week ahead. The Federal Open Market Committee (FOMC) will meet on Tuesday March 15, the Norges Bank will meet on Wednesday March 16, and the Swiss National Bank (SNB) is scheduled to meet on Thursday. All of these banks are expected to keep policy rates on hold with the Norges Bank the most likely to surprise with a hike, however we do not anticipate a move on rates.

In the U.S., the Fed has maintained the language that the bank will keep rates low for an ‘extended period’ and the large scale asset purchase program of $600B through June has a ‘high hurdle’ before altering the plan. While the unemployment rate has dropped slightly, labor data suggests that the recovery may not yet be self-sustaining. Additionally, the CPI has ticked upwards slightly but remains at comfortable levels last released at 1.6% YoY on the headline reading and 1.0% YoY for the core measure. This evidence suggests no change in policy at the Tuesday meeting.

The Swiss National Bank (SNB), whose primary mandate is to ensure price stability which it defines as inflation below 2% is likely to maintain rates at 0.25%. Recent data indicates February CPI at +0.4% and a drop in the unemployment rate from January’s 3.8% to 3.6% in February. SNB President Philipp Hildebrand recently noted that the strong franc lowers inflationary pressures in the near term however the bank noted the need to fight inflation over the medium and longer term as it sees its price stability threshold being breached in 2013.

The Norges Bank has signaled that it will resume tightening by the middle of 2011. The bank last raised rates in May and has provided guidance through the end of 2014 and expects its benchmark rate to average 2.25% this year and 3.25% next year. This indicates an expected 25bps hike each quarter from June 2011 until the end of 2014. Thursday’s release of February CPI showed a slowing to +1.2% from the prior month’s +2.0% which is supportive of no change in policy at the upcoming meeting.

A mixed picture in China, but further tightening is still needed

The past week of data released out of China has confounded many market participants. On one hand the February data showed elevated risks to inflation – Feb. PPI was 7.2% vs. expected 7.0% yoy and Feb. CPI was 4.9% vs. expected 4.8% yoy, however on the other Feb. Retail sales came in much weaker at 15.8% yoy and Feb. Trade balance turned negative for the first time in 11 months coming in at -7.31B vs. expectations of +4.9B. Finally it appears their efforts to slow the rapid rise in real estate is beginning to have knock-on effects, however a considerable amount of this may also be attributed to a robust Chinese new year.

In the end, China still has been unable to control the more pressing issue, inflation. While food prices remain the main driver of CPI (which have somewhat moderated of late), higher energy and commodity prices continue to remain the underlying concerns to PPI. Moreover, we’ve seen that commodity pricing pressures tend to lead Chinese PPI, and with crude oil and industrial metals near their respective highs, rising inflation looks like it’s a problem unlikely to go away anytime soon. Therefore, we believe the PBoC will continue to remain active over the coming weeks/months, with our central case looking for two further interest rate hikes, in sum 50bps, before the end of June. We also envision additional RRR hikes in order to further withdrawal liquidity from their financial system.

As China tightens to manage liquidity and control inflation, we may see periodic setbacks in risk sentiment as well as dips in commodity prices and the prices of commodity linked currencies (AUD, CAD, and ZAR), however we believe such pullbacks are likely to be relatively short lived and should be viewed as potential buying opportunities.

Key data and events to watch next week

United States: Tuesday- March Empire Manufacturing, Feb. Import Price Index, Jan. Total Net Tic Flows, March, NAHB Housing Market Index, FOMC Rate Decision Wednesday- MBA Mortgage Applications, Feb. Housing Permits, Feb. Building Permits, Feb. Producer Price Index, Q4 Current Account Thursday- Consumer Price Index, Weekly Jobless Claims, Feb. Industrial Production, Feb. Capacity Utilization, Feb. Leading Indicators, March Philadelphia Fed

Eurozone: Monday- Jan. EZ Industrial Production Tuesday- EZ Employment 4Q, EZ March ZEW Economic Sentiment, German March ZEW Surveys (Current Situation & Econ. Sentiment), EU Finance Ministers meet in Brussels Wednesday- EZ 4Q Feb CPI Thursday- EZ Jan. Construction Output Friday- EZ Jan. Current Account, Trade Balance, German Feb. PPI

United Kingdom: Tuesday- DCLG Jan. House Prices Wednesday – Feb. Claimant Count Change, Jan. Avg. Weekly Earnings, Jan ILO Unemployment Rate, Thursday – Feb. Nationwide Consumer Confidence

Japan: Monday- Jan. F Industrial Production, Jan. F Capacity Utilization, Feb. Consumer Confidence, Tuesday- BOJ Target Rate, Feb. F Machine Tool Orders, 1Q BSI Large All Industry, 1Q BSI Large Manufacturing, Wednesday- Feb. Tokyo Condominium, Jan. Tertiary Industry Index Thursday- BOJ Feb.16-17 Board Minutes Friday- Jan. F Coincident & Leading Index.

Canada: Monday- 4Q Capacity Utilization Rate Tuesday- 4Q Labor Productivity Rate Wednesday- Jan. Manufacturing Sales Thursday Jan. Int’l Securities Transactions, Jan. Wholesale Sales, Feb. Consumer Price Index, Feb. Bank Canada CPI Core

Australia & New Zealand: Monday- RBA March Minutes, Feb. New Motor Vehicle Sales, NZ REINZ House Sales (3/14-16) Tuesday Jan. Westpac Leading Index, 4Q Dwelling Starts Thursday: RBA Foreign Exchange Transactions, NZ 1Q Westpac Consumer Confidence

China: March 13-18- Feb. Actual FDI, March 13-15 Feb. New Yuan Loans, Feb. Money Supply (M0,M1,M2) Tuesday- Conference Board China January Leading Economic Index

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