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Im not here to discuss the past… I’m here to be positive” – Mark McGwire

The recent broad theme of an improved risk appetite in financial markets continues and there are a number of reasons for the global economy to feel as if its glass is half full at the current juncture – all of which are in some ways interlinked and indeed cross fertilising.

Peripheral yields yield

Continued improvements in the outright yields (or implied cost of funding) for the peripheral eurozone nations has been particularly evident over recent sessions, particularly for the market sensitive nations of Spain and Italy, and interest rate term structures have normalised (outside of Greece and Portugal) whereby short dated funding costs are lower than their longer term equivalents. In fact Spanish 10 year yields fell to their lowest level since November 2010, to around 4.85%.

Draghi turns the tap again

Risk sentiment has also been bolstered by the increased belief that the take up at the second ECB 3 year LTRO liquidity providing operation will be substantial.  FT Deutschland suggested earlier in the week that the banks may borrow up to EUR 1 trillion (though an amount similar to the first auction at around half that amount would seem more likely).  The unlimited liquidity auctions from the ECB have been widely heralded as having prevented a potentially disastrous credit crunch in financial markets and for having enabled the interbank market to continue to function.  Increasing the flow of available funds in the system should at some point be very supportive to the economy – once the uncertainties of the Greece situation have passed.

Manufacturing momentum

The global PMI data yesterday also highlighted the current risk positive mood as the eurozone surveys showed some improvement and China manufacturing remained in expansion (leading many commentators to accept that a hard economic landing in China is off the table or has at least been delayed for a while longer).  While the notable outlier was Switzerland, whose index slipped sharply into contractionary territory for the month, the better than expected outcomes in Australia and the UK and a strong reading in the US were enough to inspire an improved level of confidence.

“There is a lot to like about the January data” US ISM Holcomb

Greece ‘ing palms

A further risk positive lies in the fact that the Greek PSI talks appear to be entering the final stages and whilst I reserve some judgement about the ‘labelling’ of an almost 70% haircut on the Greek debt swap as voluntary and not a default, an agreement will still remove an element of uncertainty for financial markets and in that respect can be seen as a positive.  The fact that the ‘sweetener’ of improved terms in the event of Greek GDP growth outperformance has been leaked as a likely addition may also make the bitter pill a touch easier to swallow.

So what does this mean?

In reality I feel that this can mean different things for different markets.  The combination of a slightly stronger backdrop with central banks in Europe and the US flooding the markets with ever larger amounts of liquidity should be supportive of equities and with a very large amount of investor money on the sidelines awaiting clarity on the eurozone debt and regulatory issues, there may be a lot of money that will need to participate in the stock market rallies if we continue to push new ground. 

In FX the currencies that would traditionally do the worst in a risk-on world (CHF and JPY) have remained stubbornly strong despite the rising threat of intervention from the relevant authorities.  EUR for me remains the weak spot, however, as I have oft mooted, the most efficient way to trade a short EUR position in the current environment is not against the USD.  My preferred vehicle remains GBP. 

After a much better than expected UK PMI survey yesterday and a breakdown of the data which showed gains coming from new orders, employment and output, there is a very good prospect that the UK misses the much vaunted technical recession after a difficult Q4, and as the biggest risks to the UK remain eurozone related, any positives in Europe should be of considerable benefit to the UK as economic differentiation comes to the fore.  

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“Failure is unimportant. It takes courage to make a fool of yourself” – Charlie Chaplin

Yesterday was a day of reflection to a certain degree as risk and risk assets pared back some of their gains from what has been perhaps a surprisingly upbeat 2012 so far, however developments overnight have provided a springboard for that risk tempo to extend into February.

Last night Europe took a step towards fiscal union as 25 members of the EU27 agreed to a pact under which signatories (which will likely be ratified by the end of March) agreed to cut budget deficits and reduce national debt (as a proportion of GDP) or face ‘automatic fines’. In addition to this the council also agreed to bring forward the European Stability Mechanism (ESM) by one year, as has been much mooted in recent weeks to July 2012. The ESM is a formal replacement to the temporary EFSF, however hopes that the two bodies could run in parallel for a while (hence boosting the overall firepower of the European ‘firewall’) were dashed by German parliamentary disapproval yesterday.

Despite the slight disappointment for Merkel that the two ‘protection’ funds cannot run alongside each other the agreement yesterday will be seen as a victory for Merkel who has long been pushing for ‘more Europe’ in the form of tighter budgetary constraints and central accountability – fiscal union.

David Cameron refused to agree to the proposed constraints from the European union in last nights meeting and whilst his promises from the previous EU summit that he would block the new treaty from using EU institutions (such as the European court of Justice), he insisted that the agreement “places no obligation on the UK” and went on to say that…

“Our national interest is that these countries get on and sort out the mess that is the euro”

… after 27 summits in two years it is unsurprising that comments such as that of Polish PM that EU measures are “insufficiently courageous” and the Economist quote “EU leaders are at a fork in the road. They’ll probably go straight on” are widespread.

In terms of the UK it is perhaps important that the Czech Republic also refused to agree to the budget pact. A unilateral rejection may have left the UK seeming Isolated from the rest of the EU and could indeed have left the UK in a difficult position within the global investment community.

In FX, activity has been relatively light in the recent risk rally, yet for me the moves in EURCHF and USDJPY are indicative that the ‘risk-off’ trade is not over and that there is further downside risk for the EUR. I still prefer to play a EUR short via GBP and while there is a risk that an agreement on the Private Sector Involvement (PSI) generates one more rally, the reality of a rising growth differential between the UK and the rest of the eurozone will likely become increasingly apparent.

Today contains the release of a range of data from around the globe and broad risk sentiment is likely to shaped by this. The tone to equities is likely to be more positive in the short term and a rally today, given that the S&P held 1300 yesterday should be seen as a further positive.

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The actions of the Federal Reserve under the guidance of Chairman Bernanke on Wednesday evening have clearly boosted equities and risk assets and weakened the USD. As I see it however, it is not as straight forward as that.

The FOMC statement following the January meeting came with the inclusion of information relating to the interest rate path expectations of the Federal Reserve board members.  As you would expect the forecasts covered all bases with some expecting interest rate normalisation to begin at the end of this year and some expecting unchanged rates into 2016.  Despite the fact that the range of interest rate forecasts by the individual Fed members was from 0.25% to 2.75% at the end of 2014, the statement accompanying the unchanged rate announcement clearly stated the conditional expectation is that Fed funds will remain unchanged at its current 0-0.25% target through 2014.

What does this mean?

Effectively the low rate pledge from the Fed is a further move to monetary accommodation; USD bears may even claim monetary debasement. It falls short of outright QE3 it could be argued that the impact of the extended “extended period” language is tantamount to QE 2.5. 

In addition to this the Fed also gave some further clarity towards their management of the dual mandate (of full employment and stable prices) in their governance of monetary policy and in relation to that dual mandate the statement “the committee expects to maintain a highly accommodative stance for monetary policy” replaced a sentence that warned about the “close attention to the evolution of inflation and inflation expectations”, suggests that perhaps employment is the dominant driver of policy at the current juncture.

Race to the bottom?

The reality of the situation is that the world’s two most powerful central bankers are, perhaps unwittingly, in a race to the bottom for their respective front end interest rates.  Both are driven to a certain degree by the potential implications of a slowing global economic backdrop, however, there are a number of distinct differences between the motivations of the Fed and ECB.

Whilst Bernanke was quick to point out that he is “not ready to declare that the US has entered a new stronger phase” he did acknowledge that the “US economy is getting stronger”.  US interest rate policy could be deemed to be aimed directly at stimulating growth in the US economy (arguably as a result of the facet of the Unemployment part of the dual mandate).  In Europe Mario Draghi’s widely heralded ‘Helicopter drop’ of funding via the ‘non-standard measure’ of the unlimited 3 year LTRO (refinancing operation) was aimed at preventing a complete collapse of the bank funding markets and the functioning of the European financial sector.  In my mind this highlights the differential, not just in terms of policy lag, but of growth trajectories between the US and the eurozone.

“We are not yet over the worst of the crisis” – Wolfgang Schaeuble

In the short term the accommodation of the Fed will likely weaken the USD, however relative to the EUR I feel that this is a very weak argument.  German Finance Minister Wolfgang Schaeuble’s rhetoric adds to the argument that the eurozone is still at the stage of averting further declines.  The US (and others) are in my opinion in the process of encouraging and supporting the recovery.  I continue to believe that in the near term this gives an investment bias towards the US and away from the eurozone.

Later in the year when the focus of the markets attention comes back to the political shenanigans surrounding the US election and the fiscal deficit reduction plans, there may be a case for USD weakness.  However until that point the US deficit will likely take a back seat in terms of currency investment decisions, much as the deficit in Japan (predicted to breach the quadrillion Yen mark later this financial year) has since the onset of the financial crises.

There is perhaps one more near term positive on the eurozone horizon and that is the potential for an agreement on the Greek debt swap.  The legal ramifications of what constitutes ‘voluntary involvement’ in the debt renegotiations will likely go on for years if not decades, however an agreement (whether thought morally right or wrong) will be a sigh of relief for the eurozone and likely the last breath for the EUR before it begins to submerge once more.

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“it’s the economy, stupid” – Bill Clinton

Australian CPI data overnight came in slightly above expectations (on a trimmed mean basis) and as such cast some further doubt on the market expectations of a rate cut from the Reserve Bank of Australia (RBA) in its February 7th meeting.  This boosted the AUD and other risk assets, which were aided further by the strong Apple Q4 earnings release after the US close.  Risk sentiment, however, has I feel extended the reality of the situation in the current environment and I am becoming increasingly wary of a sharp correction.

After a long period of contracting daily ranges and what appeared to be falling levels of activity, the JPY has had a resurgence of interest over the last couple of days.  A large number of commentators and analysts have suggested that this could be the start of the declining trend of the JPY.  The fact that USDJPY has only moved around 50 pips above the range highs for 2012 is perhaps indicative of the desire of the market to be ‘on’ the JPY declining trade when it eventually does happen.  Indeed there have been significantly bigger moves in the JPY vs. other ‘risk positive currencies including AUD and GBP over recent sessions however I for one do not subscribe to the fact that all the worlds problems have been solved and that ‘risk on’ trades will generate uninterrupted returns.  The JPY is undoubtedly overvalued at its current level and indeed Japan’s debt situation is no less serious than many of the eurozones threatened nations, however, we may have to wait a while longer before the longer term trend of JPY decline can emerge.

In fact the current risk rally is, I feel, the start of a move that has been a long time in coming and that is the beginning of the markets focus on economic differentiation.  There has already been some evidence of this in emerging market currencies (and to a certain extent the sharp rise in demand and price of UK, and indeed multinational blue chip corporate bonds – highlighting the selective or relative value in credit) and the sharp rise in Apple shares overnight in response to better than expected Q4 earnings also highlights how this can become more ingrained in the current equity market dynamic.  

Today is a very big day for GBP.  The Bank of England released the minutes from the January MPC meeting which suggested that although the vote for further QE at the January meeting was 9-0 in favour of unchanged, “some MPC members said further asset purchases (were) ‘likely’.  The fact that the BoE see no change to their view of “broadly flat GDP Q4 / Q1 was particularly pertinent as the release concided with the release of the Q4 2011 GDP figure which suggested that the UK economy contracted by 0.2 percentage points in the final quarter of last year.  A number of factors suggest however that the situation has improved of late and even arch dove Adam Posen said in the week that “things are looking a little better than in October”.  

The recent sharp decline in inflation, which has boosted the Bank’s credibility as inflation fighters (and has vindicated their conviction not to try and tighten policy to reign in inflation due to ‘one-off’ external events) will likely give the BoE the ability to embark on further QE, however, as I have stated on previous occasions I do not subscribe to the classical economic view that monetary expansion equals debasement equals a weaker currency.  At the current juncture the BoE asset purchases are not increasing the money supply, they are merely preventing the money supply from contracting and in that environment, particularly with inflation falling, QE should be good for demand and good for GBP.

Headlines about the Greek PSI negotiations will continue to aid the ebb and flow of risk sentiment on the day, however, it may be the turn of the US to play a bigger part in the global economic deliberations and the FOMC decision this evening may provide the perfect platform.

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“With great power comes great responsibility” – Ben Parker

Historically the direction of the S&P equity index in January has a high correlation to the direction of the index for the full year.  Moving into the last full week of the month with what is a commanding lead (+4.59%), the bulls are in a strong position.

Last week I warned that the market was mispricing the risks to the near term environment and that in effect the current view was ‘too rosy’ (Risk: a wolf in sheeps clothing).  However on the face of things there does seem to be a reasonable rationale for the bullish case and as such this mispricing may continue for a while longer.  Despite the fact that there has been a significant amount of disappointment so far in the US Q4 earnings season it is the work of (Super) Mario Draghi that seems to have brought life back into the financial markets and investors alike.

The non-standard measures which are of course “temporary in nature”, have made a significant contribution to a number of financial market indicators, or barometers of risk sentiment.  The EURUSD cross currency basis swap, which was viewed intently prior to the 3y LTRO’s and the USD swap line extension, as highlighting the funding stresses of several European banks, has clearly eased back and with it so to have concerns about the immediate funding stresses of those institutions.  Sovereign bond yields have also normalised to a certain degree, with the 2y yields of Spain and Italy now clearly below their respective 10 year yields.  Pressure remains in Portugal and of course the situation in Greece still remains on a knife edge but fear of contagion beyond the current ‘programme countries’ has waned.  It even appears that the recent flood of liquidity from the ECB measures has begun to see US banks re entering the European Commercial Paper market after a long absence.

So where does this leave us?

After the long drawn out issues of the eurozone and the uncertainties that have surrounded Greece (and contagion to the rest of the PIIGS) there is an element of calm to markets at the moment but significant uncertainty still remains.  This is where the concept of relative value or economic differentiation that I have mentioned so often should begin to emerge as the dominant theme.

In FX terms what this means is that we are likely to see currencies that have historically been highly correlated to risk (such as the AUD, or my preferred vehicle at this point GBP) outperforming.  However, historically in this environment risk currency strength would have been expressed via the USD, in this instance I feel that the funding currency of choice for risk positive trades in the current environment (given its very weak growth profile as a result of high indebtedness, greater uncertainty and coordinated austerity across the region) will be the EUR.  A higher GBPEUR remains my core view.

On the data calendar this week whilst there are monetary policy meetings in the US, Japan and New Zealand, the momentum and impetus for the markets is likely to be driven by the eurozone business survey data on Wednesday and Thursday (PMI’s and IFO – strong numbers may offer an opportunity to enter a short EUR position) and the continued investor sentiment towards US equities.  In the UK, the Bank of England Minutes and public sector finances will clear the stage for Q4 GDP, which will undoubtedly drive expectations for further QE in the UK at the February meeting.  Whilst a bias towards a positive risk backdrop will, at times, benefit the EUR, the data releases (at the very least when put into context) should continue to weigh and of course any further complications with the Greece debt swap talks will have a disproportionate negative affect in the current environment.

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“Successful investing is anticipating the anticipations of others” – J. M. Keynes

Financial market sentiment over recent sessions has been dominated by the potential developments in the Greek PSI (Private Sector Initiative) and the implications for the eurozone debt crisis and the precedent set by the treatment of CDS contracts.  An announcement that creditors and the Greek sovereign have reached agreement on the haircut for Greek debt (now likely to be around the 65% level or higher) and the interest rate applicable on the remainder of the debt to its new maturity will likely provide markets with a sigh of relief and risk assets could potentially have one more push.

However, an agreement at the creditor level merely opens the door for the legal debate over the CDS contracts and ultimately the legal precedent for what constitutes a default and while it may take away one of the ‘tail risks’, the ongoing debate over the sustainability, competitiveness, and widening growth differential for the rest of the world will likely overwhelm the short term positive of a PSI agreement.  For me the EUR remains at the bottom of the list of currencies (in the major space) that I would like to own!

Similarly in US equities, the S&P has finally risen above the 1300 level as risk appetite and low yields spur a quest for yield.  It is interesting therefore that so far the Q4 earnings season has been disappointing.  Banks in particular have highlighted the slowdown in investment activity, arguably as a direct result of the uncertainty of the global (and more so) domestic connotations of the eurozone debt crisis but in some instances the release of credit impairment capital has caused earnings per share to beat expectations.  In a similar vein to that of the EUR, I continue to view equity indices as a sell on rallies until there is a conclusive plan for the eurozone – so far that is sadly lacking.

Overnight the employment report from Australia was disappointing on the headlines but the breakdown was much more positive as the decline in employment was a function of rising full time employment and falling (to a greater degree) part time employment.  I continue to be underwhelmed by the AUD, as several fundamental macro economic variables are surprisingly weak.  For now however the dominant force of ‘risk profile’ is keeping AUD buoyed.  This is, in my opinion yet another example of a wolf in sheep’s clothing.

Beyond the immediate focus of attention of the market towards the much publicised technical and systematic stops in EURUSD between 1.2880 and 1.2930, sentiment on the day will also be strongly guided the Spanish, French and UK Bond auctions.  The markets desire to take on longer dated (than the recent very short dated issues) eurozone paper will be very important.  In relation to this however it may be a better guide to monitor the behaviour of these bonds in the secondary market following the auctions, as opposed to the demand at the auctions as it is clearly in the interests of the domestic banks to give the impression of a well supported debt sale by their respective sovereigns.

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“I had hoped you would protest, but please don’t argue” – Lotte Lehman

The Martin Luther King bank holiday in the US yesterday brought with it a very quiet and largely directionless market as investors and commentators digested the connotations of rating agency S&P’s action to Downgrade a large part of the eurozones credit rating and to warn of further action on all but Germany.  After the European daily close S&P even went a stage further and cut the EFSF (European Financial Stability Fund) by implication of the reduced ratings of its component guarantors.

The protestations of the eurozone officials were audible upon release of the downgrades.  In my view this sentiment is misguided from the eurozone’s political leadership as the AAA ratings that textbooks would refer to as the ‘risk free’ rating are clearly not suitable for the embattled, indebted nations of the eurozone.  Perhaps worse that the political protestations, however, was the criticism of the ECB president Mario Draghi whose own institution is reliant on the judgement of the rating agencies when it ‘suits’ them for collateral and a number of assessments and credit bandings.

The resignation letter of Jurgen Stark, who quit as ECB chief economist in September citing personal reasons was published yesterday and perhaps his sentiment highlights the rift between the Germanic ‘bundesbank’ thinking on policy in comparison to perhaps a less inflation wary ‘rest’ of the eurozone.  Stark states that it is “an illusion to believe that monetary policy can solve major structural and fiscal problems in the eurozone.”  And that “the EFSF cannot possibly save Italy”.   

The big news overnight however was not for once derived from within the European monetary construct.  The Chinese data saw better than expected releases for Industrial production, retail sales and perhaps most scrutinised, GDP.  The GDP figure, though better than expected, slowed from 9.1% in Q3 to 8.9% in Q4.  

The impact on financial markets however comes from the breakdown of the data.  Exports and housing were a bigger than expected drag on the Q4 data and while this is clearly positive news in highlighting the rebalancing of the economy, particularly when consumption appears to have risen to compensate largely for the component weakness, the issues in housing and exports (potentially as a result of further global slowdown, or worse) created speculation that the authorities will ease lending curbs further and increase fiscal spending to support the economy.

The debate as to the hard / soft landing of the Chinese economy will continue but in the very short term, the implications for looser Chinese policy has given rise to a more positive risk backdrop, which has boosted equities and broad risk assets overnight.

Inflation data in the UK this morning has highlighted the base effects of tax change and other factors in showing a sharp decline in the annual increase in consumer prices to 4.2% year on year in December from 4.8% year on year in November.  The focus of the markets is not in the vicinity of the UK at the moment as perhaps more pressing issues play out in the eurozone and Asia.  However the ‘well behaved’ data and the quiet progress of the UK will be increasingly highlighted on a relative basis as 2012 progresses.  Uncertainty is still a core descriptive narrative of financial markets however as the cloud of uncertainty gradually dissipates, I see GBP as the best performing Major currency in 2012.

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“We may have all come on different ships, but we’re in the same boat now.”

-Dr Martin Luther King, Jr.

As the US markets remain closed today for the Martin Luther King Day bank holiday, the famous quote is perhaps more apt in Europe where the once heralded diversity and unity of the Monetary Union project leaves member states all (including the last Bastian; Germany)… in the same boat.

Credit merry-go-round or vicious circle

Fridays S&P announcement was much anticipated by the direct markets however the connotations are very significant.  The ratings of seven countries were left unchanged: Belgium, Estonia, Finland, Germany, Ireland, Luxembourg and the Netherlands.  Five countries saw a one notch downgrade: Austria, France, Malta, Slovakia and Slovenia.  Four countries were given two notch downgrades: Cyprus, Italy, Portugal and Spain. (Greece was excluded from consideration).  Of the EU17, 15 retain a negative outlook (except Germany and Slovakia).  The EFSF is a slightly different argument however the contingent liability argument along with the increased borrowing costs from the majority of the EU17 will mean that the EFSF is unlikely to keep its AAA rating and this could put further pressure on the member states. – a rating downgrade of the EFSF will significantly reduce the firepower of the EFSF perhaps to as low as EUR150 billion. (Greece on its own could require EUR130 billion!)

The actions of the ratings agency was largely expected by the market, however, this does not dampen the impact or the connotations of the action.  The action implicates and by default creates a greater diversification among the eurozone.  Political implications, potentially greatest in France ahead of the critical general elections, are very significant.  The ultimate winner from the actions is clearly Germany and while France and Mr Sarkozy have made a strong marketing campaign for the Franco German leadership out of the crisis through ‘more Europe’, further negotiations surrounding fiscal integration in Europe have become considerably more difficult and Germany now clearly holds the upper hand in all negotiations going forward. – QE from the ECB has now, at the margin, become a less likely event.

No change in strategy

So far the market response has been fairly muted.  Heavy anticipation of the S&P action on Friday saw some pre-emptive selling of EUR.  Equity sentiment is likely to be a key driver of broader risk assets and markets today however with the US markets closed we may have to wait until later in the week before the serious reality of the situation gets fully priced into the markets.  I still very much favour selling EUR on any rallies and while the currency of the embattled eurozone will likely travel faster against the USD in the near term, I still advocate EURGBP shorts as being the most efficient means to exploit EUR weakness.  

EURCHF is also a very important currency pair to watch at the moment, having broken below the important 1.2090 level.  Irrespective of the resolve of the SNB to maintain the ‘peg’ at 1.2000 the closer we get to the line in the sand, the greater the gravitational pull of the market stop losses below.

The week ahead… and further

In addition to the focus of the markets on S&P comments on implications for the EFSF, the Greek PSI talks will resume on Wednesday and will also likely shape sentiment towards the EUR and risk assets in general.  In the UK we get Inflation, retail sales and Employment reports for December.  The Bank of Canada Monetary policy meeting (expected unchanged) and importantly German and US business surveys for January and the first insight into 2012, are also released.  In addition to this the World Bank releases its growth forecast revisions tomorrow, which will potentially give us further insight into the relative growth differentials that I envisage will be the primary driver of sentiment beyond the current quarter.

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“Whenever you find yourself on the side of the majority, it is time to pause and reflect.” – Mark Twain

The theme of recent weeks has been broadly dominated by an improving macroeconomic backdrop in the US and increasing risks and uncertainty in the eurozone.  Therefore in light of the fact that the last couple of days has highlighted a more pronounced easing in European bank funding stresses and the US economic data disappointed expectations, it is not altogether surprising that we have had a modest reversal of recent trends.  The important question from here is whether or not this is a sustainable turn or an opportunity to enter the market.

As was broadly expected yesterday Mario Draghi sanctioned the apparently “collegial” decision of the ECB Governing Council to hold rates and non-standard measures unchanged.  His relatively relaxed stance suggests that the ECB are pleased with the response in bank funding markets to the ‘monetary bazooka’ of 3year bank loans (with substantially reduced collateral requirements) despite the fact that of course non-standard measures are temporary in nature.

Mr Draghi pointed out that the “Euro Area still has substantial downside risks” but that he sees “tentative signs of stabilisation in the economy” albeit at lower levels.  The question for the market however is whether or not this is indeed a stabilisation or the calm before the storm?

Overnight press reports suggest that the Greek debt deal could be agreed by the end of next week and that a public offer for the Greek debt swap may come in early February.  However, the IIF (the body responsible for the negotiations on behalf of the ‘private’ in the Private Sector Involvement - PSI) is suggesting that the time for a deal on PSI is running out!  Perhaps more significantly the suggestion that eurozone states have agreed on the outline budget pact and that a new legal draft will be submitted to the eurozone Finance Ministers on the 24th January, is giving the EUR a boost of hope. 

The EUR may be more vulnerable to bouts of strength over the next couple of weeks as hope of a solution to the uncertainties reduces positioning, however, I am still firmly of the opinion that the ultimate direction of the EUR is lower as a result of a widening growth differential with the rest of the (G10) world. 

Banking stocks, particularly those outside of the most troubled eurozone regions have been encouraging over recent sessions as risk assets outperform in general.  This risk sentiment is likely to be the predominant driver of financial market and Foreign exchange direction on the day with little data of note until the US trade balance and sentiment data this afternoon.

Much as Draghi et al. viewed this meeting, in effect, as a time for reflection, this weekend will likely generate the same response from the market.  However, in my opinion the market’s response is not likely to be as favourable to the underlying situation of the eurozone as ECB President Draghi alluded to yesterday.

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“Status quo, you know is Latin for ‘the mess we’re in’” – Ronald Reagan

After what has been an exceptionally quiet week (and indeed 2012 so far) today we get a raft of data and the focus of attention of what has become a market in need of a new reason to act.  2012 has so far, in many ways been more of the same.  Today however that has the capacity to change.  That said my personal view of the two central bank meetings today {Bank of England and ECB} is that they will leave policy unchanged.

The Bank of England (BoE) meet today on the back of what was arguably a stronger month for the economic backdrop.  Survey data showed above expectation improvements in both manufacturing and service sector data and further data over the turn of the year has shown some resilience of consumer spending (despite publicised woes on the high street).  On that basis and the practical limits on the BoE asset purchase facility I see no reason why the BoE would announce an extension to QE today.  The quarterly inflation report next month (while officially published a few days after the MPC meeting) should provide further information and a better gauge of the amount required – I would suggest a further GBP75 billion at the February meeting.

In the current environment I continue to view further QE by the BoE as being a positive for GBP.  Nominal GDP continues to rise, QE is not increasing the money supply (and thus debasing the currency) it is merely stopping the money supply from contracting and inflation appears to be starting to fall back – which retains the MPC credibility as inflation fighters under their primary mandate and is a proactive and supportive policy for the economy.  In my view, these factors in conjunction with the relative growth differential advantage over a number of other countries (most predominantly currently the eurozone) will give GBP an advantage relative to other currencies.

In the eurozone the picture is less clear.  After cutting rates twice and embarking on the ‘monetary bazooka’ of non-standard measures, Mario Draghi is likely to sanction unchanged policy this afternoon.  In my opinion the size of the take up of the 3 year refinancing facility (against a ‘broadened’ range of collateral) is likely to warrant a step back to assess the impact of the sharply increased liquidity (EUR489 billion).  There is some evidence to suggest that the liquidity is having an impact in bank funding markets, as banks begin to issue debt at an increasing rate and the banks funding cost benchmark or Euribor dropped to its lowest level in nine months yesterday.  In conjunction with the impact of the extension / expansion of the USD swap lines which has seen the USD funding mechanism for European banks fall back sharply since the start of the year, the financial market strains are arguably easing.

This does not mean that the eurozone officials have done enough, far from it.  Unresolved and uncertain progress in relation to Greek haircuts, private sector involvement and ultimately eurozone membership are still factors that weigh on sentiment and the EUR.

One area that Draghi may wish to discuss and indeed an area which is likely to come up in the Q&A is the recent rise in deposits at the ECB.  The amount of funds deposited overnight was EUR470.6 billion, within touching distance of the 3 year ‘monetary bazooka’.  Ultimately the question remains whether that money is being put to work (and it is the resultant repo income, or latent cash that is being put on deposit) or are banks simply hoarding cash in order to repair their balance sheets.  In this respect there is a chance that the ECB governing council look at the deposit rate (which is currently at 0.25% - significantly above the German 3month paper rate which is negative!) to see if there is a way in which they can encourage banks to put the funds to work.

Either way however there is more money and less stress in the financial system.  If only we can get rid of the uncertainty surrounding Greece and the EU treaty change implications then perhaps the markets could begin to focus on economic fundamentals and relative value.

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“One picture is worth a thousand denials” – Ronald Reagan

The market still appears to be battling with the concept of ‘risk on’ meaning a higher USD, largely because it held the exact opposite relationship for most of 2011.  The market activity remains surprisingly light and ranges surprisingly narrow given the magnitude and diversity of events driving the financial markets at the moment.

The data calendar has been fairly light this week so far with the German trade balance the highlight.  The figures themselves show an improvement in export demand that has driven a widening of the surplus, however imports declined, highlighting the fragility of the German (and by default) eurozone consumer as the uncertainties continue.  Falling industrial output from the eurozones strongest state, however, lead many commentators to talk of double dip recession across the union.

Private banking?

I will steer clear of any comment on the situation of the resignation of the Swiss National Bank (SNB) head Philipp Hildebrand and indeed the events leading up to it.  Suffice to say that up until this point, the market had been ‘pricing in’ an increasing chance that the SNB would raise the EURCHF peg higher again (from its current 1.20 level).  However, the complications surrounding the Hildebrand situation and the fallout for the SNB mean that a further rise in the level of the peg is less likely.  Ironically, the market unwinding its positioning for a further rise in the peg, may put the current peg level at 1.2000, and by definition the SNB under intense pressure!

The events in the eurozone continue to be the major driver of sentiment and the issue of eurozone bank ‘savings’ (or the amount of cash the eurozone banks put on deposit with the ECB – traditionally this money would have been lent to other banks / institutions on the interbank markets) continues to reach record levels, which are now approaching EUR500 billion.  Mario Draghi, at the ECB press conference last month warned that this was dampening the transmission of monetary stimulus and may have even been a factor in the ‘monetary bazooka’ of the unlimited 3 year LTRO ‘non-standard measures’. 

Tail wagging the dog?

In fact having discussed in previous blogs the fact that large multi national corporates may be emerging as better ‘credits’ than many sovereigns – recent information suggests that Blue chip multi nationals have been lending money to eurozone banks via repo markets – a channel exclusively limited to banks historically.

Sterling strength?

After the stronger service and manufacturing survey data from the UK in December, January has continued to offer reasons to be cheerful on the UK.  Overnight retail sales and housing data both showed month on month improvements and significantly outperformed expectations.  I will be publishing a more detailed insight into my views on GBP for 2012 shortly, but suffice to say my current view on GBP is firmly in the ‘glass half full’ camp.

With limited data on the day again today the market direction will be driven by sentiment.  Yesterday’s statement from Merkel and Sarkozy failed to deliver anything…well failed to deliver anything at all.  Unfortunately despite the hopeful EUR buying or short covering by some in the build up to such statements or announcements, eurozone officials have continued to disappoint with substance over the past months – to the detriment of the EUR and the credibility of the eurozone.

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“The French don’t even have a word for entrepreneur” – George W. Bush

Yesterdays French Bond auctions (predominantly in the 10 and 30 year maturity), while blamed for the sell off in the EUR, were in fact not as bad, at least in demand terms as the German auction the previous day (or indeed the failed Bill auction of the embattled Hungary).  Timing, however, remains everything.

Back to reality

Whilst many commentators welcomed the New Year by extolling a number of potential virtues of the super easy monetary environment and the prospects for global asset reflation, the last couple of days have underlined the old adage that ‘if there is one thing traders dislike the most, it is uncertainty’.  The uncertainty surrounding not only what the plan is for the eurozone but indeed what the current reality ‘actually’ is remains…uncertain.  The EUR remains under pressure and action is required to change it

UK and US outperform

The US data continues to highlight the growing economic differentiation between the US and the eurozone and indeed within Europe the UK data is also outperforming significantly (service sector survey data hit a 5 month high, consistent with Q4 non retail private service sector growth of 0.4% quarter on quarter) and my core view of the back end of 2011 that GBP will outperform EUR remains valid as we start 2012.  In part this will continue to be driven by the portfolio diversification out of the eurozone but in my view as the year progresses the UK will increasingly be seen as being part of the group of countries leading the global economy ‘out’ of recession and not ‘into’ recession as its 2008 nametag read.

Reports from Europe about delays to the release of the EU / IMF aid tranche to Greece of 3 months (too close for comfort to the point at which Greek PM Papademos said Wednesday would induce a default);  France’s desire to push ahead unilaterally with a Tobin Tax (also likely to have a greater negative implication for French Financial services than the boost to government finances that is hoped for); And even reports that Germany will not support a higher bailout fund ceiling despite Italian PM Monti calling for it; all add to the woes of the zone.

Falling short?

There were a number of articles and comment in the run up to the end of the year that the speculative or discretionary market was short of EUR at record levels (and hence suggesting that the market was vulnerable to a short squeeze higher).  My riposte at the time was that the real market was not at all short of the EUR and that the futures data in this instance is misleading was highlighted to a small degree yesterday as the EUR slid lower on relatively little news.  Over the next couple of days I would expect this anomaly to be highlighted further as EUR sell off’s from here will force those waiting on the sidelines into the market.

This afternoons US employment report may be just the stimulus needed to do that.  Yesterday’s private sector employment report highlighted a sharp rise in employment for the month however the lack of seasonal adjustment to the series may mean that the correlation to today’s payroll data is minimal.  I would however still be looking for a higher print than the 150k central market expectation as recent economic data momentum begins to feed through into employment growth.  Whilst I would not expect a similar move lower in the unemployment rate of the US, sustaining the 8.6% level should be seen as a positive after the sharp fall in November.

The subtle change for 2012 however is likely to be that strong US data will likely now be a positive for the USD as it highlights the 2 speed global economy (and not as it was for much of 2011 a negative for the USD as a function of being positive for risk).

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“If you want to change attitudes, start with a change in behaviour”

-William Glasser

After trawling through half the number of overnight news headlines as usual it is obvious that the market has not returned in full from the holiday break and in that respect some of the moves over the last couple of days should be taken with a pinch of salt as low liquidity is still the dominant feature of financial markets, particularly FX.

The start of 2012 has seen ECB intervention in Italian and Portuguese Sovereign Bond markets, the Turkish Central Bank intervene in the Lira and some very sharp movements or corrections in a range of asset classes.  However the core uncertainty that dominates both the global macroeconomic backdrop and the key driver of financial markets is still ‘uncertain’.  The events of the eurozone will continue to dominate at least the first quarter of 2012.

In equities at least the New Year got off to a risk positive start, perhaps as a function of an improving US economic backdrop, or a better than expected performance of the manufacturing sector globally (but most significantly in China and the US) in December.  However, I would expect the uncertainties on the European continent to become the dominant factor as the month of January progresses. 

Whilst I will refrain from analysing the financial markets too much at this early and illiquid stage of the year, there are a couple of events that are worth noting.  Firstly, the ECB facility as a lender of last resort and as a Bank for banks should strike a precautionary tone to markets.  The amount held on deposit at the ECB has risen steadily over recent weeks and this morning reached a record EUR453 billion, a factor that has been noted by ECB president Draghi as damping the transmission of monetary policy and non standard measures of liquidity as banks withdraw funding from the market and ‘save’ it at the ECB.  This ‘saving’ by banks has lead many to question the relative health of some of the eurozone’s banks.  

Perhaps even more worrying is the fact that so soon after the 3 year unlimited lending operation by the ECB (with reduced collateral requirements) the amount borrowed at the marginal rate of 1.75% from the ECB overnight has remained very high (reaching its highest level since March last year yesterday at EUR17.3 billion) again indicative that the interbank funding mechanism is not working, or perhaps even worse, causing some to suspect that there is good reason that banks are not lending to each other!

The second event of note was last nights FOMC (Federal Open Market Committee) meeting minutes.  The minutes suggested that the committee saw the economy “expanding at a moderate rate” and noted that “labor market conditions improved somewhat”.  However, on a more precautionary note the committee predicted only a gradual decline in unemployment and said that “global financial strains pose significant risk”.

The key point however was likely the continued progress of the fed towards a clearer communication policy.  A number of members favoured a change to the “mid 2013 rate view before long” and there was an announcement that the Fed plans to release fed funds rate forecasts at this months meeting.  The text that accompanies the forecasts will also include an analysis of the Fed balance sheet and as well as “describe the key factors underlying those assessments” they will provide “qualitative information regarding participants expectations” for the Fed balance sheet – All should enable a clearer market view of fed expectations and a cleaner transition to policy normalisation.

Over the next week I will begin to publish my views for the progression of 2012.  For now I would expect the underlying weakness of the situation within the eurozone to dominate and the EUR to suffer from a weakening bias.

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