February Month end shenanigans, mixed with a little yield play ahead of the ECB meet next week, and delivered with an assortment of U.S. data had a forex market struggling to find conviction. However, disappointing eurozone activity data this morning seems to have quickly filled some of that void. The dollar is back in demand despite the sequester cloud that kicks in with automatic spending cuts at midnight. The DXY index trades close to its six-month high as some investors ease towards risk aversion strategies now that the EUR is in a position to threaten Merkel’s highly publicized EUR low support level of 1.30.
Eurozone activity data this morning confirms that the region shrank at the same pace it did in January (47.9), suggesting that the zone’s economy continues to struggle to pick up momentum to escape recession. Activity has been shrinking for 19-consecutive months. Data within the regions confirms further divergence rather than convergence between some of the stronger north members and the peripheries.
Germany remains the dominant outlier. Factory activity grew (50.3) back into expansion territory from last month's contraction print (49.8). Manufacturing activity in France shrank markedly while in Italy the PMI dropped to 45.8. Spanish PMI held below the 50 lines for the 22nd month of contraction. The Greeks confirmed the steepest fall to 43, despite it being their best performance in nine-months.
With data like this it’s no surprise to see that unemployment in the eurozone climbed to its highest rate on record last month (+11.9%). Even inflation remains a non-issue, falling to its lowest level in two and a half years (+1.8%), and making next week's ECB meet more interesting. The data confirms that the eurozone's fiscal crisis and recession continues to impact the consumer deeply, making it more difficult for policy makers to be relying on the end consumer to buy their way out of this recession. Tame inflation certainly supports an ECB liquidity injection, however, next week meeting may come too quickly for some policy makers.
The EUR is not alone, sterling remains under pressure this morning as U.K. manufacturing activity unexpectedly contracted in January (47.9). The poor data also has gilts in demand. The weak headline certainly reignites the resumption of further asset purchases by the Bank of England. Governor King with two supporters was outvoted at last month's meeting. The somber outlook for the U.K. economy may now convince the other members to change tune. To deliver nothing at next week’s BoE meeting would be a disappointment and risk a sell-off in gilts and rally in the pound. As such a QE expansion of +GBP25b now seems to be the most likely outcome.
The eurozone crisis is a long way from being over. The peripheries are struggling and even with recent reductions in official borrowing costs, periphery countries have high and rising debt/GDP ratios. Last weekend's Italian election result highlights the political difficulties of implementing austerity and reforms in the face of recession. Cyprus is again appearing on investors' euro negative radar. It’s looking more likely that this small country will request a full standard Troika program, valued at +EUR17b, as early as next week once the new government is sworn later today.
Delving into the alphabet soup of EU policies and procedures, many now expect Italy, Spain, Portugal and Ireland to most likely request ECCL program (enhanced conditions credit line) within 18-months, a prerequisite cert for eligibility for the ECB’s OMT facility. Perhaps an indecisive election could push Italy to enter a program even sooner. Portugal and Ireland will most likely hear next week from Euro policy makers if they will get any extra time to repay their bailout loans. Despite their well performing programs it will not be as easy to rearrange debt maturities to simply grant that extra time.
Mid-week Dovish Draghi rhetoric is now shaping the EUR ahead of next week's ECB interest rate meeting. EONIA/Euribor rates are beginning to price in an ECB rate cut. Euro policy makers are helping to fan market expectations with more inflation rhetoric. By highlighting that inflation could come in significantly below the +2% desired level next year, and reinforcing the lack of an ECB exit strategy, has many FI traders attempting to price in a rate cut. For others a rate cut comes too soon. Do not be surprised to see the ECB using further communication to allow Euro money markets to adjust.
A repeat of the 2011 debt-ceiling crisis could lead to another US downgrade. However, rating agencies do not seem to be that worried about US budget cuts from Sequester just yet. The perception is that the rating agencies are giving the US added time to manufacture a long-term agreement to lower their debt. Would they be as lenient with a leaderless Italy? Capital Markets are beginning to wonder when some of these “noted” rating agencies will begin to start formulating negative rhetoric at the UK and Italy again.
Sequester, fiscal cliff and the U.S. debt limit debacle again only highlights how U.S. politicians successfully mold short-term crisis and squander precious time in formulating a more permanent solution. Next year and beyond, U.S. public debt will be deep into unknown territory, levels not “consistent with the U.S. retaining its Triple-A status”. However, the list for safe haven currencies is shrinking and the dollar still remains at the top. EUR sellers continue to work their way through option demand ahead of 1.30. Stronger CTA stops are littered below Merkel’s psychological barrier and may act as a magnet.