Lessons For The Coming Week Part 2: Beware ECB's Glaring Omission, EU Grand Delusion On Periphery Bond Risk, China's Big Risk & Challenge, What Could Rally the JPY?
The following is a partial summary of conclusions from our weekly fxempire.com analysts' meeting about the weekly outlook for global equities, currencies, and commodity markets. Here's the second part of our article on lessons for this week, which focuses on global financial market developments beyond the US.
See here for Part 1, which focused on lessons from US developments, including the very influential December US jobs figures.
Mixed Data Shows Continued Uneven Growth Picture
Overall business activity slowly improves in the EU per its composite, PMI, which rose from 51.7 in November to 52.1 in December. However the statistic is of little use given that the situation varies considerably from country to country. Mostly it's pulled up by Germany and the northern funding nations, with a bit of recent help from Spain and Ireland, both of which remain far from recovery.
Meanwhile France, Italy, and Greece continue to, and unemployment remains abysmal throughout the periphery, especially among younger workers
But Deflation Fears Rising
Eurozone inflation fell below the forecasted (and prior month's) 0.9% figure to 0.8% in December. The CPI figure remains well below the ECB's target of just under 2%, a trend that raises continued worries about the threat of deflation in the euro-zone. However, the ECB is unlikely to take action, per Marketwatch, because it's created strict guidelines for taking further monetary action. "It expects sluggish growth of 1.1% in 2014 and 1.5% in 2015, and forecasts inflation will stay well below its 2% target for two more years. Unless growth and inflation undershoot that already weak baseline scenario, additional action is unlikely."
What We Learned, And Didn't, From The ECB Press Conference For The Coming Weeks
The most significant remarks from the ECB press conference were the ones President Draghi omitted. First, however, let's look at what he did say and what it means for investors and traders.
The Apparent Main Lesson
The main lesson for the weeks ahead from Thursday's ECB rate statement and presser is that low inflation and volatile money market rates are a growing concern for the ECB, but it's not planning on doing anything about them at this time. Draghi did not suggest that the ECB was moving closer towards more exotic easing measures like negative rates or a US style QE program. He did reiterate that all policy tools are at their disposal and that they're ready to act if needed, but we've all heard that one before.
Although the ECB left interest rates unchanged, the EUR sold off and stocks rose due to the overall dovish tone of Draghi's remarks. Specifically, he said that "interest rates will remain at present or lower levels for an extended period of time," and warned that the ECB would "act if the inflation outlook worsened" or "money markets tightened."
Given that the Fed's FOMC meeting minutes also did not indicate any changes, it's no surprise that the EURUSD was virtually unchanged as of the close Thursday.
Of course, that changed with Friday's jobs reports, which tell us much about the likely direction for US data in the coming weeks, and thus also for the USD pairs, especially the EURUSD. See here for details.
Draghi spent most of his prepared comments talking about low inflation, described the overall EU economy as weak, and said output should recover at a slow pace in 2014 and 2015. He did not discuss recent positives like German growth or rising demand for GIIPS debt. Clearly he realizes that German growth by itself isn't enough to feel upbeat, and that the GIIPS debt rally could prove very temporary given that most of them, as well as France, are a long way from recovery.
With inflation expected to remain low for at least the next 2 years, interest rates should remain at their present levels or lower for the foreseeable future. In order for monetary policy to be eased again, the inflation outlook needs to worsen or money markets need to rise.
Given the dovish fed policy implications of Friday's jobs reports, for the near future both the fed and ECB look dovish and so neither should provide reason for the EURUSD to move beyond its recent trading ranges. Any fundamental fuel for a EURUSD move will likely come from one or more of the coming market movers discussed here in out post on the coming week.
Draghi's Big Omission: The REAL Lesson From The ECB
The most interesting part of the event was that Draghi omitted any mention of the "big dead horse in the EU's parlor."
As we discuss here, he surely realizes that the failure of the recent SRM deal to provide any real EU support for troubled banks creates huge imminent and future problems for the EU:
- First, it represents a grave existential danger at some point in the future for the EU, though we doubt he'll ever willingly bring up that topic, given that he has no solution and would just risk upsetting the helpful complacency about EU sovereign debt and banking crisis We discuss the latest on these here.
- Second, it presents an immediate complication for the ECB. It plans on conducting bank stress tests. Unlike past tests that failed to reveal trouble at banks that needed rescues mere months later, these tests are supposed to be rigorous, and for good reason. Before the SRM kicks in an gives the EU and ECB a growing responsibility in bank supervision, they want all of the current undercapitalized or zombie banks revealed and resolved by those who caused the mess in the first place.
However, with no functioning common EU fund to help cash strapped GIIPS nations recapitalize or close their shaky banks, any serious stress test would just risk reviving a new, and potentially fatal, chapter in the EU crisis.
Remember, the new SRM officially made large depositors, bank shareholders, and bondholders the first in line to take losses before whatever national or common EU funds can be accessed.
The private sector bail-ins sound great to voters and tax payers, but they risk scaring off the same private investors the banks need in order to survive. Yes, the nation in question could always impose capital controls to prevent that, but such moves send a terrible message: "no one keeps money here except by force."
Unless the stress tests get cancelled (meaning the whole unified bank supervision process stops and the EU gets embarrassed by the public admission of its own inability to fix itself), the only other choices are:
- Another round of meaninglessly easy stress tests
- The EU finds an alternative source of funds that is both large and able to be deployed fast to prevent uncertainty from a bank test failure metastasizing into a systemic collapse.
Given the above mentioned dangers to EU banking, particularly in the GIIPS nations that, unlike Ireland, have yet to fix their bad bank issues (like Italy and Spain), and their still relatively low yields compared to the risks, we find the market's sudden enthusiasm for most GIIPS sovereign and bank bonds, uh, insane surprising.
For the full story on that see the following section. our article Grand Delusion: Scramble For GIIPS Bonds Despite High Risk, Low Yield.
Grand Delusion: GIIPS Asset Prices Spike Along With Their Risk
By far the most important lesson for this week and beyond was the bizarre divergence between GIIPS asset prices and their growing risk. This means huge risks and opportunities for traders and investors, depending on whether they understand these and are ready to move when the time comes. For the full analysis see our article Grand Delusion: Scramble For GIIPS Bonds Despite High Risk, Low Yield.
What Could Reverse The USDJPY Uptrend?
Although traders are supposed to trade in the direction of the prevailing trend (in the relevant time frame in which they trade), we all prefer to get aboard those trends, early, just as we get enough technical and fundamental evidence to justify opening our first, partial position.
They're the lowest risk, highest reward trades, so it pays to invest the time researching and monitoring potential trend reversals. Part of that involves trying to come up with realistic trend reversal scenarios, especially for those trends that look unstoppable, and have thus become expensive, crowded, and thus vulnerable to sudden plunges as the weak hands and newbies flee en masse, often prompted by the well-funded institutions playing head games with the herd for fun and profit.
These newly reversing trends, are the lowest risk entry points because they occur near strong support, which is a relatively long term low or high, depending on whether you're looking to ride and uptrend or a downtrend. If that support breaks below your planned stop loss, you're out long before you incur a material loss.
They're also the highest yielders, because, hey, you got in at the start. Now the only trick is not to exit too quickly. Just set your trailing stop right and that's unlikely. See chapter 5 of my book for a step by step guide on how we identify and execute these low risk high yielders, and chapter 7 for a whole chapter's worth of examples. You can view a detailed overview of these chapters here using the "Look Inside" feature and selecting Table of Contents.
So when my long hours of daily market monitoring (the foundation of these articles designed to save you time and effort) turned up the following (via seekingalpha.com's market currents, global and fx vertical), it got my attention. I paraphrase and expand upon it below.
Although everyone is justifiably bearish on the JPY (FXY), including Japan's Prime Minister and central bank head who are intentionally trying to toss the Yen under the bullet train, Morgan Stanley made the case for a "tradable retracement" in dollar/yen back down to ¥98 (from nearly ¥105) this past week.
Morgan Stanley mentioned the following possible catalysts:
A debt-induced slowdown in China or another big trading partner hitting regional growth
· Something to upset the current complacency in global financial markets.
· Glitches in Abenomics (Japan PM Abe's reckless desperate final attempt to avert economic collapse bold measures to boost long-term competitiveness by devaluing the Yen to boost exports and raise inflation) fail to devalue the JPY.
· The BOJ, contrary to expectations, fails to ease and allows the JPY to rise for a while. Another JPY- debasing easing could be months away.
I add the following catalysts (to these of my esteemed and much better paid forex traders and analysts at Morgan Stanley) for a new countertrend in the Yen
· An unanticipated global interest rate spike that sparks a flight to safe-haven assets and currencies and so sends the JPY higher and Nikkei lower. The most likely source of this would be some kind of Fed communication or taper acceleration that causes speculators to anticipate higher rates and so sell US treasury debt and drive yields higher.
· Some other big flight-to-safety event that drives up the JPY. For reasons discussed here and here and in other posts over the past months (see here) the most likely event is a new EU solvency concern that threatens to become a systemic risk that crashes markets beyond its point of origin.
· Other possibilities include a spike in geopolitical tensions. A flare-up tensions between China and Japan that could directly undermine the JPY or ironically boost it (given its safe haven status), depending on how it plays out.
Those unwilling or unable to trade currency pairs on the spot market can also ride this trend reversal if and when it happens via assorted Yen surrogates or assets that move with it, for example:
· The Yen's ETF surrogates like FXY or other ETFs that track long or short JPY positions
· The Nikkei (or its ETF and other surrogates) because the Nikkei tends to move in the opposite direction of the JPY. That's because like any stock index, it's a risk asset, and the JPY is a safe haven asset. Also, as an exporter dominated index, a cheaper JPY is bullish for the Nikkei and vice versa. For more on understanding various aspects of intermarket analysis, like the definitions of risk and safe haven assets (the labels are deceptive), their correlations and what can change them, see here.
China Slowdown Story Builds Momentum
News items out last week feeding the China slowdown theme include:
George Soros wrote an article posted on Project Syndicate calling China the biggest story now, saying that depending on whether it can wean its economy off excessive debt, it could either drive the global economy to new heights or drag it down like the US did in 2008 when too many shaky debtors started defaulting and destabilized the US (and ultimately) global banking system, economy, and financial markets.
Weakening Chinese services and manufacturing PMIs, export data, and falling CPI together reinforced the China slowdown theme.
Alcoa Marks Downbeat Official Start Of Q4 2013 Earnings
Alcoa (AA) reported a drop in both earnings (below expectations) and revenues (beating even worse expectations. The firm is considered a bellwether for the global materials sector
Earnings week kicks into high gear this week. An earnings season typically exerts is biggest influence in its second and third weeks, during which time most of the sector leaders report and thus set the overall tone. With the support of QE fading, the rally's continued existence will depend more on positive fundamentals like earnings. That said, if the Fed and other central banks succeed in keeping yields low, investor cash will still have few viable alternatives to stocks
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.