- Is it time to panic yet?
- Eurozone crisis is only just beginning
- Fears of China tightening have become a reality
- Post QE2 – Has the Fed got it all wrong?
- Key data and events to watch next week
Is it time to panic yet?
North Korea is firing artillery shells at South Korea, the Irish banking system is on the verge of collapse, with fears of broader contagion steadily increasing, China is pursuing additional credit restraint, and the Fed is undertaking QE2 in a last ditch effort to salvage the US recovery. If ever there were a time to hit the panic button, now would seem to be it. While we certainly think the environment is ripe for a major risk sell-off (USD, CHF, JPY, gold higher/EUR, GBP, AUD, stocks, commodities lower), we think it's going to be more of a slow motion train wreck rather than a sudden bus plunge.
The risk to this view is that we do have a more sudden risk relapse, and we would note in particular the time of year (end of year profit-taking/positioning reduction around the corner) and the US Thanksgiving holiday week (where lower liquidity can trigger exaggerated movements), as increasing that potential. But our primary scenario is a gradual decline in the beginning, likely followed by an accelerating cascade of risk selling over the next few weeks and months. From a strategic point, this suggests looking for opportunities to get short of risk. From a tactical point, it suggests there is still time, and likely multiple opportunities, to get short risk in the weeks ahead.
In broad brush strokes, our thinking on the crisis topics above, which we look at in greater detail below, is as follows. The North Korean provocation should be a flash in the pan, as neither side wants to risk a full-out military conflict. We expect China to work behind the scenes to rein in its psychopathic ward and that crisis tensions should fade relatively quickly as in past.
The Eurozone debt crisis is far more troubling and there's clearly a growing sense of inevitability of sovereign defaults in the Eurozone, though it's likely to drag out over years. In the shorter term, a two-tiered European debt market is in the process of becoming entrenched, and we think there is more potential of the core being dragged down with the peripherals when investors suffer the expected crisis of confidence in the EUR and Eurozone debt as a whole. We would note a chart of Periphery-German bond spreads shows an ascending triangle, suggesting that yield spreads may blow-out sharply within the next couple of months. EUR/USD has also closed (slightly) below the 1.3374 bottom of its daily Ichimoku cloud.
China's efforts to rein in inflation may temporarily upset the growth/commodity demand apple-cart in the short-run, but Chinese demand is a fierce beast and should prevent a sudden collapse in commodity prices or commodity currencies. A greater Eurozone financial crisis is also a risk for a sudden collapse in commodities, but our preferred view is that ongoing US weakness and weakening European demand will gradually impact China's growth, and that's what will send commodities lower. On the charts, we would note what looks to be a 'head and shoulders' topping formation on the CRB, AUD/USD, gold, and WTI crude oil. At the minimum, the symmetry among these suggests a continued correlation-based approach to FX and commodities. At the extreme, if the right shoulder equals the left shoulder in duration, a break lower could occur within the next 1-3 weeks.
For the Fed's QE2, the flood of dollars that many feared is instead staying on banks' balance sheets. At the same time, US data have shown some encouraging signs, suggesting the Fed may not need to do the full QE2. We think there is still a more significant round of USD short-covering to come as worst-case fears of QE2 are priced back out. For the USD index, we would note the Fibonacci significance of the 80.00/10 level, with a break above it suggesting a higher USD ahead. The 1.3330/40 level is the equivalent support in EUR/USD.
Eurozone crisis is only just beginning
Those who thought a bailout of Ireland by the EU and the International Monetary Fund would calm the markets and ease pressure on Portugal and Spain were sorely disappointed. Irish bond yields have risen more than 80 basis points since the start of this week. Spain is arguably the bigger problem for the Eurozone and its 10-yr bond yield is now nearly double that of Germany’s at more than 5 per cent, pushing the Spanish/German bond spread to record highs.
Spain’s precarious financial position is extremely worrying for the markets. It is the fourth largest economic force in the Eurozone and has a EUR1trilion economy. Its budget deficit is projected to be 9.5 per cent of GDP for this year, and, like Ireland, it has a weak banking sector, hobbled by the bursting of a giant real estate bubble that caused the unemployment rate to surge to more than 20 per cent. Ireland’s bailout will amount to EUR85bn Dublin announced this week, this is small change compared to Spain where estimates for the cost of financing a Spanish bailout top EUR450bn. Investors are now concerned that the EU/IMF stabilization fund, which totals EUR440bn, would be inadequate and Spain may be too big to bail.
Right now, the small risk that Spain may need a bailout is the biggest threat to the Eurozone project. Without a permanent mechanism to deal with the troubled economies it appears that the markets will continue to target Europe’s weakest economies.
European authorities need to address both sovereign and banking sector issues. Germany is leading these preliminary discussions and it wants all bonds issued by the Eurozone nations to include standardized “collective action” clauses, which would be the first step to private investors sharing the burden in case of a default. Germany wants this clause to be included from next year, two years before the automatic default mechanism will be implemented. The European Central Bank also wants the troubled financial sectors of Europe’s periphery to be fully recapitalized. Irish banks alone have sucked in more than EUR130bn of special ECB loans, if they can be recapitalized and weaned off ECB funds then the central bank can concentrate on its aim to normalize monetary conditions by removing these special liquidity facilities.
Eurozone officials need to agree on these measures and implement them quickly and efficiently to bring some certainty to the markets and help ease pressure on the peripheral economies. Right now there is a cacophony of voices talking at odds to each other. To settle the markets, Eurozone officials need to stand firm and start singing from the same hymn sheet.
Fears of China tightening have become a reality
Fears of further monetary tightening out of China have become a reality undermining global equity and commodity prices. The PBOC has taken a myriad of measures in the past months to rein in lending and curb growth and inflation. Last Friday’s announcement of an additional 50bp hike to the reserve requirement ratio (RRR) was the 5th increase this year and brings up the average RRR across Chinese banks to 17.5%. In monetary terms, the hike is equivalent to the removal of approximately 350bln Yuan in banks’ lending capacity and is in direct response to elevated loan levels despite past attempts to depress lending (latest Net Yuan Loans release was 588bln Yuan vs. expected 450bln). Furthermore, on October 19th, the PBOC raised the benchmark interest rate by 25bps to 5.56, the first hike since 2007. Despite the historic hike, the higher than expected October CPI release (4.4% vs. expectations of 4.0% YoY) reflects continued upside pressures on inflation and suggests further tightening measures may be necessary. We believe the PBOC will continue its gradual tightening cycle and expect another hike to the benchmark interest rate by early to mid-December.
The impact of Chinese tightening measures on commodities has been loud and clear - gold prices have declined about 7% from recent highs to lows, oil prices have seen a greater than 9% move, and silver has witnessed a 14% high to low range. Declining commodity demand as a direct result of China’s policy direction has translated into the currency markets with commodity currencies (AUD, NZD, CAD) seeing significant declines of late. AUD/USD tested highs around 1.0180 in early November but fell precipitously to test the key 55-day SMA (support on recent uptrend) around 0.9750. The kiwi traded close to the 0.8000 level against the dollar but stalled just ahead of it and saw a subsequent 3 big figure decline to current levels around 0.7630. The loonie was not spared in the China-induced commodity currency selloff - USD/CAD traded under parity in early November but has since seen a test just short of the 1.0300 level. Wednesday’s Thanksgiving eve risk rally has seen commodity currencies recover some of their recent losses, but we believe further strength may be used as an opportunity to sell at more attractive price points. The impending reality of a hike to China’s benchmark interest rate in December, along with persistent eurozone periphery woes, will likely cap commodity and commodity currency upside in the weeks ahead.
Post QE2 – Has the Fed got it all wrong?
Tuesday, the Fed released the minutes of the November FOMC policy meeting. Traders wanted to see if the decision to provide another $600 billion in additional asset purchases was as contentious in the Fed, as it was in Congress and the media. As it turns out, “nearly all members” backed QE2, however they differed over the costs and benefits associated with the program. Overall, “most” participants judged that additional quantitative easing would put “downward pressure on longer-term interest rates and boost asset prices”; meanwhile “some” noted concerns that the expansion of the Fed’s balance sheet may lead to a “reduction in value” of the U.S. Dollar and “several” suggested it may cause an “undesirably large increase in inflation”.
In the early aftermath, it appears the Fed may have gotten it wrong in their assessment of the effects of additional QE. Treasury yields have risen (especially in the long end of the curve), asset prices have fallen, the USD has rallied and Wednesday’s October PCE – one of the Fed’s primary tools to measure inflation – came in line with consensus expectations. Additionally, the newly elected House members are keen to keep the seemingly ever rising costs of government at bay. Taken together, this suggests mounting inflationary fears are largely unfounded at the moment. In fairness, a majority of the USD strength can be attributed to European peripheral sovereign debt concerns, as well as the unwinding of extreme short-positioning in the dollar; however, the back up in 10-year treasury yields may continue to unpin the USD in the weeks to come. From a technical perspective, 10-year yields look to have stabilized between 2.72% and 2.96%. Should a breakout occur, we believe it will be rebuffed on either side as there is strong resistance from 3.06-3.13% – a series of horizontal pivots and the 200-day SMA – and support around 2.60%, followed by 2.45%. USD/JPY will likely see a similar pattern as it has traded between 82.80 – 83.90 of late, with further support seen into 81.50/82.00 and resistance near 84.50/85.00.
Disclosure: No positions