In the past week, the U.S. narrowly avoided a default and passed a deficit reduction deal. The ECB at the end of the week indicated it would buy Italian bonds to stem contagion in eurozone debt markets, among other liquidity measures (see below). The SNB cut rates to near zero and flooded money markets with additional cash. The BOJ intervened to combat JPY strength and increased the amount of its asset purchases yet again. But after all these official efforts to stabilize markets, investors responded by dumping risk assets en masse and continued to buy safe havens. As we have been stressing over the last several weeks, if not months, it’s because of the stalling recoveries in major economies. And recent data continues to underscore further slowing ahead. Against this backdrop, investors are desperately seeking to know where the growth is going to come from and the answer increasingly looks like nowhere. Major economy governments have mostly moved to austerity, leaving central banks as the sole growth catalyst and their efforts last week have proven to be lacking.
The late news that the ECB will buy Italian government bonds has provided some support to markets as the week closed, but we will be watching very carefully to see how long that stabilization lasts. The ECB agreed to buy Italian debt after the Italian government acceded to demands to bring forward planned austerity measures, but we don’t see how earlier austerity will result in better economic outcomes. Similarly, markets dodged another bullet when U.S. July jobs data came in slightly better than expected, but still insufficient to suggest a meaningful improvement in the U.S. labor market. We would note that safe haven currencies like the CHF and the JPY remain nearer to their highs as are U.S. Treasuries, with 10 year yields finishing the week at 2.55%, down 25 bps on the week and nearly 45 bps since the end of July. This suggests to the U.S. that risk aversion remains dominant and we will continue to look to use rebounds in risk assets as opportunities to re-enter short-risk positions.
ECB takes a baby step, but a real response is lacking
A bit unexpectedly, the ECB took a few baby steps (two) to help support the eurozone: 1) ECB would restart its 6-month LTRO program 2) ECB has decided to renew purchases of peripheral debt under the Security Markets Program (SMP). However, the revival of the SMP was not unanimous, with Germany’s Stark and Weidmann as well as two Benelux voters in clear opposition. Moreover, the SMP buying appears to be focused merely on Irish and Portuguese bonds rather than addressing those of Spain and Italy. While these actions may have temporarily boosted sentiment, it’s only further reinforced our view that the ECB’s response has been far too small to stabilize bond market contagion and inadequate to date with respect to the perilous issues the EU faces.
On Friday afternoon, reports made the rounds that the ECB will be buying Spanish and Italian bonds (would be quite a feat considering that’s roughly 3.5 times larger than Portuguese, Irish and Greek markets combined) which saw U.S. markets rally significantly off the intra-day lows (S&P500 was at one point down over 30 points). However, the devil is always in the details and such measures by the ECB could come with severe consequences. Hopefully we’ll receive further clarity on the particulars, nevertheless the sheer size of these two markets (approximately €2.1 Trillion) means even small percent changes would total huge absolute figures. Thus, one has to wonder, who is going to fund such bailout schemes? Germany already has sounded a few alarm bells (let’s not forget they only make up around 27% of eurozone GDP) and would prefer for countries under duress to demonstrate to the markets that they actually have a credible fiscal plan in order to remain solvent. Unfortunately, with Spanish and Italian 10-year yields both above 6%, these countries do not have “time” on their side and the window of opportunity for the ECB or EFSF to take action is getting smaller by the day. If this proves to be merely rumors and action is not taken next week, the fallout in the EU as well as globally could be remarkable.
Ultimately, we would be careful about getting too negative at the moment ; however it does not change our overall bearish view on the euro longer-term. While we would prefer to sell EUR/USD on a potential false break higher towards 1.4350/1.4400, we are cognizant of the fact that in the current environment, it may just not get that high. Therefore, we would also consider establishing a bearish view upon a break back below last week’s low near 1.4050. On the downside, we would highlight the psychologically significant 1.4000, 200-day SMA (1.3940) and July 2011 low (1.3835/40) levels as potential triggers to further declines. At the time of this writing, the 2-year yield spread between Germany and the U.S. suggests the EUR/USD should be trading closer to 1.3400/50 at the moment. For those looking to remove USD exposure, an alternative strategy would be to fade a EUR/CHF rally on the back of potential SNB intervention over the coming days/weeks ahead.
FOMC likely to wait and see
On Tuesday August 9, the Fed will announce the Fed funds target rate and issue the FOMC statement. The release of economic data since the last FOMC meeting has shown a deterioration in the growth outlook with a disheartening revision to Q1 GDP which showed only 0.4% q/q annualized growth and a Q2 preliminary estimate of 1.3%. Additionally, this week saw the release of personal spending, which showed a decline in June by -0.2%, the first decline since 2009. The Fed’s economic projections last released in June indicated that 2011 GDP growth is projected to be 2.7 to 2.9%. Though recent data may cause the Fed to scale back their assessment on the growth outlook, it does not warrant additional stimulus. Keep in mind that the Fed’s dual mandate is to promote full employment and price stability. Labor data continued to show monthly job gains, although at a sluggish pace and inflation data does not provide evidence of deflation. Fed Chairman Bernanke’s testimony on monetary policy to Congress in July left the door open for further easing, however it is not likely that this will materialize in the week ahead. Moreover, it appears that the market is doing the job for the Fed by pushing yields lower. Treasury yields have seen steep declines with the 10-year yields currently around 2.50% and the 2-year yields touching record lows on Thursday. We anticipate that the Fed will maintain their language of keeping rates low for an “extended period” and wait for more data making Tuesday’s meeting a potential nonevent. However, we would also note the potential for markets to express disappointment if the Fed does not signal a return to QE, as we expect.
SNB & BOJ: more intervention to come?
This past week saw central banks active in the FX markets in an attempt to regain competitiveness and moderate the excessive gains in two of the perceived safe haven currencies. The Ministry of Finance in Japan confirmed direct intervention in the markets and the Bank of Japan announced additional asset purchases to 15 trillion yen (from 10 trillion yen) at an early conclusion of its board meeting. While the Swiss National Bank did not directly intervene in the markets, they introduced easing measures to weaken what the bank called a “massively overvalued” Swiss franc. The SNB narrowed the 3-month Libor target range to 0-0.25% from 0-0.75% and said it will increase the supply of liquidity to the Swiss franc money markets.
The impact of the SNB announcement was short-lived and merely a blip in the overall ascent of the franc. USD/CHF saw an initial rally towards 0.7800 and has since resumed its downwards trend making new record lows on Friday as it dipped below 0.7600. EUR/CHF experienced similar price action with a initial surge of nearly 3 big figures before falling to fresh record lows. SNB President Philipp Hildebrand said on Friday “we won’t tolerate a further appreciation of the franc without taking action.” Though the bank has sustained losses from directly intervening in the past the SNB has stated it “remains able to act and will be able to take measures in the future if needed.” As evidenced by past episodes, SNB influence is limited. The bank is unlikely to change the underlying trend of a stronger franc in a flight to safety amid global growth concerns and uncertainty. As a potential seller in the market, the bank may be able to moderate the steep ascent of the CHF and keep speculators on their toes.
The amount of the BOJ intervention is not officially known yet, however it is rumored that a record amount of about 4.5 trillion yen was sold. The previous daily record was on September 15, when Japan sold 2.12 trillion yen unilaterally which at the time was the first intervention since 2004. Since the Sept. intervention, the BOJ has also sold 692.5 billion yen in a coordinated G7 intervention following the March earthquake and tsunami. The BOJ has said that they will continue to be in the markets sporadically. This would be characteristic of past periods of intervention as the bank sold roughly 20.4 trillion yen in 2003 followed by about 14.8 trillion in the first quarter of 2004 for a total of about 35.2 trillion.
The potential record amount of intervention seen this week has had relatively little impact as USD/JPY prices have already seen more than a 50% correction of its intervention-induced spike. Traders are apparently repositioning their yen longs as USD/JPY resumes its downward trend amid economic uncertainty. To the upside, the 80.00 level and 55-day SMA has held as resistance on a daily closing basis and key support can be seen around the double bottom and record lows of about 76.25/30.