The week ahead kicks off what we expect to be a period of intense event risk. The combination of positioning, judging from the futures market and anecdotal reports, and the low implied volatility in currencies and equity markets warn of heightened risk in the period ahead.
The week begins off slowly with a long holiday weekend in the US. It is here that continued position adjusting may dominate. Of the central bank meetings, the Reserve Bank of Australia is first (September 4) and is the least likely to surprise the market. While most participants expect that the easing cycle is not over, most look for a resumption of it later in Q4. That said, a rate cut would likely push some of the Aussie bulls to the sidelines, even though Australia will continue to offer among the highest interest rates of the major industrialized countries.
The Bank of England meets September 6. An extension of its gilt buying program was discussed last month and evidence points to continued deterioration of the economy. Extending the current gilt purchases, which run through early November, would likely have little market impact. A rate cut would likely be seen as somewhat more negative for sterling.
The ECB meeting, also on September 6, is one of the two critical events of the week, the other being the US employment report on September 7. Let us just sketch our views quickly here, with a fuller analysis to be provided in the coming days. First, without a deposit rate cut below zero, a 25 bp cut in the main refi rate will have little market significance. Second, Draghi has promised to change in the overall collateral framework, which will likely be in one direction: making it easier to access the ECB's facility and making some collateral more effective by reducing the haircuts applied. Third, it seems unreasonable to expect a discussion of the precise size and/or conditions (yield or spread targets/shields) of a new sovereign bond purchase program.
Fourth, there may be some discussion of the ECB's seniority as a creditor. It is ironic, in some respects, that this is being discussed now, two weeks after Greece had to jump through fresh hoops to ensure the repayment in full of a Greek debt the ECB had purchased (apparently redeemed at face value) and a coupon (suggesting the ECB just booked profits on some of its Greek bonds). In any event, participating in the very short-end of the market, bills for example, might be a way to square the circle for the ECB. The problem with this, of course, is that it would force countries to issue more short-term debt.
Fifth, there is also some talk that the ECB may buy Portuguese bonds to demonstrate its new approach (modalities). While we advocated this a few weeks ago, there are some shortcomings that the new advocates may not fully appreciate. Portugal is getting international assistance now. It is not tapping the capital markets to fund its deficit. If the ECB were to drive down yields in Portugal, this would not help the Portuguese government as much the current holders of short-term Portuguese bonds, like local banks. Whether it would trickle down to lower consumer and business rates is a completely different story. As we have seen elsewhere, lower interest rates in a weakening economy with rising unemployment is not sufficient to rekindle the animal spirits or the demand for capital.
Last but not least, the US jobs data, on which the outcome of the following week's FOMC meeting appears to rest. We understand the recent string of US economic data to show that the economy is improving modestly in Q3. The bar of "significant and sustainable" that the Fed has cited is a question of judgment.
The Fed places emphasis on the full employment as the other two (yes, two), price stability and long-term interest rate stability, have been largely achieved. The monthly non-farm payroll report is among the most difficult of the high frequency data to forecast. It is a net figure, as the world's largest economy creates and destroys hundreds of thousands of jobs a month. It is impacted by seasonal adjustment and complicated adjustments for the creation and destruction of small businesses.
On balance, we expect that on a net basis, the private sector generated around the same number of jobs in August as it did in July (~172k) and that this, or something reasonably close to this, will keep the Fed adjusting its future guidance rather than a new asset purchase program. Such an outcome, we suspect, will be understood as dollar bullish.
Euro: Short covering in the week through August 28 saw the net short cover position fall 22k contracts to 102k, which is the smallest in about four months. The gross shorts fell 22.4k, but at 147.5k are almost as large as the other gross short futures positions combined. The gross longs fell less than 60 contracts to dip below 46k.
While we continue to look for technical evidence that the euro's corrective advance is over, there is frankly little to hang one's hat on presently. The single currency continues to hold above the uptrend line described here last week off the July 24, August 2, and August 16 lows. It comes in near $1.2465 at the next week (September 7). On the upside, the $1.2600 has been flirted with intra-day basis, but has not been maintained on a close basis. If this is achieved, we see potential to $1.2700 and possibly $1.2740.
We have understood the price action in recent weeks as a spring coiling. The short covering in the euro corresponded to lower volatility. Last week, the three month implied volatility rose every day last week, but reversed at the end of the week. We note that the correlation between percentage change in the euro and in three-month implied volatility is inverse by nearly the most it has been since the advent of the euro. The inverse correlation is about -0.63; rarely has it been beyond -0.60.
As the euro rose in recent days, the premium the market was willing to pay for euro puts over calls, equidistant from the forward (risk-reversals) actually increased marginally. Even for participants who are not involved in the options market, important insight maybe be gleaned.
Yen: The net long position nearly doubled to 21.6k contracts from 11.2k in the prior reporting report. This was largely a reflection of 10k new longs that brought the gross figure to 56.3k. The gross shorts were by trimmed by less than 400 contracts.
The yen remains uninspiring. With a handful of relatively brief exception the dollar has been confined to a JPY78 handle. The long speculative position does not reflect optimism about Japanese politics or economics, both of which are deteriorating. Rather the long position seems to be more of low cost insurance policy for heightened capital market tensions. Although some participants may see this as n opportunity to play the yen on a cross rate basis, given the lack of dollar-yen movement, it may not be much different than a dollar trade against the other currency. Three-month implied yen volatility is near five year lows. The combination of the direct price action, low volatility and the absence of much of a skew in the risk-reversals suggest there is not a compelling case for intervention, though the rhetoric may increase.
Sterling: The gross long position fell to almost 2k contracts from 7.8k. This was a function of a liquidation of longs (3.6k) and small growth in shorts (2.3k) to stands at 42.4k and 40.4k contracts, respectively.
Sterling recorded new highs for the week last Friday at about $1.5896, just shy of the previous week high of $1.5912, which itself was a three-month high. While a retracement objective of sterling's dime fall from late April through early June comes in near $1.5910, the momentum readings and MACD are not yet flashing the signal (including divergence) that would normally be associated with an imminent top.
Nevertheless, our fundamental understanding of the UK political economy is not supportive for sterling. The economy appears to be stagnating at best or the contraction is becoming chronic at worst. Despite the government's austerity, government spending is contributing more to GDP than in the US, where federal spending has still not offset in full the cut backs by state and local governments. Talk of a cabinet reshuffle appears to be increasing and it may result in some measures that may blunt some of the austerity (infrastructure investment?).
There is still scope for additional efforts from the Bank of England. More gilt purchases and even a rate cut (where the costs and benefits should be understood dynamically, depending a number of other factors, like real borrowing rates in light of the funding for lending scheme).
Swiss franc: The franc continue to draw the least speculative attention of all the currency futures as what was intended to be a cap is acting like a peg. The new short position was reduced to 11.5k contracts from 5.7 in the previous reporting week. This is the smallest in about 2 months. The gross longs nearly doubled to 10.7k contracts. The gross shorts edged 562 contracts higher to 22.1 contracts.
The only reason at the present it makes sense to look at the Swiss franc chart is that although its practically pegged to the euro, the idiosyncratic price action may offer unique insight. This week, if anything, it confirms as we saw in the euro and that is simply the absence of the technical kind of evidence that would encourage us to aggressive express out fundamental euro bearish views. That said, we would share two observations. First, the downtrend line for the dollar comes in near CHF0.9625 at the end of next week. Second, a break of the CHF0.9485 area could spur another centime move (~CHF0.9375).
Canadian dollar: The market had shown a clear preference in recent weeks to extend long speculative positions in the Canadian and Australian dollars and Mexican peso. In the latest reporting period, the Canadian dollar was the only one to stay in such favor. The next long position rose 20% to 60.9k contracts, the largest in three months. The gross longs tagged on another 10.6k contracts to 86.6k, which itself is a two year high. The gross shorts inched higher. The new 562 contracts raised the gross short position to 25.7k.
The Canadian dollar had looked to be carving out a high. We had cited a potential double bottom for the dollar near CAD0.9843, but with last Friday's sharp drop, this area is again being challenged, but would set up a test on the CAD0.9800 support area.
If the event risk that we still envision in the coming weeks materializes, we continue to warn of the Canadian dollar's vulnerability. Over the past 30 and 60 days, the Canadian dollar is has the highest correlation with the US S&P 500 (on a percent change basis). at 0.77 and 0.84 respectively.
Australian dollar: We noted last week the divergence between the new longs still be established and the lack of satisfactory price action. That was resolved in the recent reporting week by the a lower Australian dollar and a reduction of gross longs and a increase in gross shorts. The net long position fell by about 10% to 78.1k contract, which is the smallest in more than two months. The gross longs were pared by 3.4k contracts to stand at 124.1k. This is the largest gross long of all the currency futures. The gross shorts rose 5.4k contracts and at a little more than 46k contracts, the gross short is the second largest behind the euro.
The Australian dollar traded heavily against the dollar last week and extended the losses since the early August high above $1.06. These latest losses stopped shy of the 38.2% retracement of rally off the early June low just below $0.96.
We detect a shift in sentiment toward the Australian dollar. Increased press reports of a potential end o of a secular advance in commodity prices, and a more immediately, the decline in iron ore and steel prices are hitting a market with extended long positions in the Australian dollar. Some of the Aussie bulls may have been encouraged by talk of some central banks, including the Germany Bundesbank and the Swiss National Bank, embracing it as a reserve asset.
News on September 1 that the official Chinese manufacturing PMI fell below 50 (49.2 from 50.1) for the first time in nine months will not do the Aussie any favors, nor has the Australian dollar consistently benefited when China provides additional monetary support.
Mexican peso: The net long position slipped 3.4k contracts to stand at 94.6k, which means the largest net long position in the currency futures universe. The gross longs fell 2.9k contracts to 104.2k, second behind the Australian dollar. The gross shorts increased by about 450 contacts to 9.6k, which is easily the smallest in the futures markets.
The Mexican peso sold off in first two sessions following the end of the CFTC reporting period. The dollar rose to MXN13.44 on August 30 only to recover in full before the weekend to almost MXN13.18. A strong bid for pesos appears to continue to be coming from international fixed income managers. Foreign investors are purchasing a record amount of peso-denominated government bonds this year. Mexico pays about 175 bp more than the US on 10-year borrowing. Mexico's dollar-denominated world bond yields about 108 bp more than the US-10-year Treasury. The central bank meets next week and there is little doubt that the rates that the key overnight rate will be left unchanged at 4.5%.