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Brian Dolan
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Brian Dolan is the Chief Currency Strategist at Capital. He is a 20 year veteran of the currency market, having worked as a senior trader and analyst at some of the world's leading international banks, including Dai-Ichi Kangyo, Credit Suisse and American Express. In addition to... More
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  • Greek Debt Swap—It’s On!
    The Week Ahead updated February 24, 2012


    • Greek debt swap-It's on
    • G-20 meeting, ECB LTRO, and EU Summit ahead
    • EUR short squeeze continues; JPY reversal extends

    Greek debt swap-It's on

    On Friday, Greece issued the formal invitation to bondholders to exchange their Greek debt for new bonds and take an approximately 75% loss in the process. Without getting into all the nitty-gritty details, the key for us is the rate of creditor participation and what it implies for the risk of a credit default, which would trigger CDS (credit default swaps-insurance on Greek government debt) payouts, potentially rattling global markets' nerves.

    Beginning with the most benign scenario, if 90% of bondholders sign on, the exchange will be considered voluntary and CDS will not be triggered. In a darker scenario, if between 75% and 90% of creditors participate, collective action clauses (CAC's) will be used to force the exchange on all bondholders, which would make the exchange involuntary and likely trigger CDS payouts. In the worst case, if less than 75% sign up, the entire debt swap will be scrapped, leaving the second Greek bailout in doubt and increasing the risk of a disorderly Greek default in a matter of weeks.

    We have no way of knowing the extent of creditor participation, which makes this an extremely difficult event to call. For what's it's worth, the lead IIF negotiator indicated on Friday he was 'quite optimistic' about a majority of bondholders approving the deal, leaving it open whether it reaches the 75% minimum threshold. In terms of timing, the Greek plan calls for creditors to accept the swap by March 11, or potentially be subject to CAC's.

    If the Greek debt exchange triggers CDS payouts, we think there is potential for another wave of financial sector turmoil. The net amount of Greek CDS outstanding (firms who have bought minus firms who sold Greek CDS) is small at around EUR 3.2 bio. But that figure masks the gross amount of Greek CDS obligations outstanding, which is around EUR 70 bio. The risk is that financial sector players react with counterparty panic, unsure of which institutions are on the hook and for how much, possibly leading to a wider market seizure. Stay tuned to the headlines and watch for the participation rates (the total amount of Greek debt open for exchange is EUR 206 bio).

    G-20 meeting, ECB LTRO, and month-end ahead

    This weekend will see G-20 finance officials gather in Mexico to discuss global issues and expectations are relatively low for any meaningful initiatives. The focus for markets will be on getting new capital commitments for the IMF to strengthen its capacity to support Europe. The IMF has indicated it's seeking an additional USD 500 bio in lending capacity, while the 17 euro-area nations have committed to around USD 200 bio in new capital.

    We think there is room for some disappointment coming out of the G20 if significant fresh capital is not committed to the IMF. US, Chinese and Japanese officials, among others, have indicated they want to see further measures from the Europeans themselves before committing additional support. For the US, in particular, providing further aid to the IMF to support Europe is political suicide, so we would certainly not expect any US capital commitments. If the G20 balks and no major capital commitments are made, risk sentiment may get off to a rocky start to the week, but if incoming economic data continues positively, risk appetite should ultimately rebound.

    On Wednesday at 0515ET/1015GMT, the results of the ECB's second (and, for now, final) Long-Term Refinance Operation (LTRO) will be announced. Markets are expecting Euro-area banks to draw around EUR450 bio in fresh 3-year financing, slightly less than the EUR 489 bio taken up at the Dec. 22 LTRO. Should banks take up less than EUR 400 bio, we think European government bond markets may be disappointed and we could see yields start to move higher again, which might take some of the wind out of the euro's sails.

    If bank demand is as expected, EU debt markets should remain resilient. But there, too, is the risk of a buy-the-rumor/sell-the-fact reaction, where bonds have rallied in advance of the LTRO and are now ripe for profit-taking. As well, following approval of the second Greek bailout and the LTRO, what's the next source of good news to look forward to out of the EU debt crisis, again setting up the potential for a EUR reversal.

    Next week also sees the usual month-end portfolio rebalancing flows and we expect to see a bias toward further USD-selling, typically culminating each day in the hours leading up to the 1600GMT/1100ET London fixing. The strongest dollar-sell indications are against the commodity currencies (AUD, CAD and NZD), but also against GBP, CHF and JPY. For the JPY, however, as we discuss below, we would not look to sell USD/JPY.

    EUR short squeeze continues; JPY reversal extends

    EUR continued to push higher across the board, as the large short-EUR position continues to be squeezed out. CFTC data indicate the EUR/USD net-short position was further reduced to 142K from 148K in the prior week, but the data only covers up to last Tuesday, and undoubtedly shorts were further reduced into the end of the past week. However, the net-short reduction is only down from recent all-time highs of around 170K, so it looks like there is still plenty of room to go.

    Additionally, the EUR has been supported by more positive developments in the EU debt crisis, anticipation of the LTRO, and some not so bleak data. Still, we find it difficult to enthusiastically embrace the single currency in light of stagnant growth prospects, especially at levels just below 1.3500. Instead, our preference would be to use pullbacks into the 1.3250/1.3300 (just above the top of the daily cloud) area as a potential long-entry zone, and we remain mindful of the headline risks facing EUR. On the upside, beyond the 1.3500/10 psychological/option resistance/38.2% Fibonacci retracement of the 1.4940-1.2626 decline, the weekly Kijun line comes in at 1.3586.

    Last week, we cautioned that JPY-weakness was likely to continue, but the desired pullback in USD/JPY or JPY-crosses never materialized. We think there is still more room to go, but we're also finishing the week around key resistance levels. In USD/JPY, the top of the weekly Ichimoku cloud is at 80.95, and we're still reluctant to chase the pair higher into this key resistance. As well, the US/Japanese 2-year interest rate spread still suggests a USD/JPY rate closer to 78.60/70, so we would suggest patience and continue to look to enter USD/JPY longs on pullbacks into the 78.50/79.50 area.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Tags: forex
    Feb 24 5:00 PM | Link | Comment!
  • Greece's Day Of Reckoning Is Only The Start
    The Week Ahead updated February 17, 2012


    • Greece's day of reckoning is only the start
    • Further JPY-weakness may be in store
    • Light US data may see risk rally stall

    Greece's day of reckoning is only the start

    Another week and another Greek deadline has come and gone. But EU leaders have vowed yet again that a final decision will come on Monday, and this time they really, really mean it. Except that they're still working over the weekend on the final details of the accord, so yet another impasse or breakdown could materialize. But we'll give them the benefit of the doubt and expect that EU finance ministers will approve the second bailout, likely requiring some form of escrow account. Such an arrangement will set the stage for further showdowns in the months ahead, as Greece will repeatedly need to meet deficit reduction targets to obtain subsequent aid disbursements, and their track record there is not good.

    While we think the Eurogroup will approve the next Greek bailout on Monday, we can't rule out last minute hang-ups on key issues, potentially pushing the decision into the March 1-2 EU Summit. Eurogroup officials will meet informally on Sunday night and begin the formal session around 1430GMT on Monday. If they do approve the bailout, we would look for risk assets (stocks and commodities) and EUR to make yet another minor relief rally. Clearly, if they don't approve of the aid, we would expect risk markets and EUR to come off relatively hard, as the risk of a disorderly default would be intensified. The ultimate deadline to keep in mind is the March 20 maturity of EUR 14.5 bio in Greek government debt.

    While much attention has been focused on the question of whether Greece will or won't receive the second bailout package and avoid a default, we think the bigger risks are from the fallout over the Greek debt swap deal with private sector investors (NYSEARCA:PSI). In this situation, we are looking at many so-called 'known unknowns.' This stems from the credit default swaps on Greek government debt and whether they will be triggered, which financial firms are on the hook for them, and for how much.

    The current terms of the PSI negotiations strongly suggest that a 'credit event' will be declared, but ultimately that's up to a committee of ISDA (International Swaps Dealers Association, the CDS and derivatives industry self-regulatory body) to determine. However, reports circulating on Friday indicated that some private creditors were already preparing legal action against the Greek government over the amount of losses they're being forced to swallow. Friday also saw the Greek government announce that it's preparing a 'collective action clause' law (NASDAQ:CAC) for outstanding Greek government debt. CAC's permit a super-majority of bond holders to alter the terms of existing bonds, making the debt swap deal a non-voluntary affair. Various credit rating agencies have indicated imposition of CAC's would constitute a 'credit event', likely triggering CDS payouts. This brings us back to the known unknowns of which financial firms are liable and for how much, potentially sparking global financial sector upheaval as investors retreat to safe havens. And then there are the 'unknown unknowns,' where we don't know what we don't know. For many, this is the bigger risk out there, potentially making the fallout from the Greek debt deal make Lehman look like a walk in the park.

    Overall, we think a resolution to the Greek rescue drama next week may simply be the start of a larger, messier drama involving previously unentangled financial institutions globally. At the minimum, we would expect a deal on Greece to offer only a short-lived respite, before markets begin to question anew the sustainability of Greece over the longer haul.

    Further JPY-weakness may be in store

    The JPY has undergone a distinct adjustment lower versus other major currencies over the past week following the BOJ's decision to initiate another round of QE and establish an inflation target of +1.0% (latest CPI was -0.3%), suggesting more QE will be needed in the future. Together with Japan's trade surplus evaporating into a deficit (January trade data due out on Monday morning in Tokyo; adjusted trade deficit of -JPY 850 bio expected), we think there is scope for further JPY weakness in the weeks ahead. Anecdotal reports also suggest Japanese investors started to actively reduce their portfolio hedges, leading them to buy foreign FX and sell JPY, adding yet another flow to JPY-selling pressure.

    USD/JPY and many of the JPY-crosses have reached 3-month highs and are testing key resistance levels, such as USD/JPY 79.50/80.00 and EUR/JPY 104.50/105.00. While we think there is further upside in store, we would avoid getting long at these levels and prefer to wait for a pullback to pursue long entries (selling JPY), ideally around 78.00/50 in USD/JPY and 102.70/103.20 in EUR/JPY. Breaks above the resistance zones mentioned above may see JPY-pairs move directly higher in this adjustment. Potential turmoil emanating from Europe next week could provide the desired pullback, if investors turn back to the JPY and the USD on safe haven demand.

    Light US data may see risk rally stall

    Next week sees the US President's Day holiday on Monday where US stock and futures markets will be closed. The rest of the week sees relatively minor US economic data (existing/new home sales; weekly jobless claims) only late in the week. We note this because the risk rally currently underway has been extremely tentative and seems to require frequent injections of better-than-expected news and data to keep going. More positive US data reports of late have been a primary source of that optimism, but with minimal data out of the US next week, that medicine may be in short supply. Together with potential disappointment or outright disarray out of Europe, we would not be surprised to see a more negative correction to risk assets and a further bounce for the USD.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Feb 17 4:47 PM | Link | Comment!
  • Better Data Drives Risk On, Fed QE3 Off
    The Week Ahead updated February 3, 2012


    • Better data drives risk on, Fed QE3 off
    • Still waiting on a Greek debt deal
    • Central banks' decisions on tap
    Better data drives risk on, Fed QE3 off

    The past week ended with a string of better-than-expected data releases from key major economies, suggesting the global recovery may avoid a more worrisome downturn. Mostly better than expected PMI's from Europe, UK, China and the US were supplemented on Friday by a much stronger US employment report than was expected. We're cautiously optimistic that the better US jobs report is a valid signal that the US recovery is improving, but we're also aware that January employment numbers are especially volatile due to seasonal factors, and subject to major revision. The decline in the unemployment rate in the January report, in particular, is also suspect due to the inclusion of new population data from the 2010 census. The best way to interpret the data is as though the unemployment rate was already at 8.3% in December as opposed to having declined in January.

    The series of more upbeat data allowed the current 'risk on' rally to extend further, but with a few notable twists. Of special note is that markets continue to differentiate between currencies based on the prospects for respective central banks to expand their balance sheets further (quantitative easing or QE). We saw this last week following the Fed's lower-for-longer rate pledge and Bernanke's mention that QE3 remains an option, which sent the greenback lower across the board. Following Friday's jobs report, which we think delays (at the minimum) potential Fed QE3, the USD rebounded against EUR and GBP, but lost ground to other major currencies like AUD, CAD, and NZD. The key there is that EUR and GBP, whose central banks are expected to continue asset purchases/balance sheet expansion, also lost ground to AUD, CAD and NZD, whose central banks are not expected to initiate QE. Gold prices also declined sharply on Friday, revealing the yellow metal's strong relationship with the likelihood of Fed QE3.

    We expect this dynamic to continue to influence near-term trading conditions and incoming data will remain an important driver. Next week doesn't see too much in the way of top-tier data for the majors, but what does come out could have a larger impact than normal (e.g. Australian retail sales, German factory orders/industrial production, Canadian Ivey PMI, and UK industrial production).

    Still waiting on a Greek debt deal

    Another week comes and goes with no final deal in place to secure Greece's next round of bailout funds. EU officials' comments continue to suggest that a deal is nearly complete, with the final sticking point being the amount of public sector participation in debt losses, meaning how much of a loss national governments and the ECB will have to swallow. Assuming a satisfactory deal is reached on the Greek debt swap, what then?

    We would expect a final flurry of risk-positive movement as fears of an imminent Greek default are quashed, but we think such a moment may also represent a near-term peak in the current risk rally. For if a deal is reached, we think it will likely be the highpoint in terms of good news in the Eurozone debt crisis. Markets are likely to conclude that even with a Greek debt deal, Greek debt levels are still unsustainable in the long-run. And this also assumes there is no messy rebellion by some Greek debt holders and CDS are not triggered. Moreover, despite better than expected Jan. Eurozone PMI's, the outlook is still for further weakness in Eurozone growth in the months ahead, which will likely come back to undermine European debt markets yet again.

    While there has been some marked improvement in Italian, Spanish and Portuguese bonds in the last week, we'll be looking to how much of the decline in yields was due to ECB purchases. The ECB will announce the total amount of bond buys made in the last week on Monday at 0930ET/1430GMT. If they were forced to step up purchases significantly over recent weeks, the nascent calm in European debt markets may not last.

    In EUR/USD, we continue to watch the recent 1.3000/1.3250 area as a consolidation range, with a break signaling the next directional move.

    Central banks' decisions on tap

    Next week sees interest rate and policy decisions from the RBA, BOE and ECB. The RBA is first up on Tuesday afternoon local-Sydney time and markets are expecting a 25 bp rate cut from 4.25% to 4.00%. There is some minor risk of a larger 50 bp cut, as the RBA does not expect banks to pass on to customers the full 25 bps if it only cuts by that much. There is also a small risk that the RBA stays on hold, potentially in light of recently more upbeat global data and calming in the Eurozone debt crisis. Regardless, AUD is not trading on interest rate dynamics at the moment, so we would look to the overall risk environment to gauge AUD's outlook.

    The BOE is first up on Thursday morning and they are expected to hold the benchmark rate steady at 0.50%, but also to initiate a third round of asset purchases. Markets are mostly expecting a smaller round of GBP 50 bio, with a minority expecting another round of GBP 75 bio. In light of some surprising strength in recent UK data, we think the risk is that the BOE does nothing at this meeting, which could see GBP strengthen briefly. Sterling also appears to be defying QE speculation in recent days and GBP/USD is nearer to its recent highs. However, we would note cable is having difficulty extending gains beyond 1.5900, and we are watching for a daily close below the 1.5765 daily cloud top to suggest a potential failure and the start of a reversal lower.

    The ECB is also up on Thursday, but are expected to keep policy on hold. ECB Pres. Draghi is likely to point to slightly better PMI's as a further sign that 4Q was potentially the nadir for the Eurozone, but will also certainly note that downside risks remain. Overall, we don't think the ECB meeting/press briefing will drive EUR, but that the Greek outcome and risk sentiment will be more important.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Feb 03 5:02 PM | Link | Comment!
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