Waiting for the Risk Relapse

by: Brian Dolan
The Week Ahead updated September 10, 2010:
  • Consolidation may give way to risk aversion
  • BIS capital reforms may hit Euro-area banks
  • Eurozone debt concerns resurface
  • Democratic Party of Japan’s Election and the JPY
  • Key data and events to watch next week
Consolidation may give way to risk aversion
The past week started off on rocky footing with renewed concerns over the stability of the European financial sector sending EUR and most risk assets lower. As has become the pattern of late, relatively stable data subsequently saw most major pairs move into consolidation ranges. The week's relatively restrained price action was also likely due to various global holidays reducing overall interest. But we would note that most FX risk assets, EUR/USD and JPY-crosses in particular, remain toward the lower end of recent ranges and this predisposes us to continue to focus on the risks of a further relapse in risk appetite.
Elevated European bond spreads and CDS (more below) highlight simmering fears and also suggest near-term risks are to the downside. In the bigger picture, negative data surprises seem likely to continue to outpace positive news in the weeks ahead, and we remain inclined to sell risk assets on rebounds. But the news flow has been uneven and this keeps us mindful of the current range conditions and the need to take/protect profits when opportunities permit. A continued short-term focus seems the most appropriate style for the weeks ahead, but we will give short-risk positions some more slack (let them run) if recent range lows are eventually broken. September frequently sees positions entered into for the duration of the year and given pervasive economic sluggishness and pessimism, staying short-risk seems the path of least resistance.
BIS capital reforms may hit Euro-area banks
This weekend, 27 central bank delegations will gather in Basel to iron out most of the final details of reforms to bank capital adequacy regulations. The issues boil down to how much additional capital will be required and over what time frame those capital increases will be mandated. Germany is leading the charge for lower capital increases and a longer implementation period (10 years starting from 2013), while the US is arguing for higher capital and liquidity requirements to be imposed more quickly (5 years from 2013). Germany is opposed to more stringent requirements because it fears its banking sector will be unfairly hurt by needing to raise larger amounts of capital, potentially inhibiting traditional lending activities and undermining the economic recovery there. European banks in general are less well capitalized than their American counterparts, so a shorter timeframe to raise capital will likely see some EUR-negative impact. Given the relatively long timeframes involved (either 7 or 12 years from now to meet new capital requirements), the short-term market impact may be only marginal. But given the heightened concerns over the European banking sector already in evidence, additional burdens may be a catalyst to a more extreme spasm of risk aversion. Some compromise seems likely, but it may only be in the so-called capital buffers or otherwise relatively marginal, so we will pay close attention to the final outcome.
Eurozone debt concerns resurface
This past week saw a continued widening of Eurozone peripheral bond spreads relative to Germany. The spreads have been widening since the end of July, however recent news helped to push some of the spreads to record levels. A report on Tuesday showed that the European stress test results released by the Committee of European Banking Supervisors (CEBS) may have understated some holdings of sovereign debt. Tuesday saw the 10-year yield differentials between Portugal and Germany rise to record levels around 354 basis points and the differential between Ireland and Germany 10-year yields climb to around 372 basis points – also record highs. This highlights the ongoing sovereign debt concerns in the Eurozone which has weighed on the common currency and risk sentiment. The spreads between Greece 10-year yields and their German equivalents also advanced to levels which have not been seen since the height of the sovereign debt crisis back in May. This highlights that structural issues of the peripheral countries remain present.
At the same time yield spreads are widening between the core and periphery nations, sovereign debt credit default swaps (CDS), which are a measure of the risk of default, are reaching elevated levels for the peripheral-EU. Tuesday saw Ireland’s 5-year CDS reach record highs of roughly 382bps. It is also of note that Greece, Portugal, and Spain 5-year CDS have all increased this past week. The heightened CDS are not a factor of new sovereign issues but rather a reminder that fears continue to lurk under the surface.
The elevated yield differentials and CDS should keep the euro under pressure in the week ahead. EUR/USD has consolidated over the past few days, confined to a tight range that is supported by its 100-day sma and capped by resistance in its 21-day sma. While the bias is to the downside we would note the risks to the upside as a potential bull flag consolidation pattern is also evident. Key support levels are the 100-day sma and 23.6% retracement level of the move from the November 2009 highs to June 2010 lows which converge around 1.2650. Below here is likely to see to the 1.2400-1.2430 area which is the bull flag support and 61.8% retracement of the rally from June lows. The 21-day sma and Kijun line come in around 1.2750-80 to provide immediate resistance for EUR/USD. Above here may see to bull flag resistance around 1.2850 and then to the daily Ichimoku cloud top around 1.3030.
Democratic Party of Japan’s Election and the JPY
Naoto Kan will be faced by Ichiro Ozawa on September 14th in the DPJ presidential election. Since the Democratic Party currently controls the government in Japan, the Prime Minister title is also on the line. Just a few weeks ago Kan led dramatically in the polls, however recent polling suggest Ozawa is right on his tail. Of the 411 DPJ Diet members, Ozawa has backing from 171 while Kan has support from 168; however they only make up roughly two-thirds of the vote. The remaining votes come from local assembly members, rank and file party members and registered DPJ supporters, where it’s believed Kan will receive 60 to 70 percent of the vote. Therefore, the remaining 72 undecided DPJ diet members have come into focus and likely will determine the outcome in the election. While it is unlikely either member’s election will have a dramatic effect on the Yen, it should be noted that Ozawa has been far more vocal in stating the need for intervention and greater economic simulative measures.
Additionally, the strength of the JPY has recently driven some of Japan’s largest exporters, like Toyota (NYSE:TM) and Nissan (OTCPK:NSANY), into further investments in production facilities offshore in order to protect their profits. This will likely garner attention from the MOF and create additional pressure on the BOJ/MOF to react more aggressively to address the appreciating yen. At this stage it appears only unilateral intervention is on the table to halt the yen’s strength. If this is the case, it’s hard to see how it will accomplish anything more than give Japanese exporters and large international investors, like China, another opportunity to aggressively purchase the Yen at better levels. Any way you want to slice it, excluding some form of coordinated intervention between the BOJ, FED, ECB, etc., the path of least resistance for JPY pairs remains to the downside over the coming weeks; USD/JPY to continue to fresh 15-year lows below 83.30/35, EUR/JPY to the test 8-year low near 105.45 and GBP/JPY to try the May 2010 lows around 126.75/80.
Key data and events to watch next week
The economic data for the U.S. kicks off the week on Monday with the monthly budget statement for August. Set for release on Tuesday is August retails sales, September IBD/TIPP economic optimism, and business inventories figures for July. Wednesday sees August import price index, September Empire Manufacturing, as well and industrial production and capacity utilization for the month of August. On deck for Thursday is August PPI numbers, weekly jobless claims, 2Q current account balance, TIC Flows data for July and the September Philadelphia Fed Index. Friday rounds out the week with August CPI numbers and the preliminary University of Michigan Confidence survey results for September.
The Eurozone starts the action off on Monday with the release of France’s July current account. Tuesday sees French August CPI numbers, German wholesale prices for August, Germany’s ZEW surveys results for September are released, and Bundesbank President Axel Weber will speak in Berlin. Also due out on Tuesday is Eurozone 2Q labor costs, EZ July industrial production and the September EZ ZEW survey. On deck for Wednesday are EZ August CPI and 2Q employment numbers and speeches by the EU’s Olli Rehn and the ECB’s Lorenzo Bini Smaghi. Set for release on Thursday is EZ trade balance and Friday finishes the week up with German producer prices for August as well as EZ current account and construction output for July.
The UK data stream begins with Monday’s RICS house price balance and Nationwide consumer confidence for August. Tuesday sees CPI and RPI figures for August, DCLG UK house prices for July, and the BOE’s Martin Weale (dovish) will testify to lawmakers in London. Due out on Wednesday is August jobless claims, weekly earnings and ILO unemployment data for July and BOE Governor Mervyn King will speak in Manchester. Thursday wraps up the week with August retail sales and a speech by the BOE’s Adam Posen.
Japan kicks off on Tuesday with July final industrial production and capacity utilization. BOJ Deputy Governor Nishimura will speak in Tokyo on Wednesday and the Tertiary Industry index for July and weekly foreign securities investments are due out on Thursday. Also on Thursday, the BOJ Governor Masaaki Shirakawa is scheduled to speak in Tokyo.
Canada’s calendar is light with July new motor vehicle sales, 2Q labor productivity and capacity utilization rate set for release on Tuesday. Bank of Canada Governor Mark Carney is scheduled to give a lecture in Germany on Tuesday and Wednesday wraps up the week with a speech by BOC Deputy Governor Tim Lane and July manufacturing sales.
The data down under starts with New Zealand’s REINZ housing price index on Monday , followed by house sales for August, NZ July retail sales, and August NZ card spending on Tuesday. Australia's August NAB business confidence and conditions is also set for release on Tuesday. Wednesday sees Australia’s August Westpac consumer confidence index for September and 2Q dwelling starts. On deck for Thursday is August business NZ PMI the RBNZ rate announcement. Thursday’s data also includes Australian consumer inflation expectation for September and a speech by RBA Assistant Governor Philip Lowe to finish things up for the week.
Be on the lookout for important China data as well. Sometime between Saturday and Wednesday, August new yuan loans will be released. August Actual FDI will be released between Tuesday and Thursday. The Conference Board China July leading economic index is set for release on Tuesday.

Disclosure: No positions