Is Europe About to Implode?

by: Brian Dolan

US jobs disappoint, but still in the right direction

December US job gains disappointed most observers, but that was mostly the result of heightened expectations following Wednesday's surge in the ADP report, a notoriously poor indicator of concurrent NFP changes.

Still, that more jobs were created in December represents another step forward for the US recovery, reinforcing the recent stream of better than expected US data. The decline in the US unemployment rate from 9.8% to 9.4% (exp. 9.7%) was also a step in right direction, but probably was overstated due to a 297K gain in the household survey coupled with a -260K decline in the labor force.

Again, though, the trend is clearly pointing toward growing momentum for the US recovery, which we expect will continue for the next few months at least.

Following the labor report, the USD suffered set-backs against other major currencies, with the obvious exception being the euro, which was the biggest loser for the week. Overall, though, the greenback managed to gain against 13 of the 16 major currencies to start the year (MXN, CAD, and KRW gained vs. USD), with the USD index finishing at its highest levels since late November. US Treasury yields fell somewhat following relatively somber and dovish testimony from Fed Chair Bernanke, with 10 year yields down about 7 bps to 3.32% late Friday, still above recent range lows at about 3.25%.

While we expect the EUR to see lower against other currencies in the weeks ahead (see below), the USD may have more trouble extending gains against other major currencies, especially if bonds pop and yields drop below the recent lows cited above. We would also note that the US dollar index is facing stiff resistance at the 81.43/45 level, which is the November high and the bottom of the weekly Ichimoku cloud. As such, we prefer to remain sellers of EUR on the crosses (e.g. EUR/CAD, EUR/GBP, or EUR/AUD), preferably on some kind of a bounce, rather than a buyer of USD, unless on a significant pullback toward recent lows. Consistent with broader USD strength, gold and silver prices look to have posted key reversal weeks, and we would now prefer to be sellers on remaining strength.

Is Europe about to implode?

After dodging a bullet before the holidays, Europe’s peripheral nations are once again getting punished in the bond markets. The spreads between German government bonds and the peripheral nations are close to record highs. Portuguese 10-year government bond yields (up 70 basis points this week) are now at critical levels. The government in Lisbon has said that 7 per cent is the threshold at which it would need to consider taking a bailout. Currently yields are 7.11 per cent, so it seems only a matter of time before Portugal is negotiating with the ECB, EU and the IMF and receiving funds.

Another worrying development is Belgium. Although it isn’t a core economy, it wasn’t considered a basket case either. Back in August its 10-year bond yield fell to 2.8 per cent, yet it is now above 4 per cent and has risen in line with other peripheral nations. So will the home of the European Union be forced to negotiate a bailout for itself in the coming months?

There are three main reasons that investors have targeted the peripheral nations bonds with such gusto since the start of this year. The first is a wave of supply that is about to come onto the market. On 12 January Portugal will offer 2014 and 2020 bonds for auction, Italy and Spain are also holding auctions at the latter part of next week. Investors charged a hefty premium to hold short-term Portuguese bonds in an auction last week, which doesn’t bode well for the upcoming debt sales.

The news that the world’s largest bond fund will not be participating in the upcoming bond auctions is another red flag in our opinion as it points towards a buyers strike. If Portugal and Europe’s other weak nations have to pay a higher yield to attract investors to purchase their debt, soon people will worry about the impact higher debt payments will have on growth, causing more investors to ditch their debt and yields to rise and so on. This seems like the start of a debt spiral to us. Next week could see some real fireworks, and as you can see in the chart below, bond spreads are close to breaking fresh euro-era highs.

Belgium’s problems are actually more political. It is currently without a full-time government and seven political parties are locked in discussions trying to form a government and overcome the political impasse. This is bad timing to have political meltdown as Belgium is finding out. Investors aren’t in the mood to suffer risks within the eurozone easily and until a fulltime government is found it is unlikely there will be a let-up in the pressure on Belgium’s bonds.

Another factor weighing on sentiment toward the periphery is the European Commission’s plans to overhaul the governance of Europe’s banking sector. One of the proposals is to give regulators the power to write down senior bank debt by any amount necessary, or to convert bank debt into equity if a bank were to get into trouble. Until the risks to the investor are set in stone, European debt is an unattractive asset to hold.

The sovereign debt crisis in Europe appears to be spilling over to the euro. EURUSD is currently below 1.3000, and if the sovereign debt crisis is poised to get worse then it will be hard to muster up much enthusiasm for a stronger euro and we could see a continuing grind lower in the single currency. A convincing break below 1.2960/65 could herald losses toward 1.2900 then 1.2650 – the lows reached back in October.

But the decline may not be in a straight line due to continuing demand for the single currency from Asian central banks that want to diversify away from the dollar.

Queensland flooding slows down the Aussie

The Australian dollar has fallen over 3% against the U.S. dollar since reaching record free-floating highs on the last day of 2010. This past week, massive flooding in the state of Queensland has disrupted the economy by negatively impacting resource production and allocation. Mines, roads, and railways have been incapacitated by the rising waters.

As an economy that is reliant on its natural resource exports as a key driver of growth, the floods have been significantly negative for GDP growth in Q1 (Queensland accounts for roughly 80% of Australia’s coking coal exports). This downbeat outlook has reduced the RBA’s near term tightening bias and has put pressure on the AUD.

While the Queensland state government estimates that so far the floods have generated a loss of up to 5 billion AUD or about 0.4% of annual GDP, it will be some time before the damage can be fully assessed. Additionally, the Australian Bureau of Meteorology forecasts heavy rains will continue into next week. We view this as a temporary supply-side shock and note that reconstruction will generate growth in the future.

Technically, AUD/USD sees a long-term rising trend line support come in around 0.9850 and the top of its daily ichimoku cloud to lend additional support around 0.9820. This support line begins at the June lows of around 0.8080 and was most recently tested on December 1. The 55-day sma is currently above that at about 0.9920 to provide initial support.

The current pullback in AUD/USD may present a buying opportunity at these support levels however a break below the trendline may see towards the 100-day and 21-week sma which currently converge around 0.9710 and then towards the December lows around 0.9540. A sustained move back above parity may see towards 1.0100 ahead of 1.0200 and prior highs.

Encouraging jobs data and accelerating price gains supporting the Loonie

Much has been made of greenback strength with the USD Index surging close to +2.5% for the past month to current levels near 81.00. One major exception, however, has been against the Loonie – the greenback is down -1.84% against the Loonie month to date. The fundamental backdrop behind divergent CAD strength relative to most other majors can be attributed to a dichotomy of factors.

The first is the improving economic outlook in Canada and its likely impact on policy direction. Of significant influence to this has been the spate of positive data surprises in the US – Canada’s largest trading partner. Even more influential, however, have been implications of recent domestic data releases. Starting with the labor market, Net Change in Employment for December rose to +22k from +15.2k in November.

Even more encouraging were the components of the report, full-time employment rose +38k while part-time employment declined -16k, a good sign for consumer confidence and spending which is likely to have a positive spill-over effect for 4Q 2010 GDP. Additional support to Loonie strength emanates from inflation related data.

Wednesday’s higher than expected rise in November industrial product prices of +0.5% in conjunction with the +3.5% rise in November raw materials prices sent USD/CAD sharply lower from above parity to lows around 0.9930.

A second significant factor supporting the Loonie is the bullish outlook for oil prices. Improving growth outlooks and tightening supply (DOE weekly crude oil inventories have dropped for the past 5 consecutive weeks) suggest higher crude oil prices in 2011. Considering 2010’s inverse correlation of -.64 between USD/CAD and WTI oil – the outlook for higher oil translates to a corresponding strengthening in the Loonie.

Further progression in price gains, a likely possibility if Canada and US data continue down the path of positive surprises, may see the BoC consider resuming monetary policy tightening sooner relative to central banks of most other developed nations. The result is likely to see a continuation of CAD strength from a divergence in future interest rate expectations and widening differentials.

Key data and events to watch next week

Unites States:

  • Monday – Fed's Lockhart speaks
  • Tuesday – December NFIB Small Business Optimism, Fed's Plosser speaks, Jan. IBD/TIPP Economic Optimism, November Wholesale Inventories, weekly ABC Consumer Confidence
  • Wednesday – December Import Price Index, weekly DOE U.S. Crude Oil Inventories, Fed's Beige Book,
  • Thursday – Weekly Jobless Claims, December PPI, November Trade Balance, Bernanke Speaks
  • Friday – December CPI, December Advance Retail Sales, December Industrial Production & Capacity Utilization, Jan. preliminary U. of Michigan Confidence, November Business Inventories, Fed’s Lacker & Rosengren speak


  • Monday – French November Industrial & Manufacturing Production, EZ Jan. Sentix Investor Confidence,
  • Tuesday – French December Business Sentiment
  • Wednesday – German 2010 GDP, EZ November Industrial Production
  • Thursday – EU's Van Rompuy speaks, Jan. ECB Interest Rate Announcement
  • Friday – German December final CPI, December EZ CPI, November EZ Trade Balance

United Kingdom:

  • Tuesday – BRC December Retail Sales Monitor
  • Wednesday – BRC Shop Price Index, November Trade Balance
  • Thursday – November Industrial & Manufacturing Production, Jan. BOE Interest Rate Announcement, December NIESR GDP Estimate
  • Friday – December PPI


  • Tuesday – December Official Reserve Assets, November preliminary Leading & Coincident Index CI
  • Wednesday – December Bank Lending, November Current Account, December Eco Watchers Survey
  • Thursday – November Machine Orders, December preliminary Machine Tool Orders
  • Friday – December Domestic CGPI


  • Monday – November Building Permits, 4Q Business Outlook Future Sales, 4Q BoC Senior Loan Officer Survey, BoC Cote speaks
  • Tuesday – December Housing Starts
  • Wednesday – November New Housing Price Index
  • Thursday – November International Merchandise Trade

Australia & New Zealand:

  • Monday – November NZ Trade Balance, Imports & Exports, AU December AiG Perf. of Construction Index, AU December Retail Sales
  • Tuesday – 4Q NZ NZIER Business Opinion Survey, November NZ Building Permits, November AU Trade Balance,
  • Wednesday – November AU Home Loans and Investment lending
  • Thursday – December NZ Business PMI, December NZ Card Spending, December NZ House Prices, December AU Employment Report, December NZ ANZ Commodity Price


  • Monday – Trade Balance (USD)
  • Thursday – Conference Board China November Leading Economic Index

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

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