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Euro Weekly Outlook 1/4:Following USD Events, PIGS Complicate Policy Decisions

 

Like its chief counterpart, the USD, the EUR faces a likely busy and volatile week as it is likely to move on much of the same news.

EUR/USD Daily AVA FX Chart     11 DEC 31

Summary

Fundamental Forecast for Euro: Neutral – much depends on US jobs data and market reaction to it

-    Key Events: Mon.-Euro-zone (EZ) Sentix Investor Confidence,  Final Mfg. PMI,  Tues.-German Jobs Change, EZ CPI Flash Estimate y/y, Wed.-EZ PMI Composite, EZ Industrial New Orders, Thurs.-EZ Retail Sales m/m,  EZ economic Confidence Survey, Fri.- German Trade Balance, EZ Unemployment Rate

-    US jobs data to decide if EUR/USD resumes downtrend

-    Reaction of EUR/USD to Risk Sentiment is Changing As USD Moves Up With Jobs, Spending

-    PIGS (Portugal, Italy/Ireland, Greece, Spain) and others’ default risk complicates ECB monetary policy, as both hawkishness and dovishness carry dangers

-    Long-term fundamentals are still disappointing as of year end

-    German consumer-based inflation figures hit an eight-month high – fueling the hawkish momentum   despite credit rating troubles in weaker countries

-    Short-term EURUSD technicals conflict with longer-term trends

Analysis

This week will tell us much about whether December was an anomaly or sign of the year to come.  The week is likely to be intense in terms of both liquidity,  as traders look to make up for lost time, and news, particularly items hinting at Friday’s US jobs reports result. As noted in our comments on the USD, the week is packed with US employment data and will likely determine whether the USD rally lives or dies. Given the centrality of the USD to the fortunes of the EUR, as well as most other widely traded pairs, this is also a critical week for the EUR on the basis of US jobs data alone

The key EUR drivers continue to be:
  • The USD: Given that the EUR/USD, because a third of all purchases or sales of one result in the opposite action for the other. 
  • Overall Risk Sentiment: Positive news fueling optimism favors the EUR over the USD, unless the good news concerns USD fundamentals, primarily US jobs and spending. Those favor the USD over the EUR.
  • EUR Specific Events: If good news, good for the EUR and vice versa. Especially important for the coming months at least,  is the potential for good or bad news regarding Euro-zone member credit ratings, which almost always dominate trading for the day, and often well beyond. (reword)
Liquidity

Starting with the larger trends first, the return of liquidity could play a big role in how the euro trend is shaped into the opening week of the year. With liquidity returning, traders will be less concerned with profit-taking and more focused on whether the trends that have defined direction through most of 2009 will resume. The dollar’s recent rebound no doubt took a major toll on the euro’s health heading into the New Year just as surely as it defined price action through the past year. From the perspective of nations, central banks, large banks and individual traders; the euro is considered the primary counterpart to the US dollar. This is an important distinction when you consider the IMF released a report this past week that showed the euro’s presence of global reserves rose to a record, while the and the dollar’s hit a 10-year low. When policy officials look to diversify away from the dollar, they will first turn to the euro as the world’s second most liquid currency. Thus the two currencies will continue to push each other in opposite directions, as buying of one brings selling of the other.

Risk Appetite: The EUR/USD Response is More Complex Now

Another prominent driver for price action is the direction and intensity of risk appetite. Over the past year, EUR/USD reaction to risk appetite was straightforward. Optimism supported the higher yielding euro, whereas fear events supported the lower yielding USD, whose ultra low 0.25% short term rate by default made it a “safe-haven” funding currency for purchases of higher yielding currencies.

Since the events of late November, that correlation is more complicated, and must be amended as follows.

  • IF the good news in the market concerns US jobs or spending, the key metrics which the Fed is using to decide the timing, rate,  and degree of QE exit and rate increases, then the USD moves up along with other risk assets, consequently pushing the EUR down.

 

  • If the good news is hawkish for EUR rate increases or QE exit, it is no longer unambiguously good for the EUR. While such news is good in the North, especially for France and Germany, it is potentially disastrous for the Southern PIGS (Portugal, Italy/Ireland, Greece, Spain) as well as Latvia and other suspects among the weaker economies in the EZ. Thus EUR traders must balance the affects and risks involved in ECB tightening. Is raising rates and reducing inflation risk better than risking multiple sovereign defaults? Very tough to gauge.

 

The weaker economies will likely continue to be a significant drag on the EUR, though the ECB may well welcome the excuse to keep rates down and credit easy, especially if it can stimulate more exports to the US. Should traders notice a new dovishness to the ECB, that too will weigh on the EUR/USD and other affect most other major pairs.

Using the S&P 500 daily chart as a representation, it’s clear that the rate of overall risk sentiment increase is stalling, though in nominal terms it is still rising.

S&P 500 Daily AVA FX Chart     05 DEC 31 H

It’s unclear at this time whether stocks and other risk assets can continue to climb without at least some sort of retest of support, especially given the genuine threats to growth from the numerous quarters, as noted above in the Stocks section.  

PIGS Complicate Policy Choices for ECB – But ECB More Likely to Tighten

Finally, there is interest rate policy to consider. Though there has been little development in the global rebound in interest rates, speculators are impatiently waiting for signs of which currencies will enjoy accelerated rate hikes (which will drive capital gains on early adopters before the yield can really offer a profitable differential). Through the end of this past year, there has been little to no precedence offered by the ECB of near-term rate hikes; but there has been a tangible rollback in stimulus programs over the past few months. In the meantime, no other central bank (with the exception of the RBA and arguably the RBNZ) has moved up their own time frame. This means the field is still wide open for rate speculators. As noted above, ECB policy makers have no clear path, as they try to weigh which threat is greater to EZ prosperity:

  • Rising inflation if rates are kept low in order to help the weaker member states. If inflation control in the stronger economies is the priority, growth in these countries will mean more hawkish policy, less inflation, and a stronger euro. The cost could be multiple sovereign bankruptcies or bailouts, which in turn could wipe out anticipated gains from such policy as credit markets dry up and confidence in the EZ and EUR fades

 

  • Sovereign debt defaults among the PIGS (Portugal, Ireland/Italy, Greece, Spain) and possibly others. If so, that would mean the priority is keeping rates low and stimulus flowing. This may keep the PIGS alive, but with concomitant, weakening of the EUR and credit worthiness of the EZ members, even the stronger ones. These problems too may in turn wipe out whatever gains were made by the loose money.

 

Our guess – the ECB will seek to preserve a core of healthy economies and give priority to keeping the strongest economies healthy with more hawkish policy and keep inflation at bay with reduced spending and rising interest rates as growth in the better economies demands it. Once that goal is met, EZ policy makers will do what can be done to help the sinking weaker countries.

Events: USD Events Dominate

Look at next week’s economic docket, we believe most of the key event risk is with the USD and data related to expectations for Friday’s NFP and Unemployment reports.  There may be some movement on ECB rate speculation. Perhaps the most influential indicator is the Euro Zone CPI estimate for December. The advanced inflation indicator is expected to accelerate into positive territory; providing the most tangible force for hawkish officials. Other indicators can have a significant impact on growth and inflation; but their influence over actual policy will likely be reduced. Nonetheless, watch the German employment data, Euro Zone sentiment indicators and regional sales figures for volatility.

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