What to look for in the week ahead
- EU competitiveness pact may disappoint
- Fallout from Japanese earthquake
- Spain gets a wakeup call
- Central banks expected to maintain policy rates
- A mixed picture in China , but further tightening is still needed
- Key data and events to watch next week
EU competitiveness pact may disappoint
Without the final details in hand as of late Friday afternoon, we can’t be sure of the ultimate reaction, but price moves ahead of the release of the EU pact suggest markets are going to be underwhelmed. The draft of the pact suggested that no concrete rules will be established and that individual governments will operate on a ‘best efforts’ basis to rein in debts and deficits and stimulate growth. The only enforcement mechanism will be discussions between member states. If the final pact follows these outlines, markets are more likely, in our view, to voice disapproval. Indeed, in the run-up to Friday’s summit, peripheral-EU bond spreads widened to near crisis peaks from last year, suggesting many still expect defaults and restructurings to follow. Alongside threats to the global recovery emanating from MENA and China , and now Japan , we think the downside for the Euro is vulnerable and we will view a break below the 1.3730/50 daily Kijun line/weekly low/21-day mov. avg. as an indication of a Euro likely headed back toward 1.3500/50 in the near-term. Should the pact contain more disciplined measures, then we would expect to see some further recovery in the single currency, but think it should remain below 1.4000, as growing risk aversion limits the upside.
Fallout from Japanese earthquake
The massive earthquake and tsunami in Japan on Friday undermined risk sentiment further and this led to JPY-strength as JPY-shorts were rapidly covered. There has been talk of Japanese repatriation of funds to cover insurance costs, but we think this is likely overstated and that risk aversion is the better explanation. The tragedy there is still unfolding, with additional earthquakes registering through Friday night, and no estimates of damage costs are available at the moment. However, given the largely agricultural nature of the affected region, we don’t think the impact to Japanese GDP will be especially severe, but that’s not saying much as Japanese growth already turned negative in 4Q. While we think the near-term pressure will remain on USD/JPY, we don’t think the pair will test the pivotal 80.00 level and seems most likely to find a base in the 80.50/81.50 area in coming weeks. We think the MOF will seek to avoid a further surge in the JPY which would add fresh burdens to the Japanese recovery. The BOJ is meeting at the start of next week and may announce emergency measures such as additional asset purchases, which could see the JPY weaken sooner. The government will also likely soon pursue a supplementary budget to pay for clean-up and reconstruction, and this may revive fears over the size of Japan ’s debt burdens and also cause the JPY to weaken.
Spain gets a wakeup call
There are growing signs that the market is losing patience with the EU authorities who have failed to come up with a credible, long-term solution to the region’s sovereign debt crisis. As EU leaders gathered for a summit in Brussels at the end of last week, the markets had low expectations that an effective solution would be found. Bond yields spiked to euro-era records for Ireland and Portugal ; Spain and Italy were not immune either as the risk premium to hold their government debt also increased.
The downgrade of Spain ’s sovereign credit rating by Moody’s to Aa2 from Aa1 at the end of last week focused the markets’ attention back on Europe ’s troubled banking sector. A third round of bank stress tests is scheduled to be conducted in the next few months. On 18th March the EU authorities will publish the macro economic scenarios and the sample of banks that will undergo the tests. This is key for the market as it will determine whether the tests are strong enough to really give a true snap shot of the bad debts and recapitalization needs of some of Europe ’s most troubled lenders, particularly the Spanish Caja banks. More details will follow in April when the stress test methodology is disclosed and then in June when we finally get the results.
There is no doubt that the EU authorities have made a hash of dealing with their financial problems. It has taken three rounds of stress tests to try and make sense of the bad debts still swimming in Europe’s financial system.
Investors will only be happy once they know exactly how bad the problems are. When the US published devastating results of their bank stress tests in 2009 it was greeted warmly by the markets and led to a stock market rally. Investors will only be happy to hold assets from Europe ’s periphery if they can accurately calculate the risk of doing so. Right now they are guessing that things are worse than the authorities are saying, hence bond yields are rising to unsustainable levels. If the truth was out there then bond yields may even start to moderate. Until the full extent of the debt crisis is known there can be no remedy. If the results of the tests are published in June, then a solution is unlikely to be found until the end of the year.
By that time Portugal is most likely to have applied for bailout funds, while Spain just about avoids doing so. But there is a lot of pressure on the larger of the two Iberian nations. Although debt issuance in 2011 is only about 80 per cent of what it was in 2010, Spain still has to tap the markets for an enormous EUR600bn or more for the rest of this year. Doing so at the same time as the bank stress tests are taking place could test investors’ patience. If Spain’s banks require significantly more capital than the EUR 20bn the Spanish authorities have disclosed then its debt could be significantly harder to sell to foreign investors who have already been cutting back on their exposure to the weaker Eurozone states.
The euro has brushed off sovereign debt woes in the past, but they are increasingly weighing on the single currency. It fell back to the 1.3800 level versus the dollar at the end of last week, and the key 1.4000 resistance level is unlikely to be broached for the time being. Technically EURUSD is still in an uptrend above 1.3535 – the top of the Ichimoku cloud, but it has fallen sharply and if we don’t get a bounce somewhere between 1.3600 and 1.3700 then we could see a sharper decline over the coming months, especially versus the greenback.