Larger risk retreat underway in markets

The euro gets hit as sovereign crisis enters its second act

Since last summer the euro has shrugged off sovereign debt concerns. It brushed off the Irish bailout in November, and within days of the Portuguese bailout EURUSD was in touching distance of 1.5000. But since last week the prospect of a second bailout for Greece and a new phase of the crisis have spooked investors.

It appears that the market is starting to discount sovereign concerns, which makes it unlikely that EURUSD will move back to the 1.5000 level in our opinion. EURUSD closed last week on a weak note, below 1.4190 – the top of the Ichimoku cloud and the end of the EURUSD technical up trend. Below 1.4150 we may see a sharp decline to the 1.3950/60 zone, which is also the bottom of the Ichimoku cloud chart.

The decline in the euro is not only down to sovereign concerns. The single currency is also weakening along with other risky assets and it is moving inversely to the dollar, which has strengthened 4 per cent against its major trading partners since the start of May.

As risk aversion and the dollar re-bound grips markets then the euro will remain under pressure. However, we don’t anticipate the single currency to go down in a straight line. The ECB still seems committed to normalizing interest rates at a quicker pace than the Federal Reserve and strong growth figures for the first quarter of this year have kept interest rate expectations elevated.

Right now there are another two ECB rate hikes priced in by year-end. This seems excessive when the peripheral economies are struggling and Portugal returned to recession in Q1, but unless we see a dramatic slowdown in inflation or overall growth rates then the ECB may hike rates again in July. If interest rate differentials do start to drive FX markets once more then the euro is the sure winner.
However, we believe that sovereign concerns may run for some time yet after Germany said it would not agree to extend more aid to Greece until the conclusion of an IMF audit in June on how well Athens is complying with the conditions of the first bailout. While Germany remains unwilling to pledge extra financial help to Greece then the euro may be on the back foot. After all, this time last year the euro was in free-fall when Germany and other nations failed to agree on the first rescue package.

Asian growth outlook subdued

This week, the People’s Bank of China (PBoC) raised banks’ reserve requirement ratio (RRR) by 50bps effective May 18. This is the fifth time this year the PBoC hiked the RRR which has reached a record high of 21%. This comes after an abundance of Chinese economic data was released on Wednesday. The data showed that while inflation ticked down slightly in April to 5.3% y/y from the previous 5.4%, it remains at elevated levels which is likely to be concerning to policymakers. Additionally, new yuan loans for April rose by much more than anticipated to 739.6B from the prior 679.4B, also an alarming indicator. This suggests that the PBoC may continue to tighten to withdraw liquidity and control inflation. As the world’s second largest economy and major consumer of commodities, expectations of continued tightening by China may keep pressure on risk sentiment as the policy measures are likely to weigh on growth. This can be seen by a lower than forecast April industrial production to 13.4% y/y (cons. 14.6% prior 14.8%) and an unexpected drop in retail sales to 17.1% y/y (cons. 17.6% prior 17.4%). As noted by PBoC Governor Zhou, “there is no limit to how far the required reserve ratio can be raised”.

On Thursday, Japan will release its first quarter GDP which is expected to show a contraction of -0.5% q/q from the prior -0.3%. The decline is largely due to the March 11 earthquake and a second consecutive quarter of negative GDP would confirm a recession. Recent indicators suggest significant deterioration in the Japanese economy with the most notable being a sharp drop in March industrial production by -15.3% m/m from the prior +1.8%. Weakness is expected to persist for some time and the expectations are for continued contraction before a recovery materializes. The Bank of Japan is set to meet next week and is not expected to make any changes at its policy announcement on Friday though the risk is for board members to support Deputy Governor Nishimura to increase asset purchases. While markets are risk averse, yen crosses are likely to remain under pressure, however the downside in USD/JPY may be limited as the threat of intervention lingers, suggesting more pronounced weakness may materialize in non-JPY dollar pairs.

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