It's crunch time for U.S. debt negotiations

• Crunch time in US debt negotiations
• QE3—not so fast
• Europe ’s stress test results with a caveat
• CHF and JPY strength prompts jaw-boning
• Divergent economic performance in Oceania
• Key data and events to watch next week

Crunch time in US debt negotiations

US congressional leaders and the White House appear far from reaching any sort of comprehensive ‘grand bargain’ to cut the US deficit and raise the government’s debt ceiling. Talks are ongoing, but the rhetoric on both sides seems to be deteriorating, suggesting that compromise may be falling out of reach. Time is tight and a deal needs to be reached by the end of next week to allow for legislative passage before the drop dead date of Aug. 2. At this point, we see three main potential outcomes, ordered from least to most likely: 1) a ‘grand bargain’ where the deficit is cut by around USD 4 trillion over a decade through a combination of spending cuts and revenue increases; 2) a smaller deal with deficit reduction of only 1.5-2.0 trillion on spending cuts alone; and 3) no deficit reduction deal and only a ‘clean’ debt limit increase is passed.

Credit ratings agencies have put the US on notice that its AAA rating may be cut if the debt ceiling is not raised in time to prevent a default. Even if the debt limit is increased, the credit raters suggested that without a substantial deficit reduction plan, the US sovereign rating was still at risk of a downgrade. So we remain extremely concerned that political intransigence will lead to a breakdown in deficit reduction negotiations, resulting in a last minute measure to only raise the debt limit. Given some of the blithe comments from Republican lawmakers on the supposed manageability of a US default, we can’t even rule out that no deal at all will be reached, keeping the potential of a US default very much in view. Until an agreement is forged, we think the USD will remain vulnerable and safe havens (precious metals, CHF and JPY) will stay in demand. As next week wears on and as long as a deal remains elusive, risk sentiment overall will likely deteriorate, we think. If an agreement is reached, however, risk appetite is likely to rebound, possibly sharply, potentially sending those same safe haven assets down abruptly.

QE3—not so fast

Some may say Fed Chairman Bernanke threw markets for a loop this past week, but we think markets overreacted to his comments on the first day of his semi-annual economic update to Congress. Bernanke’s statement that the Fed was prepared to consider additional easing measures should current US weakness prove more persistent was nothing more than a reiteration of previous FOMC policy statements, but markets responded quite strongly, sending stocks and commodities higher and the USD lower. On the second day of his testimony, Bernanke seemed to want to correct the impression that QE3 was imminent, and noted that the Fed was not prepared ‘at this point’ to take action. Risk assets quickly reversed lower and the USD rebounded. We think three points can be drawn from this: 1) market sentiment is extremely divided over the near-term outlook and conviction is extremely low, keeping price movements headline driven and short-term in nature; 2) any mention of additional easing seems to be risk positive and USD negative, and incoming data will increasingly be interpreted for what it implies for the potential of QE3; and 3) the Fed is likely to need 2-3 months’ worth of sputtering US data before it would act with additional unconventional measures.

Europe’s stress test results with a caveat

The results of Europe ’s stress tests were as expected. For example, there was no surprise that the Spanish banks fared the worst; however, the fact that only 8 banks failed the test (5 from Spain , 2 from Greece and 1 from Austria ) isn’t going to inspire that much confidence in investors.

The report that accompanied the results emphasized that if there hadn’t been a large amount of capital raised in the first four months of this year then 20 banks would have failed the test with a total capital short-fall of EUR26.8bn. However, EUR50bn of new capital was raised between January and April this year. This is an impressive sum, however, worryingly, although 8 banks failed the tests, a further 16 only passed by the skin of their teeth with Core Tier 1 Capital ratios of between 5 and 6 per cent. So Europe ’s banking sector is not out of the woods yet.

The adverse scenarios that tested for a recession and a significant drop in equity markets are nothing compared to the carnage a default could cause. Even the European Banking Authority (EBA) seemed to suggest that a 5 per cent capital ratio is only “necessary but not sufficient to address potential vulnerabilities at this conjecture.” The EBA made explicit reference to the damage a deterioration in the sovereign debt crisis (a default) would do. The report stated that it “might raise significant challenges, both on the valuation of banks holdings of sovereign debt and through sharp changes in investors’ risk appetite.”

So these are test results that come with a caveat – things could be worse if there is a default. So we still don’t know how bad banks would be ravaged if a member state failed to pay its debts.

There are two positives from this report: firstly, it has pressured Europe’s banks to raise more capital in recent months, secondly it has increased the transparency of Europe ’s banks’ balance sheets. The 91 banks that were tested had to provide the amount of sovereign debt they hold. It also recommends that sovereign debt holdings in banking books should been treated like any other credit risk, and not given special status. The key findings are that 67% of Greek sovereign debt is held by domestic banks, 61% of Ireland ’s debt is held by Irish banks, and 63% for Portugal .

France is the second largest holder of debt issued by Athens , and currently has 8 per cent of it, Germany has 2 per cent. However, German banks are exposed to counterparty risk from Greek banks. Euro banks’ exposure towards Greek institutions is estimated at EUR17.2bn in total, and Germany is exposed to nearly 70 per cent of this.

The market reaction was fairly muted, though it will probably take a few days for markets to digest all the data. While the euro is comfortably above 1.4100 as we end the week, the stress test results received a less sanguine reaction from the credit markets. Although the markets had closed by the time of the release, yields for Italian and Spanish 10-year bonds had reached fresh euro-era highs as we end the week.

Next week’s focus will shift to the July 21 EU summit at which EU leaders are expected to hammer out a deal on Greece ’s second bailout package. German officials continue to insist on some measure of private sector burden-sharing, but the ECB remains equally adamant on avoiding any type of credit event. We’ll be looking for signs of Germany moderating its position to reach a consensus. Failing that, next week’s summit may prove as inconclusive as earlier debates, prolonging uncertainty to the EUR’s detriment.

On the whole, we don’t think the stress tests resolve Europe’s problems, and any rally towards 1.4300 would be an opportunity to sell. Likewise, we still believe the trajectory is lower for EURCHF; below 1.15, we think we could see 1.12 in the coming weeks and months.

CHF and JPY strength prompts jaw-boning

The mounting uncertainties of the global economy, debt crises and geopolitical risks have seen flows in ‘safe haven’ assets. Two notable beneficiaries of late have been the Swiss franc and Japanese yen. This past week, CHF reached record highs against the euro and the greenback in a flight to quality. EUR/CHF touched record lows of nearly 1.1495/1.1500 and USD/CHF fell to record lows of about 0.8085 as investors sold euros on elevated sovereign debt concerns while the dollar was dumped amid political debt debate and the prospect of additional monetary policy easing. The yen surged this week as well with USD/JPY falling to about 78.45/50, the lowest level since the March 17 record lows of nearly 76.25.

Officials from both Switzerland and Japan have ratcheted up the intervention rhetoric as their respective currencies continue to ascend. While unilateral intervention is unlikely to change long term trends, it is used to deter excessive speculation and attempt to reduce volatility in favor of more ‘orderly’ movement. A currency that is too strong is an impediment to economic growth especially as both of the countries rely heavily on exports. In Japan, Finance Minister Yoshihiko Noda said this week that yen moves have been one-sided and that the Ministry of Finance (MOF) would carefully monitor FX markets. Japanese Chief Cabinet Secretary Edano echoed Noda’s statements noting that Japan is watching FX markets with tension. Both officials declined to comment on potential yen intervention. In Switzerland, Swiss National Bank (SNB) Vice Chairman Thomas Jordan said that policy makers are ‘very concerned’ about recent FX developments and that the bank is “monitoring the euro-franc exchange rate very closely”. The SNB has intervened in the past mainly in the EUR/CHF pair with limited success.

We expect markets to remain on edge with regards to potential intervention and view the likelihood of a BOJ intervention as greater than that of SNB action. In our view, the prospect for intervention even from Japan remains low as the Nikkei remains well above the March lows, economic indicators are showing signs of rebounding, and indicators of volatility are substantially lower than they were ahead of the previous September and March interventions. Jaw-boning from officials may continue in the week ahead and we would be cautious with CHF and JPY pairs as the risk of intervention is present.