August managed to end on a reasonably hopeful note after the drubbing that started the month, but September has started on a decidedly downbeat note. U.S. and European data continue to point to stalling recoveries and the market debate over whether it’s merely a slowdown or the start of a double dip recession has been reengaged. While it’s too soon to say which way the outlook may break, both prospects are decidedly negative for risk sentiment. Looking ahead, there seems to be little light at the end of the tunnel either, as governments continue to pursue austerity and deficit reduction measures even in the face of slowing growth. Pres. Obama is set to deliver a long overdue job creation plan next week, but it’s unlikely to result in meaningful stimulus measures given the intractable opposition of House Republicans. While the Continent and Washington fiddle, risk appetite and financial markets seem likely to see further distress in the weeks ahead.
Risk assets responded in relatively predictable fashion this past week, with stocks and commodities falling from key technical levels, gold soaring, and JPY, CHF and USD strengthening against other major currencies. The S&P500 tested the upper level of a potential bear flag consolidation channel we highlighted two weeks ago at 1230. Price was also rejected from above the daily Kijun line and has since fallen back to test the Tenkan line at 1176, both signs the downtrend may be resuming. The base of the bear flag is at 1140, below which we would expect declines to accelerate. The CRB commodity index similarly failed above the 342 daily Ichimoku cloud top and has since dropped back below the cloud, though it held above the 335 Tenkan line on Friday. Gold and silver rallied sharply back to near recent highs as Eurozone debt concerns reignited (more below), but we are cautious due to a shift in thinking on additional Fed easing (also more below). Safe haven currencies performed well, but they have all run into key price/intervention levels: EUR/CHF tested 1.1000 following Friday’s NFP report; USD/JPY is holding above 76.00/50 as the new PM/former Fin. Min. Noda warns on additional JPY strength; and the USD Index ran into the bottom of its daily cloud at 74.76. We’ll be watching all those levels next week, and breaks through them will suggest to us a more material erosion in risk sentiment. Until then, our preference remains to re-sell risk assets on rebounds.
Eurozone concerns ignite again on Greece
The Euro was the biggest loser in the past week against other G-10 currencies, as incoming data pointed to further slowing in the core and tensions flared again over Greece as the week ended. IMF/EU auditors suspended their examinations of Greek progress on deficit reduction targets as it became evident Greece was likely to miss its 7.5% deficit target due to a deeper than forecast recession. But the auditors also pointed to deficiencies in the implementation of austerity measures, and markets quickly grew worried that the next installment of EU/IMF aid to Greece would be withheld. We don’t think that’s plausible, since the result would be a Greek default, which the EU powers-that-be have ruled out. Should they ( Germany ) renege on that commitment, it would open the door to speculation of which member would next be thrown overboard. We think Greece will ultimately get the next aid package late in September, but with a serious wet noodle lashing by EU/IMF auditors.
Even though we don’t think Greece will be denied further aid, it doesn’t mean markets won’t continue to question the EUR and push it lower. Indeed, beyond Greece there are multiple reasons to keep selling EUR. Slowing growth in the core and weak growth on the periphery remain obstacles to further deficit reduction, suggesting broader Eurozone debt concerns should plague the single currency for some time to come. That same erosion in growth is likely to see the ECB step back more explicitly from further tightening, and next Thursday’s ECB press conference could see a much chastened Trichet. Last, but certainly not least, in a development we have been watching for several weeks now, German yields have plunged, narrowing the spread between US and German 2-year yields to levels last seen in January. The spread suggests EUR/USD should be trading around 1.3100/50. EUR/USD has also dropped back under the cloud (1.4251 cloud bottom/1.4267 cloud top), and the downside should remain in focus while those levels hold. Finally, the Tenkan line (1.4367) looks set to cross down below the Kijun line (1.4302), and with price below the cloud, that would constitute a strong sell signal, possibly making next week a very bad week for EUR. We look to use 1.4250/1.4360 as levels to enter short EUR/USD positions if possible.
Shift in thinking on additional Fed easing/QE3
The latest FOMC minutes released earlier this week suggest a greater likelihood of additional easing measures by the Fed. Perhaps significantly, they decided to extend the one-day Sept. 20 meeting to a two-day affair, where two-day meeting have historically tended to result in policy changes. The minutes indicated that more data would be needed, but incoming data since the last FOMC meeting has all been disappointing, highlighted by today’s zero change in jobs in August. While the Fed could decide it needs more time to evaluate the economic outlook, and certain hawkish members will oppose additional easing, we think the chance of additional Fed easing is increasingly likely later this month.
Among the more likely options the Fed has at their disposal to stimulate the economy is to lengthen the maturities of Treasury debt held, in an effort to drive down longer-term interest rates, which would lower consumer borrowing costs on mortgages and other financing rates, potentially spurring consumer activity. (The current average maturity is in the 5-7 year range.) The Fed could do this by selling shorter-dated debt and buying longer maturities in equal amounts, keeping its balance sheet at the same size. Additionally, the impact could be increased if the Fed also shifts its Treasury purchases from maturing MBS/agency debt to longer maturity Treasuries. Importantly for the USD, this would not amount to additional quantitative easing, as the Fed is not increasing the amount of money in the system. If they pursue this course, the USD may actually see gains against most other majors, the exception being the JPY, where USD/JPY would stay under pressure as US yields fall further. Additionally, the absence of increased asset purchases may also prevent another speculative surge in commodity and stock prices, which could simultaneously prevent another surge in inflation and shield the Fed from criticism it’s seeking to support equity markets, both key objectives for the central bank. Precious metals prices could also react quite negatively, as additional dollars will not be 'flooding' markets and inflationary pressures will be restrained, hence our caution on gold ahead of $2000/oz.
While we’ll need to see what the FOMC ultimately decides, the important point is that additional easing measures may not necessarily be USD-negative. If they choose to lengthen maturities without increasing the size of the balance sheet, it could turn out to be a USD-positive, as fears of QE3 are priced out. USD strength, in turn, could also contribute to further weakness in commodities on top of the absence of QE3. If they do pursue additional asset purchases and increase the size of the balance sheet, then the USD picture is worse, but it will depend on the size of QE3. We’ll be looking closely at the Sept. 7 Beige Book, as well as listening to what Fed Chair Bernanke has to say at his Sept. 8 speech, his next/last speech before the Sept. 20-21 meeting.
Key data and events to watch next week
United States: Tuesday – August ISM Non-Manufacturing, Fed’s Kocherlakota speaks
Wednesday – Weekly Mortgage applications, July JOLTs Job Openings, Fed’s Beige Book, Fed’s Evans speaks; Thursday – July Trade Balance, Weekly Initial and continuing jobless claims, July Consumer Credit; Friday – July Wholesale Inventories
Euro-zone: Monday – EZ August PMI Services, EZ July Retail Sales, EU’s Van Rompuy & Merkel meet; Tuesday – EZ 2Q GDP, German July Factory Orders, EU’s Van Rompuy speaks, Schaeuble addresses Bundestag; Wednesday – German July Industrial Production, Merkel addresses Bundestag, EU’s Rehn speaks, EU’s Van Rompuy speaks; Thursday – French 2Q NFP, German July Trade Balance & Current Account, French August Business Sentiment, French July Trade Balance, ECB Interest Rate Announcement; Friday – German August CPI, French July Industrial & Manufacturing Production, Italian 2Q GDP, EU’s Van Rompuy speaks, EU’s Merkel speaks
United Kingdom: Monday – August PMI Services, August Official Reserves, August BRC Retail Sales; Tuesday – August BRC Shop Price Index, August New Car Registrations; Wednesday – July Industrial & Manufacturing Production
Thursday – BOE Interest rate announcement; Friday – August PPI
Japan: SEPT 06-07 – BOJ Target Rate Wednesday – July Leading Index, July Current Account, July Trade Balance, July Machine Orders Thursday – Aug Bankruptcies, Aug Eco Watchers Surveys, 2Q GDP, Aug M2 & M3 Money Stock Friday – Aug Consumer Confidence
Canada: Wednesday – BOC Rate Decision, August IVEY PMI Thursday – July Building Permits, July New Housing Price Index, July International Merchandise Trade Friday – Aug Unemployment Rate, Aug Net Change in Employment, Aug Housing Starts, 2Q Labor Productivity
Australia & New Zealand: Sunday – AU Aug TD Securities Inflation, AU Aug ANZ Job Advertisements, NZ Treasury Monthly Economic Indicators Monday – AU 2Q Current Account Balance, AU July Home Loans, AU July Investment Spending Tuesday – AU RBA Cash Target Rate, AU AiG Perf of Construction Index, AU 2Q GDP, NZ Fin Min English speaks Wednesday – AU Aug Employment Change, AU Aug Unemployment Rate, AU Aug Participation Rate, NZ 2Q Manufacturing Activity, NZ Aug Card Spending
China: Monday – Aug HSBC Services PMI Thursday – Aug Consumer Price Index, Aug Producer Price Index SEPT 8-9 – Aug Industrial Production, Aug Fixed Assets Investments (excluding rural), Aug Retail Sales SEPT 9 -10 – Aug Trade Balance
Brian Dolan is chief currency strategist at www.FOREX.com.
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