As expected, EU leaders came up with a sufficiently credible plan to prevent a disorderly default of Greece , recapitalize EU banks, and increase the size of the EFSF in an attempt to quell contagion to other EU sovereign debt. Risk markets responded with a massive rally on what we think is over-exuberance, but also likely due to a huge squeeze on short-risk/long USD positions. The details of the EFSF expansion, the Greek debt swap and other mechanisms are still to be worked out over the coming weeks, but market sentiment over the package appears to be fading rather quickly.
No less of an authority than the new president of the Bundesbank, Jens Weidmann, has already called the EFSF expansion into question, telling a conference in Munich the plan is “not too different from those which were partly responsible for creating the crisis, because they concealed risks.” His comment hits at the critical issue behind the Eurozone debt crisis, namely that it’s all about confidence and perception. If markets believe the plan is credible, then it may not even be needed. But if markets don’t buy the notion that more borrowing will solve Italy ’s already over-extended debt, then even the expanded EFSF won’t be sufficient. Ultimately, that comes down to growth prospects for the individual debtor nations, and there we think the prospects are daunting to say the least.
European credit markets appear to be already voting with their feet, as core-peripheral bond spreads have begun widening again after a mere 24-hour respite. Italian 10 year government bond yields are back over 6% and Spanish bond yields have reversed their declines from the post-summit euphoria. US Treasuries rallied on Friday on safe haven demand, sending 10-year yields lower by about 10 bps in a potential failure/rejection above the daily Ichimoku cloud. US stocks look to have stalled for the moment, with the S&P 500 possibly topping below the top of the 1290 weekly cloud/1300 psychological resistance levels. Across markets, the rebound in risk assets this past week basically ‘closed the gap’ from the collapse that started in August (in stocks) and the surge in the USD that started in early September. While there has been some potentially serious technical damage done to the risk-off trade, we think we’re more at a crossroads than a major turning point. We will be especially alert for indications that the risk rebound is reversing next week. We think the FOMC will need to deliver QE3 for gains to continue (see below for more).
Back to the EU debt crisis, in the weeks ahead we think there is likely to be a fair amount of cheerleading for the EU package, not the least from next Friday’s G-20 meeting, and we expect several commitments of support from key potential investors, like China, Brazil, mid-east and other sovereign wealth funds; Japan has already signaled willingness to invest. We’ll be watching the reaction of risk assets on those expected signs of support, and the less risk markets respond favorably, the greater our doubts about the sustainability of the rebound will grow. We will be especially alert to how markets trade to start the week, after a weekend spent digesting the full implications of what the EU has actually delivered.
Next page: Analyzing the dollar
USD under pressure on a number of fronts
The USD was hit hard this week, as long-USD positions were liquidated en masse. Apart from positioning, the USD is under pressure as risk markets rebounded, reducing safe-haven appeal of the buck and US Treasuries. We would also note that risk aversion remains in the background as seen by continued strong demand for the other FX safety valves, CHF and JPY. But the big driver by far of the current risk rebound/USD weakness are growing expectations that the Fed may deliver QE3 at the conclusion of next Wednesday’s two day meeting (see more below). We would expect further USD weakness if the Fed delivers more QE, but it will depend on the size of the program. If the Fed abstains, the USD is more likely to bounce back. Lastly, we also think the USD is under pressure across the board on month-end portfolio re-balancing flows. Given the outsized gains in US stocks in particular, foreign investors have larger USD exposures and need to sell more USD to maintain hedging ratios. We would expect further USD weakness to start the week based on these flows, but that the selling pressure may culminate following the 11EDT fixing. If the USD shows resilience in early NY trading, it likely means markets have turned more risk averse on a reconsideration of the prospects of success of the EU debt plan and USD-demand is swamping asset manager USD-supply.
The USD index has dropped to finish the past week just above the 75.00 level, holding above the 76.4% retracement (75.01) of the late August rally to just below 80.00. In EUR/USD, that level equates to 1.4220/50 as the key hurdle to further gains. In AUD/USD, August highs at 1.0765 are the equivalent pivot to fresh upside. Gold prices have recovered as the USD has weakened and are currently testing the daily cloud between 1747/1756; price looks like it should open next week above the cloud top, which falls to 1727/26. However, be alert for a failure and daily close back below. Friday’s price action across most major USD-pairs also resulted in numerous small real bodies (doji and spinning tops) on daily candle sticks, an indication of uncertainty following Thursday’s huge rally/USD sell-off. This keeps us alert for a potential USD reversal, but mostly we expect further consolidation ahead of the FOMC.
Next page: Events this week
G-20, FOMC, ECB and RBA meetings next week
The G-20 will gather in Cannes, France on Thursday and Friday next week. We expect the group to show solidarity with the Eurozone and endorse the EU debt plan. We would also look for signs of cash-flush members indicating at least a strong willingness to consider investing in the EFSF and related vehicles, though firm commitments will likely need to wait until all the details are worked out.
On Wednesday, Nov. 2, the Fed is expected to maintain current rate policy, but the key will be whether they announce a third round of QE. We think there is a 50-50 chance that they announce a program to increase the amount of mortgage-back securities they’re purchasing. The move would be to complement the White House’s plans to revise the Home Affordable Refinance Program (HARP) and jump start the US housing market and potentially reinvigorate the broader economy. The key is the timing. The details of the HARP revisions are not yet finalized (sometime by mid-Nov.), so the Fed may announce a conditional QE3 pending the changes to HARP. But US data has also showed some improvement in recent weeks, potentially leading the Fed to hang on to this last bullet. Still, with unemployment stuck at 9%+, what’s the point in waiting. Bernanke will hold a quarterly press conference and take questions following the announcement.
This will be a major event for the USD, as recent Fed speakers hinting at QE3 have contributed to recent USD declines/rallies in stocks and other risk assets. If the Fed delivers QE3, we would expect further USD declines/gains in risk assets, but the size of the program will matter. QE3 on the order of $500 bio may not see much further USD weakness as the rumor has already been sold. QE3 of USD 1 trillion or more would likely trigger further USD declines. Analyst estimates suggest a program of USD 1-2 trillion is what’s needed to have the desired impact on the housing market and economy. No QE3 and the risk rebound is likely to reverse hard, especially if markets are already having second thoughts on the EU debt plan.
The ECB will meet on Thursday, with new president Mario Draghi at the helm. We don’t expect any changes to the ECB base rate, but we do expect a further weak economic outlook, which may add to pressure on the EUR. We expect Draghi to reiterate the ECB’s opposition to participating in the EFSF and maintain that the ECB will not be the lender of last resort. The ECB is the only European institution with the ability to fully resolve the debt crisis, so continued opposition is not a good thing for overall confidence in the debt crisis.
The RBA is meeting next week and is expected to announce a 25 bp rate cut to 4.50% when it announces on Tuesday afternoon Downunder, but it’s a close call with 11out of 26 forecasts indicating steady rates. More benign CPI this past week opens the door to a rate cut and we think recent AUD gains will also bias them toward a cut.
Brian Dolan is chief currency strategist at www.FOREX.com.
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