As we start a new week there are high expectations for official action from the European authorities to reduce the credit costs for Spain and Italy, the latest victims of the sovereign mess. This comes after fighting talk from ECB President Mario Draghi on Thursday who said that the Bank would do "whatever it takes" to save the euro. Next the German and French leaders came out and also pledged to defend the single currency from attack.
Politicians and central bankers are fairly loose with the phrase "whatever it takes" especially during a crisis, so as we start a fresh week we need to find out three things: 1, what can be done to ease the problem, 2, what is the time frame, 3, will all Eurozone members agree to a solution. The ECB is the only institution in Europe that can stem this crisis in the short-term. Since Draghi mentioned that elevated sovereign premia (read: rising bond yields in Spain and Italy) are hindering the transmission of the Bank's monetary policy, this has increased market expectation that the Bank will take further policy steps at its meeting this Thursday. It is important to remember that Draghi added a caveat to his comments in London that the Bank could do "whatever it takes" in accordance with its mandate. Its mandate is to maintain a steady inflation rate at close or just below 2% per annum, not to re-finance governments. Thus, if Draghi believes that elevated borrowing costs are depressing growth and could weigh on inflation in the future then he has a mandate to act.
So what could the Bank do? The "gold" standard would be to give the Eurozone rescue funds a banking licence, that way the EFSF and then the ESM could print money and act as a lender of last resort for sovereigns in trouble, but essentially solvent, like Spain and Italy. This could be combined with a pledge to keep interest rates at a record low for a prolonged period and maybe even a full bailout for Spain. The "silver" package would be re-starting the SMP programme with a bang, and throwing a decent amount of cash at buying sovereign bonds. This would mean the Bank would have to do much more than the EU 210 bn of bond purchases it has done so far as Spanish and Italian bond markets are much deeper and more liquid than Greece, Portugal or Ireland. The bronze would be another round of LTRO and a loosening of collateral agreements so that it is easier for banks to get access to cash at the ECB that could then trickle down to the wider economy.
On balance we believe that the more likely route the ECB will take is a mixture of the silver and the bronze routes. Restarting the SMP programme would likely have a positive effect on Spain's sovereign bond market and since its domestic banking sector holds so much government debt this could boost the banks. The ECB also has control over banks, so it could probably get away with any action that could be seen to support the periphery's struggling financial sector.
The euro wins the fight with 1.20 for now
So what will be the market impact? ECB action in the past has tended to have a short sharp impact on asset prices (remember the short-term impact of the LTRO?). Thus, we don't think that ECB bond purchases will have a long-term impact on risky assets. A banking licence for the EFSF and ESM rescue funds could have a more stabilising impact on the market, but we don't think the ECB will stretch that far. Thus, as we lead up to the meeting on Thursday we think there is a high chance that the markets could be disappointed, which could spur a sell off in risk. EURUSD may have warded off attempts for it to break below 1.20 last week, but we think that the "positive" news from Draghi doesn't do enough to change the long-term picture for the euro, which we continue to think is bleak. If we start the week above 1.2360 then we could target 1.2410 then 1.2480, closely followed by 1.2510. Support lies at 1.2250 then 1.2040 - the lows from earlier this week. If the ECB disappoints then we may see a sharp decline in the single currency as the bounce higher that started last week has cleared the way for a decline towards the June 2010 lows.
Even with Draghi's support it is not a given that the Eurozone can stabilise in the near term. The ECB can't deal with the real problem: too much debt; that is up to the politicians to sort out. Sine there doesn't seem to be a real plan in place to 1, save Spain and 2, boost growth in the region, and Germany seems against stepping up bond purchases, we believe any ECB action this week will be a temporary salve at best to try and remedy this crisis.
Looking ahead next week's flash CPI estimate for July, the unemployment rate for June and the second reading of the PMI surveys for July are all released next week. Weak inflation will boost the chances of more QE (the market expects it to remain steady at 2.4%), while the PMI surveys are not expected to get any worse, although they remain below 50 in contraction territory. Debt auctions by Spain on Thursday and Italy on Monday are also worth watching out for to see if the decline in bond yields last week can entice investors to re-think the creditworthiness of the debt on offer from Madrid and Rome.
FOMC is prepared to act but maybe not next week
The Federal Open Market Committee (FOMC) will announce policy on August 1 at the conclusion of its 2-day meeting. Expectations of further monetary easing have been mounting as a result of increasingly dovish rhetoric from Fed officials (including the Chairman himself) and continued weakness in economic activity. However, we believe that the Fed will refrain from announcing a new round easing. In our view, the Fed is likely to wait for more employment data before announcing additional measures. Fed Chairman Ben Bernanke laid out a "range of possibilities" at his recent testimony before Congress. He indicated that options include the purchase of treasuries and/or mortgage backed securities (QE3), reducing the interest rate on excess reserves, use of the discount window, and altering communications on the forward guidance of interest rates.
The Bank has expressed its frustrations in meeting its employment mandate and soft labor data has raised speculation of QE3. While we would not rule out another round of purchases if job growth continues to disappoint, it does not seem likely that the Fed will pull the trigger before gathering more data. The July employment report will be released two days after the FOMC decision and therefore we think it would be more prudent for the Fed to assess its outlook following the release. Furthermore, with the ECB pledging support, pressure is taken off of the Fed to act for now ahead of the ECB's meeting next Thursday. Taken together, it becomes more likely for the Fed to remain on the sidelines in the upcoming meeting.
With some investors pricing in another round of QE, markets are likely to be sensitive to the tone of the FOMC statement. Fed expectations have been a key driver of price action and a more dovish statement may weigh on the USD while a less dovish statement may see the dollar trade firmer. The dollar index has corrected lower in recent days to test the 50-day simple moving average around 82.50, however it remains in a year-long upwards trend channel with support currently just above the 80.00 figure. While the USD remains in its long term bullish channel, we favor buying dips.
US employment data in focus
The USD has been sensitive to data surprises, especially employment data, as this is a key focus of the Fed. In the week ahead, the ADP employment change, weekly jobless claims, and most importantly the Bureau of Labor Statistics (BLS) July employment report are due. Consensus expectations of surveyed economists are for the addition 100k jobs in July on the headline nonfarm payroll change and an 8.2% unemployment rate. In the previous 3-months, fewer than 100k jobs were added to the U.S. economy. Weak job growth has adversely affected the ability to spend as reflected by declining retail sales, slowing personal consumption, and softer GDP growth. U.S. 2Q advance GDP released Friday morning slowed to 1.5% q/q annualized from 2.0% in the prior quarter. Another less than 100k print would be viewed as a negative which may further elevate speculation of QE3 and put pressure on the USD, while a better than expected reading would likely boost the dollar as it would reduce the probability of QE3.
The Olympics offer a flicker of hope to the UK
The biggest news of the week was the Olympics coming to London. Republican Presidential candidate Mitt Romney learnt how proud Londoners can be when he questioned if London was ready to stage the greatest show on earth. After sharp rebukes from the PM and the Mayor of London he swiftly changed his tune. Olympic fever is in the air, the weather is fine - the sun is out and the rain has kept off so far - could there be an uptick in consumer confidence for August? The UK economy certainly needs it after the dismal Q2 GDP report, which showed a decline in economic output of 0.7%.
The data is subject to revisions and growth could have been distorted by the 1, the Jubilee Bank holiday and 2, the bad weather especially in June, the wettest on record. However, the Chancellor may find it hard to keep blaming weak growth figures on the weatherman. He first did so in Q4 2010 after heavy snow fall. However, since then there have only been two quarters of positive growth in the UK, the rest have all been negative.
So can growth turn around in Q3? There is a good chance that the productivity lost in Q2 could be made up in the coming three months. Back in 2002 the Queen's Golden Jubilee caused an upward revision of 0.3% to growth, thus the -0.7% decline is probably painting a bleaker picture of the UK economy than is actually the case, but maybe not that much bleaker. The economy in 2012 is at a different point in the cycle, and even if growth is revised up by a couple of tenths of a per cent, the U's growth performance looks more on par with a country like Spain. The boost to retail sales and services from the Olympics, plus the pick-up in the weather in July could also help growth to "recover" in Q3, but we doubt this will disguise the weak state of the UK economy.
Manufacturing and service sector PMI's are released this week for July, which should give us a steer on how the economy performed. The manufacturing sector survey is expected to slip deeper into sub-50 territory, while the market expects a slight pick-up in the services sector to 51.6 from 51.3.
The market impact of a weak UK economy
The pound tends to have a fairly loose relationship with UK economic data, thus even though growth in Q2 was dismal, GBPUSD rallied. It is getting close to an important level at 1.5785 - the top of the Ichimoku cloud. Above here is the end of the technical downtrend. This level is likely to be sticky for this pair; it reached a high of 1.5760 during the European session on Friday. If it tests this level again at the start of a new week then we could see further gains towards 1.5810 then 1.5880 - a key resistance level from May.
The BOE may choose to remain on hold when it meets on Thursday because of the cloudiness that surrounds the underlying strength of the UK economy. We expect the UK economy to remain weak for some time and for the Bank to eventually do more QE and maybe even cut rates further. But, even if the economy is floundering, the immediate outlook for the pound is more likely to be driven by overall market sentiment than domestic concerns.
Japanese intervention rhetoric picks up
Japan's Finance Ministry has been increasingly vocal about the potential for action to stem currency gains. Finance Minister Jun Azumi reiterated that Japan would "act decisively if needed" against excessive moves in currency markets. Officials have made similar comments in the past and we believe that they may not pull the trigger on intervention just yet.
Despite a stronger JPY, volatility is relatively low compared to recent bouts of intervention (in Oct. and Aug. of last year). Moreover, previous interventions have not had a lasting impact as broader market activity and overall sentiment has been a main driver of the yen. Safe haven flows have been a primary factor of yen gains as investors around the world shun risky assets. Though yields in Japanese government bonds are very low, they beat negative yields that have been seen in other perceived safe haven countries. The threat of intervention increases as markets become more risk averse as volatility picks up and the JPY strengthens.
Intervention efforts in the past have not been able to reverse the trend in the Japanese yen and as such we would view weakness in the JPY as buying opportunities. With the country far from its 1% inflation target and still facing deflation (CPI released on Friday showed a prices falling -0.2% y/y), we would expect to see more stimulative measures, however FX markets have disregarded efforts by officials as the yen approaches historic highs.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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