Highlights

  • Trading the potential jump in risk appetite
  • Greece needs budget reform to win back confidence
  • UK politics/economics may be turning favourable for GBP

Trading the potential jump in risk appetite

The 1Q earnings season kicks off next week and if the last reporting season is any indication, it should have significant implications for risk appetite. 4Q earnings were viewed as constructive for the markets as they showed the first semblance of organic growth. In other words, all of the earnings were not based on cost cutting alone but also a smart pickup in top-line activity. While cost cutting did dominate and helped overall earnings beat expectations by more than 5% in 4Q, sales figures also impressed to the upside by nearly 2%.

We expect this pattern of organic growth to continue and show through in the 1Q reports. Estimates for overall earnings growth currently rest around 30% from a year ago. To be fair, very low comparable levels from last year make reaching this threshold quite easy. However, the evidence of late (especially from the retail space) suggests we could surpass these estimates in a big way. Should this come to fruition, there are a couple of plays in the currency space that should do quite well.

In this vein, we like to look at the inter-market correlations and what has done well in tandem with equities this year thus far. The currency pairs best correlated with US equities in 2010 thus far have been - perhaps unsurprisingly - USD/CAD and AUD/USD. The former has seen a whopping -95% correlation while the latter has moved in concert with stocks 90% of the time this year. Should we see a similar rally in equities that we got in 1Q (roughly 7%) this would pin the S&P 500 near 1275. While not our base case, it is important to note that given the 2010 relationship this would place USD/CAD near 0.9530 and AUD/USD around the 0.9800 area by the end of June.

The better tone to earnings would also do well to nudge economic optimism higher. This coupled with what is likely to be a slow but steady improvement in US economic data should help yields trend higher. We witnessed this past week the US 10-year flirting with the 4.0% area only to be rejected on what was a very constructive auction later in the week (positive for bond prices, negative for yields). We think this was only the beginning stages of what will be a gradual move higher, however.

In terms of playing this via the currency markets, USD/JPY stands out. The pair has seen an impressive 93% correlation with 10-year yields in 2010. The next major area of resistance once we clear the 4.0% hurdle is 4.3% and a move up there would translate with a USD/JPY trading near the 100 zone. Food for thought!

Greece needs budget reform to win back confidence

Speculation that the EU may step in with a bail-out for Greece over the weekend provided a boost for the EUR ahead of the close of the European business week. Comments from EU President Van Rompuy that the EU stands ready to intervene on Greece and remarks from the European Commission that the interest rate that Greece would be charged would be worked out in due course suggested that the authorities are working out the detail on how last month's EU support mechanism could be tailored to meet the needs of the Greek government. Without doubt time is running out for Greece. While the Debt Agency has met its April funding requirement, there is a need to raise EUR11.6 bln in May and EUR 32 bln through the rest of the year.

While Greek bond yields have retreated from their highs, the government cannot issue at current levels and simultaneously hope to slash its budget deficit to 3% of GDP by the end of 2012. While emergency funding from the EU or the IMF may provide some temporary relief to the Greece funding crisis, it cannot heal the budget deficit. Years of fiscal mismanagement, a culture of low collection of taxes and inaccurate statistics has left the market sceptical of the ability of Greece to embrace severe economic reform. As a consequence the EUR saw little initial reaction to the announcement by the Greek government that the Q1 budget deficit has declined by 39.2% to EUR4.3 bln. The EUR may see relief in the near-term if Greece funding crisis is offered a reprieve. However, the market will need to see concrete proof that Greece is implementing budget reform before it takes Greece off the watch list. The EUR thus remains vulnerable.

UK politics/economics may be turning favourable for GBP

UK political opinion polls have not been consistent, but over the past week the Tory opposition party has found additional support. A commitment by the Conservatives that they would not raise national insurance (tax on wages) has been met with approval by the electorate and their decision to clarify how they would make GBP 12 bln in efficiency savings has been met with relief in the markets. The Tory party's promises to tackle the budget deficit have made it the more market friendly political party. However, its previous lack of detail on budget reform combined with fears that too much austerity too soon could lead to a double dip recession have been undermining support. Fears of a double dip recession were further pushed into the background on the release stronger than expected manufacturing production data and on the indication from the NIESR that the economic recovery continued in Q1 in spite of prolonged wintry weather. If the Tory party pull a victory out of the hat on the May 6 election day EUR/GBP would likely move a notch lower. This outcome would also strengthen the likelihood that cable has already seen the lows of the year.