- Ouch! Where to from here?
- German election likely to provide more evidence of Greek fall out
- Data point to continued USD strength
- UK markets need to see election ambiguity cleared
- Key data and events to watch next week
Ouch! Where to from here?
A few weeks back, in the April 16 weekly report, we suggested that the rally in risk assets (Stocks, commodities, long JPY-crosses or carry trades) was set for a correction lower. The intervening weeks were mostly sideways to neutral, but we stayed with the view that risk assets were topping and that the risks remained to the downside. (Our 'gold lower' view was obviously misplaced.) Just last week, we pointed to several market internals and technical signs that such a correction might unfold:
Reprinted from April 30 The Week Ahead
Risk sentiment may falter further
This past week saw some extreme volatility across all asset markets, but by the end of the week, many recent range levels had held. The clear exception was gold, which is closing at new highs for the current advance. The demand for gold suggests all is not well in risk appetite-land and that in turn suggests that risk assets may see further downside in the near-term. In stocks, the S&P 500 posted both a weekly and daily bearish engulfing line as well as a close below the daily Kijun line. In FX, the JPY-crosses topped out before the end of the week and are showing signs of failure/rejection after attempts above the week's highs. In USD/JPY, a test above the top of the weekly Ichimoku cloud at 94.28 failed, potentially setting up a return to the cloud base around 91.90 next week. US Treasury yields also look to be extending their decline, closing at new lows (3.65% in 10 Year US notes) and below the daily Ichimoku cloud. A move higher in Treasuries/lower in yields is negative for USD/JPY and likely risky assets overall as it suggests safe-haven buying similar to what's driving gold.
However, while getting the direction correct and the timing reasonably prescient, this past week's price moves overwhelmed our expectations completely. For instance, in our 2Q market outlook, presented on March 16, we forecast that EUR/USD would see a range of 1.32-42 and that the risk was for a drop below 1.32, which would then target a move to the 1.25/1.27 area. 1.3200 held on a daily closing basis for the first month, but once it gave way EUR/USD plunged to 1.25 in a matter of days. Along with many in the market, given the speed of the price moves, we are left wondering where we go from here. The outlook is further clouded by the price distortions from Thursday's stock market collapse and rebound.
At time like these, it's helpful to take stock of why this is happening to gauge the potential for a continuation or a correction. In broad brush strokes, there are two main forces driving risk assets lower: the global recovery and European credit market contagion. The global recovery is clearly ongoing, but recent developments (China restricting credit, increasing risk of credit markets seizing up on peripheral Europe debt, financial regulatory reform, etc.) suggest the easy money has been made and that risk aversion is increasing. On European credit market contagion, absent a policy response from the EU/ECB to settle increasingly nervous credit markets, the risk environment looks set to worsen. We would note that markets fell most precipitously after the ECB briefing in which Trichet offered no hint of additional liquidity/credit measures, as he turned a blind eye to what markets were saying. (We would also note market rumors on Friday that the ECB would announce over the weekend a EUR 600 bio credit facility to support Eurozone banks, which we don't find convincing.)
Over a multi-week horizon, technical developments suggest there is more room on the downside for risk assets. But Friday's price action (a number of spinning tops/inside days) suggests that in the short-run (i.e. next week) there is some potential for consolidation and a correction. Overall, we would focus on re-selling risk assets on corrections higher and we'll closely watch recent lows for indications declines are resuming. USD/JPY and its highly positive correlation to US Treasury yields will serve as the likely best barometer of risk sentiment, and it while it remains below 3.50/55% risk is likely to remain in the off position.
Among the key technical breaks that occurred this past week, the S&P 500 closed just below the base of the daily Ichimoku cloud at 1112.97 (it rises to 1116/1119 next week), but above the 200-day mov. avg. at 1095.74, and well below a cluster of trend line support in the 1140/50 area. 10-year US Treasury yields closed inside the weekly cloud, just below the weekly cloud top at 3.4424, and well below the daily cloud up at 3.74. WTI crude oil closed below the daily cloud (bottom rises to 78.25 next week) and the 200-day mov. avg. at 76.43, but above key trend line support at 74.39. In FX, USD/JPY closed inside the daily cloud, base at 91.46 and above its 200-day mov. avg. at 91.29. EUR/USD is below most every support, but has seen a bounce from the 1.2500 level for time being; a daily close below the March 2009 1.2457 low should see losses extend. GBP/USD closed well below the daily cloud bottom at 1.5066, but closed above Feb/March lows at 1.4780/85 and posted a potential spike low reversal. AUD/USD closed below the daily cloud (base at 0.8916) and below the 200-day mov. avg. at 0.8965, but bounced just above the top of the weekly cloud which rises to 0.8771 next week. USD/CAD closed above the daily cloud top at 1.0422, but below the 200-day mov. avg. at 1.0509. AUD/JPY closed below the daily cloud bottom at 81.64 and the 200-day mov. avg. at 81.83. EUR/JPY is below most everything and remains biased lower while below the 118.34 daily Tenkan line. GBP/JPY is similarly situated and remains vulnerable while below 137.75/138.03 Tenkan/Kijun lines. As should be apparent, some key levels have been broken, but potential exists to regain many of them and set the stage for a correction.
German election likely to provide more evidence of Greek fall out
The May 9 regional elections in Germany are expected to weaken the political position of Chancellor Merkel. The indebtedness of the North Rhine Westphalia region has surged over the past decade leaving the populace in no mood to support a bail-out of Greece. Merkel's difficult position is yet another example of fallout from the Greek crisis which has now rocked markets across the globe. The ECB has made clear that it does not have a mandate to fix the problems of a sovereign government and this has intensified the pressure on Ecofin ministers to ring fence Greece and prevent further contagion from spreading through to other markets. Portugal is due to issue debt this quarter, if capital flight from its bond market continues it may find it difficult to affordably raise funds in the open market. This would be a situation unwelcome to everyone and illustrates how important it is for EU officials to be seen taking further action to deal with Greece's fiscal situation. The market's view is that default is probably unavoidable for Greece. Therefore as long as Ecofin continue to offer supportive rhetoric to Greece without taking concrete action that will fix Greece's ailments long-term, the EUR will remain under pressure. EUR/USD's long run average since inception is around 1.1830; the EUR could yet fall a lot further.
Data point to continued USD strength
The economic data this week continued to point to a recovery well under way in the United States. Top tier reports for manufacturing activity, business spending and employment were all constructive and a welcome sign for the USD bulls.
ISM manufacturing rose to 60.4 in April after a 59.6 read the prior month. This was the highest print since June 2004 and another reminder that the manufacturing renaissance in the US continues unabated. Business spending also looks poised to contribute nicely to GDP in 2Q. The March factory orders report showed a sharp 4.5% monthly increase in nondefense capital goods excluding aircraft. This is the number that feeds directly into the business spending component of GDP and the pop in orders is a very good handoff for 2Q growth. This coupled with strong 1Q corporate earnings reports suggest firms might be ready to ramp up hiring in the months ahead.
Speaking of hiring, the April nonfarm payrolls report surprised markets with much stronger than expected results. NFP printed 290K on the headline while the private payrolls number rocketed 231K on the month. This means the impact from the census hiring (government workers) was much lower than the anticipated 120K distortion. The unemployment rate did edge higher to 9.9% from 9.7%. This is a bit deceiving, however, as the unrounded increase was to 9.863% from 9.749% and thus much less than the two tenths advertized pop. What is more, the increase was due to an expansion in the participation rate, as previously discouraged workers came back into the labor market. The 805K jump in the labor force was the highest since January 2003, the quarter that saw US employment finally put in a cyclical bottom. The economy went on to add more than seven million jobs over the ensuing four years.
The strength in US data in the face of intensifying problems in the Eurozone and how this will lead to (at best) the fiscally-austere peripheral economies underperforming over the next few years gives us even more confidence that the US dollar will continue to handedly outperform the Euro.
UK markets need to see election ambiguity cleared
The UK general election result produced what the opinion polls had been predicting since the end of 2009; a hung parliament. The Conservative party won the most parliamentary seats. However, it is short of an overall majority. Although the Labour party came in second, under the terms of the constitution Brown remains PM and is within his rights to try and form a new government. That said, even with the support of the LibDems he would be short of a majority. A Labour/LibDem coalition may thus be unworkable. The ambiguity that this result implies has taken its toll on the pound. In the best of times the markets do not like uncertainly. Given that the UK government currently has a budget deficit in the order of 11.5% of GDP the costs of having a weak or indecisive government could be particularly high. Following sharp initial falls, the prospects for the pound have improved slightly in the hours since the election results first became clear. Firstly, the Lib Dem leader Clegg leader made it clear that he would be willing to negotiate with the Tory party. Cameron has since reciprocated this offer. A coalition government or a working Tory minority government may thus be possible. Failing this PM Brown has made it clear that he is willing to talk with all leaders. While a swift end to cross party talks would be reassuring for the pound, investors are likely to remain skeptical of any minority/coalition's performance in deficit reduction until clear action is seen. In the coming months and years, sterling and UK gilts are likely to be judged harshly by how successful the new government is in making inroads into fiscal repair. Against this backdrop, sterling buyers may remain thin on the ground. That said the crisis in the Eurozone should pressure EUR/GBP lower.
Key data and events to watch next week
The top tier data reports continue next week in the United States. The NFIB small business activity indicator and wholesale inventories kick off the week on Tuesday. International trade and the monthly budget are up on Wednesday while import prices and jobless claims are due Thursday. The key data will come Friday in the form of retail sales, industrial production and the University of Michigan consumer sentiment index.
It is an ultra-important week in the Eurozone. EU Foreign Ministers will hold a meeting on Monday (Greece the topic du-jour?) while French business sentiment, French industrial production and German trade are due that day as well. German consumer prices are up on Tuesday while Wednesday brings EZ industrial production, EZ GDP and French consumer prices. One of the highlights of the week will be Friday when Greece is due to submit its deficit-cutting progress report to the EU.
The UK has a key week ahead as well. Monday is exceptionally busy with the BOE rate decision and asset purchase target on deck along with the retail sales monitor, home prices and industrial production. The NIESR GDP estimate is up on Tuesday while the employment report, quarterly inflation report and consumer confidence are up Wednesday. Trade numbers round out the week on Thursday.
Japan will see a pretty normal week. Leading indicators, the current account, trade balance and bank lending make for a busy Wednesday. Thursday has the Eco Watchers economic surveys as the only other noteworthy reports.
Canada's week is light but important. Housing starts kick off the action on Monday while Wednesday has new home prices and international trade on deck. Friday rounds out the week with new motor vehicle sales and manufacturing sales.
There are some top tier events down under. Australia has business conditions on Monday, home loan data on Wednesday and the employment report on Thursday. New Zealand sees credit card spending on Monday, business PMI on Wednesday and retail sales on Thursday.
Keep an eye on China in the week ahead as well. Monday has trade data lined up while Tuesday will be busy with producer prices, retail sales and industrial production.