Risk sentiment stumbles again
Risk assets (stocks, commodities, JPY- and CHF-crosses, and commodity currencies) stabilized further to start this past week, but suffered what seems likely to be the first in a series of periodic relapses, as market conviction remains extremely low. We remain cautiously optimistic that the sell-off in the first half of August marked the low point in the current risk retrenchment, but we are keenly aware that risks remain skewed to the downside. In support of the view that a medium-term bottom may have been reached, we would note that last week's lows in most risk assets were not tested, much less breached. But to argue the bearish side, the charts do look quite damaged, with all major currency risk pairs and stocks trading below their daily Ichimoku clouds. In particular, we would also point out that the rebounds from late last week/early this past week, all reversed at or just below the Daily Kijun lines (see AUD/JPY and EUR/JPY Ichimoku charts as examples), a textbook example of a bounce within a larger downward trend. Lastly, on the S&P 500 we would note what may be the beginning of a bear flag consolidation channel, where a break below the 1120/25 flag base might signal declines are resuming. Gains above the 1215/20 flag top would be needed to invalidate the pattern. If we are in fact entering into a consolidation phase, we would expect to see continued short term volatility into the end of the month, but would then expect a resolution at the start of September.
To be sure, there is no shortage of negative news. While the ECB has managed to stabilize European sovereign bond markets, there is a creeping sense of stress in the European banking sector. Overnight interbank lending rates have been moving higher and there is growing talk of another potential USD funding shortage. European bank shares have been pummelled in the recent shakeout and we think banking sector stress is the most likely catalyst for a renewed bout of risk aversion. We will keep a close eye on interbank borrowing rates in coming weeks.
Waiting for Jackson Hole
Markets are waiting for next Friday's speech by Fed Chair Bernanke at the annual Fed symposium in Jackson Hole, Wyoming. A year ago, Bernanke used the venue to announce the Fed was considering a second round of asset purchases, which then came to fruition as QE2 started in November. From the August 26, 2010 Jackson Hole speech, the S&P 500 bottomed and turned higher, rising nearly 300 points by spring 2011. So the questions this time around are 1) Will Bernanke signal QE3? and 2) Will markets respond as enthusiastically, if he does? We think the answer is 'no' in both cases. A year ago, deflation loomed as a threat, while today inflation is temporarily elevated. A year ago, the recovery was struggling, and today it remains eerily sluggish. But there is little evidence that QE2 generated any sort of economic stimulus, apart from a stock and commodity rally. Besides market interest rates are currently below levels seen before QE2 was announced, meaning markets have done the work of QE3 on their own. Bernanke will surely repeat his prior indications that additional asset purchases remain an option, but we think the Fed is too far from consensus to expect more decisive signals. On the market reaction, the current gloomy outlook is predicated on reduced growth prospects, and the best that can be said is that maybe most of that negativity is already priced in. Perhaps Bernanke will pull a rabbit from the hat and strike a more confident tone, but we think markets in search of a saviour will end up disappointed.
However, in the run-up to Bernanke (ECB pres. Trichet will also be speaking there Friday), we think markets are still likely to anticipate some magic balm from him and we would not be surprised to see risk assets attempt to rally/safe havens decline early in the week (see below). We would then expect disappointment following Bernanke to see another risk sell-off as markets conclude there's no one riding to the rescue, and even if they are, they're out of bullets. Such a rebound and failure fits nicely with the potential S&P 500 bear flag consolidation channel highlighted above.
Are 'safe-havens' due for a short-term pullback?
Over the past week many of the traditional safe-havens have made new All-time highs - Gold, 10-year Treasuries, Japanese Yen and Swiss Franc (last week), due to fears over a potential European banking crises and slowing global growth concerns. In efforts to fight this risk aversion, a few central banks have taken action over the past 2 weeks. The BoJ/MoF intervened aggressively on August 4th by selling an estimated ¥4.6 trillion, which is the largest single day intervention since 2004. The Fed announced that they will keep rates exceptionally low...at least through mid-2013 at their August FOMC rate decision. The SNB initially expanded bank sight deposits from CHF30B to CHF80B and narrowed the Libor target range 0-0.75% to 0-0.25% on August 3rd, and then once again expanded banks' sight deposits a few days later to CHF120B. On top of all of this, even the Chicago Mercantile Exchange (CME) joined in when they raised gold margin requirements by 22%. Unfortunately, all of these measures failed to stem further risk aversion.
It wasn't until rumors circulated that the SNB may peg the Franc to the Euro (we've heard 1.15) that the CHF began to weaken. On top of this the SNB once again took further measures this week in an attempt to further weaken the Swissy by increasing sight deposits to CHF200B and restated their intention to use FX swaps to inject further CHF liquidity. This saw the Franc fall relative to the USD and EUR by over 13% and 14% respectively at one point this week. With that said, other safe-havens continued to strengthen. U.S. 10-year treasury yields reached a low of 1.97% yesterday, USD/JPY broke below the 76 handle today to touch 75.95 and Gold soared to a high of $1877 this morning (each of them new all-time records).
So where do they go from here? The torrent appreciation of these assets is currently unsustainable and we believe a short-term pullback may be warranted. It appears that safe-haven momentum is weakening as underlying indicators are failing to confirm these recent highs/lows, thus creating a divergence. Furthermore, using Elliot Wave analysis we have identified 5-wave sequences in both treasuries and gold which suggests a reversal is in order towards the prior wave 4 and/or 38.2% retracements. Therefore, we would not be surprised to see gold trade lower towards $1700/25 and 10-year yields to rise to around 2.40/45%. Additionally, USD/JPY may catch a bid towards 79/80.00 and USD/CHF could test 0.82/8300 over the coming days/weeks. However, in the end this is most likely just a relief rally rather than a longer-term bottom. Consequently, such a rally could be used as an opportunity to re-enter 'risk-off' positions in these otherwise turbulent markets.
SNB intervention risk is here to stay
Last weekend reports suggested that the Swiss National Bank (SNB) would consider taking drastic action to limit franc strength including a currency floor or peg to the euro. In the middle of last week the SNB did intervene although not using such extreme measures. The Bank announced FX swaps and more quantitative easing to try and reduce its value. After initially strengthening the franc eventually reversed course and EURCHF rose 2.6 per cent last week.
It seems like investors are taking the SNB seriously. However, we believe that it is unlikely that the SNB will use more extreme measures to weaken the franc for a few reasons. Firstly, a floor on EURCHF or a euro peg are nuclear options that would require a hefty financial commitment from the SNB. It would also mean that the SNB would have to lock in the Swissie at the current rate, which is already extremely strong. This could further damage the Swiss economy.
Secondly, If EURCHF looks like it is going to hurtle to parity once again we think the SNB will come out and announce a peg or a currency floor. But right now the cross is above 1.10. At this level we believe that intervention-lite measures like FX swaps, more QE and possibly a further reduction in interest rates are more likely means of intervention in the near term.
However, rumors have been circulating that the Bank may choose to introduce capital controls - a tax on foreigners/ speculators holding CHF. We think the tax would apply to future Swiss purchases and would only be applied to speculators. There is a high chance this could happen as it would show the markets how serious the SNB actually is about reducing pressure on the franc. Although this may spark fears of currency wars, we think there is a high probability of capital controls in the near future, especially if we see the franc start to strengthen again in the coming days.
Overall, intervention risk in the Swiss franc is here to stay. The SNB's FX reserves are now worth 50 per cent of GDP, up from 10 per cent of GDP when it intervened two years ago. Thus, it has the fire power to weaken the CHF if needs be and the threat of SNB intervention will remain a theme in FX markets for the medium term.
In the absence of a currency peg or floor we believe that EURCHF will trade in a range over the next few days. 1.1150 should act as good support as it is the 21 day moving average, a key technical level. Last week's high of 1.1550 should act as the range top.
The ECB calms sovereign debt markets
Spanish and Italian bond yields have remained below 5 per cent this week, out of the danger zone, after it was announced that the ECB bought EUR22 billion of their debt the week of 8th August. The Bank is likely to have continued actively purchasing debt this week. In the past the bond yields of Europe's most troubled nations have been positively correlated to stocks. But as stocks have sold off heavily this week, yields have remained stable, which is most likely to be down to the ECB.
While the ECB is helping to stabilize Europe, the politicians are having a de-stabilizing effect. Firstly, Angela Merkel and Nicolas Sarkozy highlighted the EU leaders' resistance to implementing radical measures to bring the crisis to a halt. Sarkozy ruled out the prospect of enlarging the EFSF rescue fund and German Chancellor Merkel has said that the euro-area would be worse off with the Eurobond. The joint issuance of debt by all members of the currency union has been hailed by some as the only workable solution to the crisis. However, it has divided Europe's leaders. While Germany is opposed to the idea, Europe's regulators may try and make Eurobonds legally binding. The head of the EU's Economic and Monetary Commission Ollie Rehn said that a report into the benefits of Eurobonds currently being commissioned will, if appropriate, be accompanied by legislative proposals to make the bond law. He said that these securities would improve fiscal discipline in the long-run, however no other details like a deadline for the report were disclosed.
It is unlikely that anything as drastic as Eurobonds will be introduced in the near term since members are still arguing over the second bailout loan to Greece agreed on 21 July. On Thursday, Finland announced that it would demand collateral from Greece in return for second bailout loans. This opens the way for other member states to demand the same, and on Friday the Dutch Prime Minister said that he wants also wants a secured loan before he lends more money to Greece.
As we enter the last week of August the Eurozone's sovereign problems seem no closer to being resolved. Combined with this growth is slowing, second quarter GDP moderated to a 1.7 per cent annual rate from 2.5 per cent in Q1. German growth also slowed sharply. This week's PMI data is expected to show a contraction in the manufacturing sector and further weakness in the service sector. This doesn't bode well as Europe's economies need growth to reduce debt levels.
However, the euro remains fairly resilient and EURUSD traded between 1.4500 and 1.4250. This range trading is likely to persist, but we think the risk remains to the downside. Even though Europe is suffering from slow growth and a sovereign debt crisis, the US and the UK both have seen growth slow and their debt problems are actually worsening, so we think EUR resilience is only due to others' weakness. As such, we remain on alert for a renewed flare-up in Eurozone risk perceptions and the potential for a drop below 1.4250 to see a re-test of the more important 1.4000/50 range lows.
Key data and events to watch next week
United States: Monday - July Chicago Fed National Activity Index, 2Q Mortgage Delinquencies and Foreclosures Tuesday - July New Home Sales, August Richmond Fed Manufacturing Index Wednesday - Weekly MBA Mortgage Applications, July Durable Goods Orders, June House Price Index Thursday - Weekly Initial and Continuing Jobless Claims Friday - 2Q second GDP and Personal Consumption, August Univ. of Michigan Consumer Confidence, Bernanke speech at Jackson Hole
Euro-zone: Tuesday - EZ August PMI Services and Manufacturing, German August ZEW Survey, EZ August Consumer Confidence Wednesday - German August IFO, EZ June Industrial New Orders Thursday - German September GfK Consumer Confidence, French July Jobseekers Friday - EZ July M3
United Kingdom: Tuesday - July BBA Loans for House Purchase, August CBI Trends Orders and Prices Wednesday - July Nationwide Consumer Confidence Thursday - August CBI Reported Sales Friday - 2Q preliminary GDP, June Index of Services
Japan: Monday - July Store Sales Tuesday - July Machine Tool Orders Wednesday - July Corporate Service Price Index Friday - August Tokyo CPI, July National CPI
Canada: Tuesday - June Retail Sales, BoC's Boivin Speaks Wednesday - BoC's Macklem Speaks
Australia & New Zealand: Tuesday - RBNZ 3Q Inflation Expectations Wednesday - NZ July Trade Balance, AU June Conf. Board Leading Index, AU 2Q Construction Work Done, NZ Finance Minister English speaks Thursday - NZ July Food Prices, NZ 2Q Retail Sales, AU 2Q House Affordability Friday - RBA's Stevens Testifies to the House
China: Tuesday - August HSBC Flash Manufacturing Friday - August MNI Business Condition Survey, July Industrial Profits
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