What to look for in the week ahead The Week Ahead updated July 2, 2010

• EUR bounces and the USD sags • Risk retreat accelerates on China, US • ECB refinancing center stage; banking woes likely a more durable concern • Steady policy for the BoE, but the inflation debate rages

EUR bounces and the USD sags The Euro came storming back in a massive wave of short covering on the first trading day of July and a day before US employment data was released. The ostensible basis for the rebound was the successful 3 month ECB refinancing operation (more below), but a more likely explanation was extreme EUR short-positioning. The first clue is that the EUR's gains came against all major currencies, but the biggest losers vs. EUR were those with the largest short positions: CAD -2.66%; USD -2.59%; and AUD -2.29%. Perhaps most strikingly, the price of gold denominated in EUR fell nearly 60 EUR or almost 6% and those in silver almost 6.7%. The second clue was the supposed easing of funding tensions in Eurozone money markets. While it's true that the 3-month refi saw only about EUR 130 bio taken, less than the expected EUR 250 bio, it's also true that the following day's 6-day auction saw more than EUR 110 bio taken up, bringing the total rollover of ECB financing in the past week very close to the expected demand. It may be that Euro-area banks have simply opted for shorter-term borrowings in light of ECB pledges to keep unlimited funding in place, but it's still clear that financing for European banks remains problematic. More tellingly still is that Euribor lending rates jumped the most in a single day since the height of the financial panic (Oct. 2008) and to the highest since last fall. Clearly, the European banking sector remains stressed.

The next key event will be from the middle of July onward, when the ECB is expected to make known the results of the so-called 'stress tests' of Euro-area banks. While there are many variables involved, the most likely outcome is that regional lenders (e.g. the Landesbanken in Germany and the Caja's in Spain) will be judged to need significant state-sponsored recapitalizations, while the larger international banks may get a clean bill of health. The latter could see some relief in markets, but if the necessary recapitalizations (or potential insolvencies) are large enough, the new burden on government budgets is likely to outweigh and hurt the EUR on debt/deficit concerns.

While the EUR has additional potential higher while daily closing prices hold above 1.2450/1.2500, we think the move higher will be short-lived and prefer to use further strength as a selling opportunity. In particular, the daily Ichimoku cloud bottom is key daily close resistance at 1.2594 (it falls to finish next week at 1.2431), where a daily close above would put our view in doubt. The weekly Ichimoku Tenkan line at 1.2619, the first line of resistance, contained the past week's EUR/USD rally (high of 1.2610/15), so that is another source of resistance to keep an eye on. Friday's price action (at this writing, at least, 4 hours before the close) looks to have made a spinning top on the daily candles, a sign of uncertainty after the prior day's move up, and a potential reversal signal. The price action on Monday and Tuesday will be very important to determine whether the EUR recovery is for real or what we think is a flash in the pan.

The USD also experienced notable weakness throughout the past week as US data consistently disappointed and traders positioned for an anticipated weak US jobs report. US Treasury yields fell to new lows for the current decline, adding pressure to the buck, especially against the JPY. But 10-year US Treasuries showed some signs of stabilization at the end of the week and may be basing out above 2.85/90%. USD/JPY will remain mired below 88.50/89.00 while yields are below 3.00%, and in the current environment of risk aversion, it's difficult to contemplate a sudden rebound in sentiment or yields. In fact, just the opposite seems more likely, with 10-year yields falling further to 2.70%, and sending USD/JPY down towards 85.00. Which raises the question of when the 'USD as safe-haven currency' will re-establish itself? If risk sentiment continues to deteriorate, which we think likely, we can easily envision USD/JPY moving lower, while the USD strengthens against other currencies (except CHF), resulting in further downside for the JPY-crosses (AUD/JPY, CAD/JPY, EUR/JPY, GBP/JPY and NZD/JPY).

Risk retreat accelerates on China, US Risk assets saw marked declines in the past week, with stocks falling sharply, the CRB commodity index losing nearly 4%, and JPY crosses all lower (with the exception of EUR/JPY). The reasons are quite clear with stagnant Eurozone growth/banking sector concerns and new evidence of a faltering US recovery. In last week's note, we argued that the global recovery was in greater jeopardy now that the anemic US rebound looked to be joining Europe/UK as a drag, with China and Asia left as the main pillar of demand. We can now add China to the club of slowing recoveries and this obviously strengthens our view that risk sentiment is likely to deteriorate further in the weeks ahead. In this environment, commodity currencies (AUD, CAD, and NZD) will likely continue to suffer and we find it very difficult to see how EUR and GBP can avoid further weakness either. While the USD-index has indeed suffered some damage, and many analysts are calling for further declines, we think the USD may surprise with a quick rebound. But rather than swim against a potentially new tide against the USD, we will wait for some evidence of a reversal, and we would highlight early next week as a critical time. If the USD rebounds on Monday/Tuesday, we'll take it as a sign that this past week's moves were the anomaly and that recent correlations are reasserting themselves.

ECB refinancing center stage; banking woes likely a more durable concern Money market activity has been a central force in both European fixed income and FX markets this week. Its impact may lessen in the coming weeks but it is likely to remain a prime focus near-term. It was the expiration of last June's ECB 12 mth EUR442 bln allocation that created the unease. The 12 mth loan was part of the ECB's package of emergency measures aimed at ensuring ample provision of liquidity at the height of the financial crisis. This year the ECB has committed itself to withdrawing emergency liquidity measures. The 12 and 6 mth 1% loans have been withdrawn with declining demand for funds noted at the most recent 6 mth allotment. While conditions in the inter-bank market had eased by the end of last year, in recent months fears that some European banks could be saddled with non-performing loans have led to increased tension in the money market. Reports that some banks are having difficulties funding themselves in the open market have coincided with an increase in speculation that the ECB remains the prime source of funds for some financial institutions. This implied that the withdrawal by the ECB of its emergency liquidity provisions could thus trigger difficulties for some banks.

In the refinancing, the 3 mth 1% loan which was scheduled to coincide with the expiration of last June's 12 mth loan created much lower than expected demand for funds; EUR 131.9 bln was lent. That said, the fact that the allocation was spread among 171 bidders and the 1% interest rate was much higher than the interbank rate suggests that all is not well. Also worrying is that the ECB followed the 3 mth loan with an EUR 111.2 bln 6 day loan also at 1% which also suggests that things are not all as they should be. In reaction to these money market operations 3 mth Euribor jumped to 0.782%; the highest rate since Sept last year and the biggest daily gain since October 2008, when strains in the US banking sector were at their peak. Yields on the 2 yr German note coincidentally jumped by 9 bps and 10 yr bunds yields also saw upward pressure. This upward pressure on rates may be giving the EUR some short-term support. However, insofar as it coincides with fears over the strength of the global recovery the timing is poor and the ECB need to tread particularly carefully in its management of liquidity in the coming weeks. On the assumption that the ECB have no desire to signal tighter policy via money market operations, concerns over the health of some European banks is likely to be a more durable influence over the summer suggesting that the EUR is likely to remain under pressure on a 3 mth view. That said, with focus on money markets the July 8 ECB press meeting could be another colorful event.

Steady policy for the BoE, but the inflation debate rages The BoE is not expected to alter policy at the July 8 meeting. That said two MPC members have made known their inflation concerns over the couple of weeks. Most notably Sentance voted for a rate hike during the June meeting. Since then Posen has noted a slow upward creep in inflation expectations. The depth of concerns over inflation within the MPC will not be known until the publication of the minutes but the fact that this debate exists will make sterling particularly sensitive to all inflation indicators suggesting the PPI release could garner more attention than usual. Now that the initial impact of the government's austerity budget is past movement in the sterling crosses are likely to be more heavily impacted by movements in EUR/USD. Upside in EUR/GBP remains constrained by resistance in the 0.8275/8300 area. A break above could lead to some short term gains for the EUR. That said, with European banking concerns set to weigh on the EUR this summer, EUR/GBP may continue to trend lower on a 3 mth view.


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