Week Ahead - week of 12th March
- What now for the euro?
- To hike or to cut? A global central banker's dilemma
- Why the rise in oil prices should grab our attention
What now for the euro?
The debt deal agreed by Greece and its private sector bond holders to wipe EUR 100 billion from its enormous debt pile was an historic move: the largest sovereign debt restructuring in history. This is the latest piece of the jigsaw to try and solve the sovereign debt crisis, but the market's response suggests that the saga does not end here.
Not only did Fitch place Greece into selective default after Collective Action Clauses or CACs were introduced to force reluctant bond holders to accept losses, but as Europe closed on Friday night expectations were growing that Credit Default Swaps on Greek debt would also be triggered.
These moves were expected and as such had a relatively minimal impact on the markets. What was unexpected though was the deeper than expected contraction in the Greek economy in Q4 2011. The economy shrank by a massive 7.5% last year, which is the seventh consecutive quarter of negative growth. Even with haircuts on private sector debt now in place, the lack of growth in the Greek economy means that debt targets for 2012, let alone the 120% debt-to-GDP target for 2020, will be tougher to achieve. This week we get unemployment data from Athens, which is already at 17.7%, and is expected to deteriorate further.
But now that Greece has agreed on the private sector debt swap along with austerity cuts to the tune of EUR 3 billion earlier this year, Athens is expected to be given its next tranche of bailout funds on Monday. Is this merely throwing good money after bad? Yes in our view, especially if there is no accompanying growth strategy to neutralise some of that austerity. Unlike the developing world, if a country like Argentina receives IMF aid and agrees to austerity it gets support to re-build its economy from the World Bank. In contrast, the Eurozone has no World Bank; hence Greece's future plans are lopsided and are likely to mean more support from the EU community and investors may be necessary down the line.
But while Greece dominates the headlines what really matters for the markets and for the euro in particular, is what the ECB is doing and what is happening with the other economies in the Eurozone. We will learn more about the German economy this week when the ZEW investor sentiment survey is released on Tuesday. The forward-looking component is expected to rise to its highest level in 12 months in March, which underlines the two-speed economy in the currency bloc.
This leaves a major headache for the ECB. It has focused its efforts on recapitalising banks with its LTRO auctions, which placated markets and helped the single currency to recover from its 1.26 low at the start of the year. But the Bundesbank, the German central bank, has voiced its criticism with the cheap debt offered to European banks, which could make another round of funds less likely. Added to that the focus shifts to inflation this week, as European CPI numbers are released.
Economists expect prices to remain steady at 2.7% when they are released on Wednesday. However, the risks are to the upside as oil prices remain elevated.
ECB President Draghi already pointed out the upside risks to inflation in his press conference last week and his tone was decisively less dovish than some expected. Inflation fears combined with German resistance to more liquidity provisions to banks may mean that the ECB's next move is to remove liquidity and follow the Fed by shrinking its enormous balance sheet - currently EUR 3.023 trillion.
Thus, oil prices and the inflation data in the currency bloc could overtake Greece as the main driver of EURUSD going forward. On Friday we closed the week in Europe with EURUSD looking very weak and testing 1.31. This makes a breach of 1.30 vulnerable, however, signs of a less dovish ECB could limit euro losses and due to this Draghi's speech on Tuesday along with the release of the Bundesbank's annual report should be watched closely, as signs of hawkishness could make 1.30 a very sticky level for EURUSD in the short-term.
To hike or to cut? A central banker's dilemma
In recent memory it's hard to find a time when central bankers were stuck in such precarious positions as they are now. The arguments for more monetary stimulus in Europe, the US, the UK and emerging markets are all fairly potent; however the arguments against further stimulus are also strong. So what is a central banker to do?
Let's take the US first. February's payrolls report showed a very healthy 227K increase in jobs. This would usually suggest that the US economy is back on a self-sustaining growth path; however, the detail of the report was far less encouraging. Firstly, the under-employed rate - the total unemployed persons plus those who are only marginally attached to the workforce, or those who are working part time because they can't find full-time work, remains a hefty 14.9%. Although this number has fallen, it is still far too high for the Fed to take its foot off the pedal. The fact that 45,000 of the 82,000 jobs created in the professional and business services sector were for temporary help positions could also keep the Fed cautious going forward.
Added to this, the type of jobs the US is creating are the wrong kind - i.e., not the high-paying jobs that can fuel a consumption boom. For example, there have been a high number of jobs created in restaurants and bars that are typically low paying. This is why hourly earnings have increased by a measly 1.9% over the past year. Compare that with 2007 when the US was seeing wage growth of nearly 4% per annum.
Post the payrolls report on Friday we witnessed a strange phenomenon. Although we saw a strong payrolls number, which caused USDJPY to spike above 82.00, Treasury yields, which usually have a close relationship with USDJPY, remained weaker. 2-year US Treasury yields remain at 0.3%, while 10-year yields are just over 2%. Thus, if wages remain constrained it's hard to see the impressive 3% annual growth rate recorded in 2011 continuing in 2012, which may be one reason for the muted reaction to the number in the Treasury market.
But as we mentioned above, the Fed's balance sheet has shrunk from $2.94 trillion to $2.88 trillion over the past month. This has certainly helped to fuel dollar strength in recent weeks; however we think further contraction in the Fed's balance sheet will be a slow, steady affair, and the Fed may not
be done with adding stimulus quite yet. Although USDJPY may gain (the Bank of Japan seems much less likely to reduce stimulus anytime soon compared to the Fed) an ECB that is less dovish than expected could make the trajectory of EURUSD less certain going forward. We shall find out more when the FOMC meeting concludes on Wednesday.
The Bank of Japan also meets on Wednesday, but after ramping up its stimulus programme last month it is likely to refrain from boosting QE right now and keep its target rate at 0.1%.
In contrast to the Federal Reserve and the ECB, some of the emerging markets seem more likely to boost stimulus than the developed markets. The Reserve Bank of India unexpectedly cut its reserve requirement for banks by 0.75% on Friday, before this week's official rate announcement. This is expected to inject roughly $10 billion into the Indian banking system and the RBI said it was necessary to do this prior to the tax season coming up in India. However, this move by the RBI seems like a longer-term shift to try and boost lending and thus growth in India after it recorded the slowest pace of growth in two years in 2011.
This follows China, who reduced its growth forecast for this year to 7.5%. This was a concession from the Chinese authorities that the years of strong growth for China could be coming to an end and that the Asian power house may be moving to a more mature phase of its economic development. But while China may be shifting to a domestically-charged economy the fall in inflation data for February to 3.2% leaves room for more monetary stimulus going forward. Beijing's favoured tool to try and loosen monetary policy has been to cut the reserve requirement ratio, and this may well be activated again in the coming weeks. Traditionally this causes the Aussie dollar to rally since China is Australia's largest trading partner.
Thus, divergence in monetary policy between Eastern and Western economies could be a theme that is starting to develop. Watch this space.
Why the rise in oil prices should grab our attention
Since the start of the year markets have shown the traditional signs of positive sentiment: a falling yen, rising stock markets and a recovery in the EURUSD. But all of this has occurred when oil prices have been surging. Brent oil (UK oil) is back above $125 per barrel, while WTI (US oil) is above $107.
Anyone who follows inter-market analysis will know that traditionally oil prices should cause bond yields to rise and eventually stocks to fall. However, since the surge in oil price this year we have yet to see a meaningful move higher in Treasury yields and both 10-year and 2-year yields remain within their long-term ranges.
These relationships can go through periods when they diverge, especially when central banks like the Federal Reserve manipulate the Treasury market through QE, Operation Twist and its pledge to keep interest rates low for a prolonged period. Added to that, throughout recent history stocks tend to react to changes in commodity prices with a lag, sometimes of many months. However, the divergence, particularly in crude oil and Treasury yields, which usually move together, is a warning sign, especially since oil has held up so well even with a rising dollar.
Thus, the oil price may be one reason why the Dow Jones, which I will use as a proxy for global stocks, has been extremely sticky around 13,000, and others have voiced concern that the current market rally has been on extremely thin volume. So, stocks may have further to go, but the warning level is currently on amber, and should be taken seriously by equity bulls.