The Week Ahead
- Can the ECB save the day?
- Fed speak provides more transparency but not clarity
- Bank of Japan easing pressure mounts
- A very mixed UK recovery
- Bank of Canada to hold
- RBA minutes to provide more insight
- Norges Bank's battle with the Nokkie
- Market Moves
Can the ECB save the day?
At the end of last week market sentiment towards the Eurozone took a turn for the worse. Stocks closed down sharply and Spanish 10-year bond yields surged to 6% at one stage. The cost to insure Spanish debt against default reached a record high; while bond yields are a mere 70 basis points away from the euro-era record highs reached in November 2011.
Problems have been simmering in Spain for some time, and there was no new news that triggered the sharp dip in sentiment. However, we have seen how quick situations can deteriorate in the past with Greece, Portugal and Ireland, thus we could be on the cusp of a dangerous new phase of the sovereign debt crisis.
The ECB is the only entity with the immediate firepower necessary to deal with this crisis. There was expectation earlier this week that the ECB could step back into the market and purchase more debt of the peripheral governments as part of its SMP programme. This helped to boost sentiment temporarily, however, without further details or confirmation from the upper echelons of power in the currency bloc market sentiment soured towards euro-based assets.
The problem for the ECB is that its tools may not be as effective as they have in the past at controlling this crisis. The idea behind the SMP is that it reduces pressure on bond yields and also shows that the central bank is acting as a financial back stop, which may entice investors to buy the debt themselves. However, Greece re-negotiated its debts this year and implemented haircuts on its bond holders, which has left the private sector with a sour taste in its mouth especially since the ECB was exempt from losses. Thus, if the ECB does act as a buyer of last resort for Spanish and maybe even Italian debt it may need to spend significantly more than the EUR 200bn it has spent buying government debt in the past.
There are also growing strains in the banking sector. A number of Italian banks had their shares suspended on the Italian stock exchange on Friday after their price collapsed below a certain threshold. The banking sector of the Eurostoxx 50 pan-European stock index has also fallen sharply and is down more than 15% since peaking in March.
The LTRO auctions only had a temporary impact on the banks, and since Spanish and Italian lenders used the money to load up on sovereign debt the deterioration in the sovereign bond market is, ironically, making matters even worse for the banks. This also complicates the ECB's efforts to stabilise this crisis. Banks are bleeding money in the periphery, share prices are falling and their asset quality has deteriorated in recent weeks. Thus, if the ECB offers them more cheap money then it may not be used to purchase more government debt; instead the banks may use it to ensure that they are fully funded in an attempt to weather the latest flare up in this crisis.
The technical picture is weak for the Eurozone right now. Peripheral bond yields, default insurance and European stock markets have all been ravaged by Eurozone bears. Spain's stock index the Ibex 35 fell to its lowest level since 2009 last week and is now only 10% away from the lows reached during the Lehman crisis. In the past, 7% has been the threshold where 10-year yields need to fall through to make a bailout imminent. So there is time for Spain to turn-around, but without prompt action from the ECB that could be difficult. The concern for investors is that Spain is on the cusp of its own Lehman moment.
Next week the key event will be the two Spanish debt auctions on the 17th and 19th April. Madrid is planning on auctioning long-term debt that matures in 10-years on the 19th April; this is a major risk event. If this auction disappoints or if bond yields rise to unsustainable levels then the writing may be on the wall for Spain.
As an aside, we do think that the European authorities will act at the 11th hour to prevent an all-out collapse; however the lack of a definitive solution to this crisis is extremely worrying especially now that Spain is in the firing line.
Fed speak provides more transparency but not clarity
Members of the Federal Reserve have been quite vocal of late with a number of speeches on the economic outlook and monetary policy. Markets and risk assets specifically have reacted positively to comments that indicate the potential for additional easing while statements that indicate accommodation should begin to be removed sooner than the official FOMC statement suggests have been met with a sell-off in risk. The sensitivity of markets to policy expectations underscores the notion that the Fed is expected to maintain its accommodation and keep additional easing options on the table. As such, short term price action in the USD is likely to be driven by official commentary and economic data surprises while a broader view indicates the buck trading in a larger range. Positive data surprises or more neutral commentary should be supportive of the USD, while the prospect of more easing would weigh on the buck. The increased transparency does not necessarily increase clarity as markets have been chopped around as they try to decipher recent Fed speak and weigh the views of various Fed officials.
Bank of Japan easing pressures mount
As expected this week, the Bank of Japan kept policy on hold and while the decision was unanimous minutes showed that the board members agreed the Feb. easing had a positive effect on the market. Political pressure has been increasing for the bank to be more proactive and take further measures to fight deflation with lawmakers going as far as rejecting BoJ nominees that are not perceived as members that share this view. Comments on Friday from Governor Shirakawa reinforced the notion that the bank will cooperate with the government to beat deflation. This followed Shirakawa's earlier statements in which he reiterated reiterates the bank's commitment to fight deflation and pursue powerful easing. In our view, the BoJ is likely to act at the next policy meeting on April 27 and the JPY may decline as expectations build.
The very mixed UK recovery
The UK has been in the headlines recently for all of the right reasons. The economy, it seems, has picked up slightly after the disappointment of the fourth quarter of 2011 when the economy contracted by 0.3%. The PMI surveys for March were stronger than expected while retail sales as measured by the British Retail Consortium also surprised to the upside last month. Next week we get inflation, official retail sales data and Bank of England minutes from its meeting earlier this month. This will help to complete the picture of the health of the UK economy before the first Q1 GDP print is released on the 25th April.
This is going to be extremely important as any signs of weakness could seal further stimulus from the BOE at its May meeting. Right now the prospect of more QE is finely balanced. Some key underlying drivers of the UK economy are weak and the unemployment rate is moving in the wrong direction, however the slightly better tone to the data could keep the Bank in wait-and-see mode for a while longer.
Next week's inflation data is worth watching. The BOE expects a sharp contraction in inflation this year, however, rising oil prices in the first quarter could mean that it takes longer to fall than what is expected. Consumer prices are expected to remain steady at 3.4% YoY for March, however producer prices were stronger last month, which increases the risk of inflation overshooting its target. If this happens it could be pound negative as it would reduce market expectations more QE from the BOE.
Bank of Canada to hold
On Tuesday April 17, the Bank of Canada (BoC) will announce interest rates and we agree with the consensus view that the bank will keep rates steady at 1.00%. The accompanying statement is likely to be more upbeat as recent data has showed stronger than expected improvement. The March unemployment rate unexpectedly dropped to 7.2% from 7.4% and the economy added a staggering 82.3k jobs in March from the prior months -2.8k (exp. 10.5k). To put this in perspective, Canada has roughly one-tenth of the population of the US and therefore the 82.3k print would be roughly similar to about an 823k number in the US.
Bank of Canada Governor Carney noted in a speech last week that “conditions in the Canadian economy have been somewhat stronger and the degree of slack somewhat smaller than the bank had expected”. He also said that external headwinds abated. Therefore when considering policy, we believe that the bank may focus more on the strengthening domestic conditions. This could provide a relatively hawkish tone as expectations for other major central banks are tilted towards the potential for more easing. On a relative basis, a more hawkish outlook would be supportive for the CAD.
RBA minutes to provide more insight
The Reserve Bank of Australia (RBA) has been increasingly dovish over the past few meetings leaving the door open for rate cuts. Market expectations for policy easing have been mounting and the AUD has come under pressure as a result. External factors such as slowing growth in China - Australia's largest trading partner - were cemented with the release of Friday's disappointing GDP figures (data showed yearly growth of 8.1% in Q1 from the prior 8.9%). The most recent trade balance figures showed a second consecutive monthly trade deficit which has not occurred since early 2010. Domestically, conditions have been subdued with a decline in investment and household spending, low consumer and business sentiment, and tight credit conditions.
At the last statement, the bank noted that the pace of output growth is lower than initially estimated and also said that it is prudent to wait for CPI data before considering easing. The minutes are likely to detail the discussion on the potential for more easing, however it is clear that CPI figures released later this month will be a key in determining the bank's next move.
Norges Bank battle with the Nokkie
The Governor of the Bank of Norway sounded a note of caution during a speech last week. He said that exporters were feeling the effects of a stronger krone through reduced sales. The krone has appreciated 3% versus the euro since the start of the year and 4.4% versus the dollar.
The Governor also noted cautious consumers and rising household debts as a cause for concern. His speech was resolutely dovish and he explicitly said that Norway has room for manoeuvre in economic policy, suggesting that if things deteriorate in Norway then the Bank could cut rates or add stimulus. However, the market may not take this threat too seriously. No one wants a strong currency in this environment but the underlying strength of Norway's government finances and economy will make it attractive during stable periods in the financial markets (it sells off sharply during risk-off periods due to its relative thin liquidity.)
Thus, while the Norges Bank may try to talk down Nokkie strength we believe that ultimately it will be unsuccessful and the krone will continue to move with overall risk sentiment.
The EURUSD closed the week at the lower end of its recent range. 1.3050 continues to hold as key support - the bottom of the Ichimoku cloud. We believe that if there are continued tensions in the currency bloc this week then there is a risk that EURUSD could cross below the 1.30 level. If this happens then the next key support level is 1.2905. 1.3200 has capped gains for now.
GBPUSD has been relatively resilient in recent days as safe haven flows into the Gilt market helps to protect the pound. GBPUSD is above the cloud, a breach of 1.5824 - the top of the Ichimoku cloud - could cause deeper losses towards 1.5700. 1.6060 is still the resistance level to beat. Above here suggests that an extension of the GBP uptrend could be on the cards. Overall we think the pound is range bound. Although it is not immune to the problems in the Eurozone, the “safe haven” label and the pick-up in economic growth should provide a cushion of support for the pound if things in Europe take a turn for the worse.
The Nokkie remains range bound versus the euro between 7.54 on the downside (the 50-day sma) and 7.63 on the upside (the 100-day sma). This pair is likely to remain range-bound while sovereign fears continue to rock the Eurozone as the Nokkie tends to be sell off sharply during periods of risk aversion.