Euro Consolidates Close to $1.25, but Downside Risk Remains

Highlights

The euro was confined within a $1.25-$1.26 range in the euro session, with intervention talk and hope (in vain) for new measure at today’s EU Fin ministers meeting leaving a slightly more bid sentiment in place. This is all about short-covering though, the medium-term outlook has not changed. Note that US Treas. Geithner announced yday that he will visit Europe next week. The Aussie was the strongest performer in the G10 world overnight (+1.5%) but is still down over 6% on the week. RBA intervention talks. The BoJ has left rates on hold as expected but has also announced a new loan scheme for growth, limited impact on the yen (see below). Cable lost early momentum and was trading below $1.44 in early US session, with the latest PSNB figs highlighting the UK debt predicament.  Gr’s May IFO survey was close to expectations (at 101.5 from 101.6). No major US data release today. Cad inflation data slightly stronger than exp., March retail sales to follow. EMEA currencies have recovered but are still significantly lower on the week and will remain shaky until Euro concerns fully dissipate – i.e not for now.  

It was yet another negative close for the Asia equity mkt, with the MSCI Asia Pacific index down 1.5% on the session – global equity mkts have wiped $5.3tn off mkt value so far this month. The Nikkei ended the session 2.45% lower and negative closes were also seen on the Taiwan Taiex index (-2.5%), the Kospi (-1.8%), the BSE Sensex 30 index (-1.25%) and the Hang Seng (-0.2%). Meanwhile, the Shenzen ended the session 1.3% higher. European bourses were trading lower by mid day and the S&P future points at a negative open on WS. WTI crude oil prices are trading back above the $70brl mark by mid-euro session, but only just.

The JGB mkt recorded its largest weekly gain since last Nov., with the BoJ’s latest anti-deflation measures and global mkt jitters providing support. 10 year JGB yields were trading 2bp lower by the end of the session –at 1.228%. The European bond mkt has opened lower with 10 year bond yields down 3bp in France and Germany and 1bp in Italy. Periphery continues to underperform with Greek and Portuguese yields up 5bp and 1bp respectively.

Currency Markets_

Policy was left on hold (rates at 0.1%) at the BoJ, as expected. However, additional easing measures to boost lending were endorsed. The BoJ conducted its third one day operation to boost liquidity and said it would provide one-year loans to banks in order to encourage lending and to defeat deflation. The view that additional monetary/fiscal stimulus is appropriate in Japan is a view shared at the IMF and this came through in a report out on Wednesday. Note that a time of heightened global concerns over debt, it was also interesting to note that the IMF indicated that it is important that the government pursues a credible fiscal programme, including the introduction of the 5% sales tax from 2011. Given the highly domestic nature of Japan’s debt (80% domestically held), Japan has not come under market scrutiny of late, but a gross debt to GDP ratio at 220% cannot be ignored forever. Domestic forces are having a very limited impact when it comes to the yen trading direction – still but we remain of the view that the move below Y0.90 was overdone and at a time when deflation concerns obviously remain a dominant concern at the BoJ, a stronger yen is the last thing the economy needs/the BoJ wants.

This has been another challenging week for the financial market, but what shall we take from this week’s developments?

1) Lack of euro zone coordination has come back to the forefront. Germany’s Merkel decision to unilaterally decide to ban naked short-selling on top bank and insurer stocks and government bonds has come as a major surprise to the market and provided fresh ammunition if you are a euro bear. While the merits and efficiency of the measure per se are highly questionable to start with, we believe that it is the fact that Germany ‘went solo’ that was highly disappointing. This came just a few days after Sarkozy had been reported threatening to leave the euro (later denied of course) should Germany not immediately join in the bailout package. At best, all this highlights the highly uncoordinated nature of the euro zone policy response to the crisis. At worst, this captures rising drifts between the euro zone engine, the Franco-German axis – a highly problematic development at this stage of the crisis, when leadership and united approach to policy are required from Germany and France. 2) The pace of euro decline has rekindled intervention talks. Extrapolating the pace of the euro decline of the past five weeks, we have the eur trading at 1.10 in a month time and at parity towards the end of July. Add to this the fact that volatility has picked up significantly of late and intervention talks are back in fashion. The standard 3-month euro volatility is currently trading close to 16% which compares to a 10% level in mid-April, to a 14.4% level during 9/11 and to a high 25.5% in late 2008. At what point this becomes disorderly so that the case for coordinated intervention becomes convincing? We believe not just yet, but we are also of the view that market intervention talks are enough to settle a slightly more cautious approach in the short euro trade.3) Risk off trade is back and commodity currencies are vulnerable.The risk off trading approach is back in vogue and this is leaving commodity currencies highly vulnerable. However, we are of the view that in the current context and considering the respective, fiscal/monetary/growth/political environment, the Canadian dollar is better positioned than the Aussie dollar. This points at a bearish outlook for AUDCAD, even if the scale of the recent moves suggests that a correction was due and has already started. We would take bounces back towards 0.90 as good selling opportunities. Our interim support target is at 0.8797, with additional support identified at 0.7727 (Feb low) and 0.7227 (Oct08 low).  4) China Concerns have resurfaced and the EM world is vulnerable for now. China’s overheating jitters have resurfaced and this is well captured in the Shanghai SE which is now trading 22% lower ytd. While we continue to think that EM fundamentals remain strong in Asia and Latin America in particular (arguably stronger than developed market fundamentals), there is no way that EM FX can mount a sustained rally until the European crisis has been addressed appropriately. For now, we recommend cross-EM plays rather than playing EM vs. the dollar, as that will be subject to wild swings based on market sentiment and perceived risk aversion. 5) This is not the time for statistics lovers. Economic releases have become totally irrelevant and this is unlikely to change until market jitters over the euro zone debt crisis fade away, once and for all. The moderate, non-inflation econ. recovery has been confirmed through an overwhelming majority of recent indicators though, with the US a leader.  The EZ lags, but the weaker euro is filtering  through export orientated industries, in Germany in particular.

On The Calendar Today__
America: Canadian April CPI, March retail sales. Events: ECB’s Papademos to speak.