Week of June 19, 2011
Immediate Greek debt crisis looks to be averted
The short-term risk that Greece will not receive the next installment of the original EUR 110 bio EU/IMF bailout, needed by early July to roll over maturing government debt, is close to being resolved favorably. EU officials have indicated their funding will be available, contingent on the Greek parliament passing additional austerity measures this weekend. And the IMF has relaxed its stance, indicating it will accept EU governments’ assurances that funding for Greece will be available in 12 months rather than a concrete long-term financing arrangement. So the risk this weekend, then, is that Greek lawmakers are unable to agree on a combination of tax increases and spending cuts that satisfy more stringent EU conditions on additional aid. In light of Greek politics, we think this is no small risk. However, Friday’s Greek cabinet reshuffle suggests to us PM Papandreou will achieve the necessary majority to pass the measures. Failure to do so would trigger a government debt default within days or weeks, rendering the Greek banking system insolvent and triggering an inestimable wave of contagion throughout Europe, potentially unleashing another global financial crisis in the process. So failure is not an option, and for this reason we think the measures will pass and the immediate crisis will be averted. The EUR may see further upside in this case, but we do not expect strength much beyond the 1.4450/4500 area in the current environment.
Even with Germany relenting in its demand for private sector burden-sharing on Greek government debt, we think the long-term solvency of the Greek state remains in doubt, and we don’t think we’re alone. Even if Greece does adopt additional austerity measures, there’s no guarantee they’ll be successful in implementing them and achieving deficit reduction goals. The overall Greek debt load continues to increase and with negative growth, investors are right to question whether Greece will ever be able to pay off its debt, meaning a default will continue to loom, though further out on the horizon. And it’s not just Greece or the periphery. Late headlines on Friday that Moody’s has placed Italy’s ratings on review for a possible downgrade underscore the widespread over-indebtedness of major Eurozone economies. With growth on the continent having peaked earlier this year, the debt headwinds are likely to continue to weigh on the single currency. In this light, we would favor using any relief rallies in EUR as an opportunity to get short, highlighting the 1.4450/4600 area as the preferred level for a multi-week decline. Our view is invalidated on a daily close above 1.4710/20.
Global recovery still being marked down
While Greece dominated the headlines this past week, investors remain increasingly cautious over the strength of the global recovery, and we won’t lose sight of that bigger picture. We think this is most evident in overall commodity weakness, which persisted even with the relatively favorable Greek/EU news at the end of the week. The CRB index has dropped back to lows last seen in May and may be set to break down further. We think next week’s reaction in risk markets (stock and commodities) will be exceptionally telling: in light of the ostensibly positive news out of Greece and Europe, we’ll interpret a failure of risk assets to stabilize and test higher as an indication of further risk aversion and downside ahead. In FX, JPY-crosses have not seen a significant rebound, as one would expect if risk sentiment were improving. Indeed, US Treasuries remain nearer to recent highs and the USD index looks set to finish the week above the daily Ichimoku cloud, potentially signifying an intensifying period of risk aversion ahead. We’ll be focused on recent lows in stocks, commodities and JPY-crosses as triggers to further weakness.
Euro’s fate rests with China
At one point last week it looked like the Eurozone was going to descend into chaos. The political situation was deteriorating and the prospect that the various branches of authority could not agree on whether private investors should shoulder some of the burden of further bailout funds for Athens threatened to lead to a disorderly default that could rock the entire financial system.
This weighed on the single currency, which threatened to break below 1.4000. However, as we move into a fresh week there is a sense of calm. The EU along with the IMF have suggested that the next round of bailout funds will be available to Greece, which will stave off default next month when coupon payments and bond redemptions come due.
So the euro managed to avoid a Friday sell off and closed the European session comfortably above 1.4300 on Friday. This was also fuelled by signs that Germany would not push for private investors to accept a 7-year extension on their Greek debt holding, thus preventing a default, a credit downgrade and contagion to other parts of Europe.
But while the long-term solutions such as private sector involvement still have to be decided, the FX market is happy enough to hold euro as short-term disaster has been avoided. But we would not get too complacent.
The Chinese premier Wen Jiabao is visiting Europe next week and the currency bloc needs his support (both political and financial) to see it through this sovereign crisis.
The last time that China pledged to support Europe and buy EFSF rescue bonds in January (we don’t know how much they actually bought) the euro rallied from a 1.3000 low. So, support from China could see further upside in the euro towards 1.4500.
However, any stern words or signs that China is not going to continue to purchase EFSF bonds along with the debt of Greece, Portugal and Spain may see a sharp reversal.
There are also some important data releases in the Eurozone next week. In Germany there is the IFO – a measurement of industrial sector sentiment. Although this survey remains at elevated levels compared to its long-run average, analysts expect it to moderate in June, adding to evidence that growth in Europe’s largest economy has passed its peak.
The final readings of the Eurozone PMI surveys are also released at the end of this week. The market is currently looking for a sharp downward revision to both the services and manufacturing surveys. Signs that the Eurozone is going through a summer malaise like the US is euro negative in our view, so watch out.
The outlook for the single currency remains cloudy and next week is littered with event risk, which requires a nimble strategy and tight stops. In EURUSD, resistance lies at 1.4340 – the base of the Ichimoku cloud and end of the technical downtrend. This pair is in a technical uptrend above 1.4505.
New boy at MPC shows his colors
The minutes of this month’s MPC meeting are released on Wednesday and the markets will be eagerly waiting to see how the swing of voting has been affected since the departure of arch-hawk Andrew Sentance at the end of last month.
His replacement Ben Broadbent, a former Goldman Sachs economist, hasn’t given much away, but at his Treasury Select Committee hearing although he sounded concerned about inflation and especially commodity prices, he seemed to agree with the MPC’s actions so far. Thus, it seems likely that Broadbent voted with the majority and the Governor Mervyn King to keep rates on hold.
With another member sitting on the fence the camp voting for rate hikes will be weakened, making a rate hike this year look increasingly unlikely. Added to this, it was reported last week that retail sales data was incredibly weak in May, falling 1.6 per cent. This is worrying for an economy that relies on the consumer and the service sector for approx. 60 per cent of its output.
While Europe has been grabbing the headlines, the UK has been benefitting and the Gilt market rallied last week after attracting safe haven flows caused by the Greek debt crisis. 2-year Gilt yields fell more than 10 basis points on the week.
It will be interesting to see how the Gilt market reacts to the public finances figures released on Tuesday. The fiscal year got off to a bad start in April when borrowing surged to GBP10bn, above last year’s figure of GBP7.3bn.
However, as activity on the High Street and in factories starts to slow, tax receipts are inevitably going to fall, which will weigh on the borrowing figures for as long as this economic malaise lasts. The markets think that government borrowing will surge to GBP 16.5bn, above last year’s GBP13.4bn.
This may call into question the government’s target to cut borrowing by 15 per cent this year. Signs of slippage in the fiscal plans will most likely hurt Gilts, pushing yields up for all the wrong reasons. It is also sterling negative in our opinion.
Any strength in sterling we think is a selling opportunity, especially versus the Swiss franc. This pair has cracked fresh multi-year highs already in recent weeks, but it could have further to go especially if the Eurozone debt crisis rages on. We think any rallies above 1.6250 in cable are unsustainable. Support comes in at 1.6020 – the 200-day simple moving average.
Soft patch to keep Fed policy on hold
On Wednesday June 22, the FOMC will conclude a two-day meeting and announce its stance on monetary policy. It is unlikely that the Fed will make any material changes to the previous assessment as the U.S. economy appears to be trudging along. Recent data indicate that the economy appears to have hit a soft patch as highlighted by this week’s disappointing May industrial production and recent negative surprises in regional data such as June Empire Manufacturing which fell to -7.79 (prior 11.88) and the June Philadelphia Fed index which dropped to -7.7 (prior 3.9). Moreover, the most recent BLS monthly figures suggest a slowdown in the pace of hiring and uptick in the unemployment rate. We believe that Fed Chairman Bernanke is likely to underscore the sluggishness of the economy but maintain the view that growth may pick up in the second half of the year, ignoring another round of QE. Chairman Bernanke will give his second press conference following the release of the FOMC statement and we would anticipate the Q&A session to include discussion on events in the European periphery and the risks posed to the domestic economy.
What are precious metals secretly telling us?
Fundamentally the commodity market continues to be driven by the many of the same factors: uncertainty surrounding the European Union and sovereign debt crises, completion of QE2 and political bickering regarding the debt ceiling in the United States, geopolitical concerns in the Middle East and North Africa, reconstruction efforts in Japan, Australia and New Zealand and the current global low interest rate environment beginning to come to end. While a tremendous amount of headline risk exists, gold and silver are likely to be torn between those who perceive it as another “asset class”, thus trading in-line with risk and those who believe its “flight-to-safety” play. However, when we compare the two, their relative performance appears to be hinting a material change may be underway.
While both precious metals are typified as safe havens and hedges against inflation, silver accounts for a much larger share of industrial demand than gold. Consequently, it will tend to out-perform gold as the global economy recovery takes hold and under-perform once the economy slows (best seen by looking at the gold/silver ratio). Thus, it can be a great proxy for ‘risk’, as a lower gold/silver ratio promotes risk taking and a higher ratio suggests risk aversion. This is predominantly explained by silver’s typically lower margin requirement and greater volatility in the futures markets.
Interestingly, at the end of April the ratio made a fresh 28-year low around 31 and then saw a sharp rebound higher, briefly touching 45, before settling around current levels of 43. Historically, an inverted gold-to-silver ratio has tended to coincide and even occasionally lead the S&P500. Therefore, the recent outperformance of gold relative to silver suggests we are potentially at a huge turning point for risk overall as reality begins to set in and the prospects for growth are not quite as rosy as they once appeared. While we cannot rule out a possible correction back towards 36-38 in the short-term, we believe a longer-term bottom may be in place. Subsequently, we envision a substantial shift in the way investors perceive ‘risk’ as we head into 2H of 2011.
Key data and events to watch next week
United States: Monday – Treasury Secretary Geithner Speaks Tuesday – May Existing Home Sales Wednesday – Apr. House Price Index, FOMC Rate Decision, Bernanke Speaks at Fed Press Conference Thursday – May Chicago Fed Nat Activity Index, Weekly Jobless Claims, May New Home Sales, Fed’s Evans Speaks Friday – May Durable Goods Orders, 1Q Final GDP Figures
Eurozone: Monday – EU Finance Ministers Meet, German May Producer Prices, EZ Apr. Current Account, 1Q Labor Costs Tuesday – German June ZEW Survey Wednesday – EZ Apr. Industrial New Orders, Jun. EZ Consumer Confidence Thursday – German Jun. Manufacturing & Services PMI, EZ Jun. Manufacturing, Services, & Composite PMI Friday – EU Leaders Conclude Two-Day Summit in Brussels, German Jun IFO Surveys, May Retail Sales
United Kingdom: Monday – Jun. Rightmove House Prices Tuesday – May Public Sector Net Borrowing, Jun CBI Trends Wednesday – BOE Releases MPC Minutes Thursday – May BBA Home Loans, Jun. CBI Sales Friday – BOE Governor King Hold Press Conference
Japan: Monday – May Trade Balance, April Final Leading and Coincident Index, Cabinet Office Monthly Economic Report Tuesday – Apr. All Industry Activity Index Thursday – BOJ’s Morimoto Speaks
Canada: Tuesday – May Leading Indicators, Apr. Retail Sales
Australia & New Zealand: Monday – NZ 1Q Manufacturing Activity, NZ Jun. Performance of Services Index, Prime Minister Key to Speak, NZ. May Credit Card Spending Tuesday – RBA’s Board June Minutes Wednesday – NZ 1Q Current Account, Deficit-GDP Ratio, AU Apr. Westpac Leading Index Thursday – AU Apr. Conference Board Leading Index
China: Friday – MNI Business Condition Survey