Highlights

• Don’t be fooled by strong US jobs data
• Waiting for a rate cut from the ECB
• Don’t expect too much upside in EURCHF
• More positive data out of China
• The yen holds relatively steady as an anticipated power handover draws near
• The RBA is expected to remain in easing mode

The headline figures from the November US labour market report may look good on paper, but if you dig deeper then the picture looks less rosy. The drop in the unemployment rate to 7.7%, the lowest level since the start of 2009, was down to a drop in the participation rate of the workforce, which fell to 63.6% from 63.8%. Thus, the unemployment rate is not falling because there are more employed people, but instead because there are less unemployed people.

Likewise, the 146k increase in NFP’s for November, which is well within the range of the last 5 months, was well above expectations of 85k and was puzzling for a couple of reasons. Firstly, some large corporations have recently announced they would be cutting jobs in Q4. Anecdotal information also suggests that corporations may be stalling their hiring programmes until there is some clarity about the growth outlook for the US next year and the resolution of the Fiscal Cliff issue. Secondly, super-storm Sandy didn’t have a meaningful impact on the national data, according to the Bureau of Labor Statistics. However, state employment data is released on December 21st, if this suggests that the North East’s employment picture was affected by the storm then November’s NFP number could be subject to revisions in the future.

Added to this, the NFP data has been a bright spot in an otherwise dismal week for US economic data. The manufacturing ISM for November fell into contraction territory, dropping from 51.7 in October to 49.5. The non-manufacturing ISM registered a slight rise, but not enough to pick up the slack from the manufacturing sector.

Political deadlock in Washington may start to spook the market as we get closer to the fiscal cliff that the US will hit on 31st December unless a deal between Republicans and Democrats is reached soon. If $600bn of tax hikes and spending cuts hits the economy early next year then the US is expected to plunge into recession. However, discussions have stopped in recent days and there are no signs that either side is willing to give up enough ground to reach a deal.

Weak underlying growth combined with fiscal cliff fears are likely to keep the FOMC on its guard when it concludes its meeting next week. The market expects the FOMC to expand QE3 to make up for the end of Operation Twist, which expires this month. The market is looking for new purchases of approximately $25-45 billion per month. There is a chance that the Fed may choose larger rather than smaller purchases due to the risks facing the economy as we move into year end. Thus, the spike higher in the dollar on the back of the payrolls data may not last.

Watch the gold price if the FOMC does decide to boost QE3 this week. The yellow metal has acted like the ultimate QE3 trade since August this year. After rejecting $1,800 at the start of October, the yellow metal has been stuck around $1,700 for the past week. We may see a knee jerk reaction higher on the back of the FOMC meeting. Resistance lies at $1,750 then $1,795 – the high from October.

The biggest development from the last ECB meeting of 2012 wasn’t talk of Spain or the Bank’s bond-buying OMT programme, but rather the ECB staff projections for growth and inflation over the next two years. The forecasts were revised lower; GDP growth is now expected to fall between -0.9% and 0.3%. Inflation may also under-shoot the 2% target rate over the next 12 months. Even though the Bank is predicting negative growth and falling prices, it still kept interest rates on hold. However, there were signs that the Bank could be moving towards cutting rates as soon as January.

In his press conference last Thursday, Mario Draghi said that a cut in the deposit rate (the rate paid to banks who deposit money with the ECB) to below zero was discussed for the first time. ECB member Josef Makuch then said that ECB members discussed an interest rate cut and if the economy doesn’t improve then expect the Bank to cut. We believe the ECB is more likely to cut the base rate of interest, which is currently at 0.75%, rather than the deposit rate. Once you cut the deposit rate it is basically a green light to say that the ECB is now targeting the exchange rate. There are a couple of issues with this: 1, Germany and other stronger countries may be fearful that a sharp decline in the euro will stoke inflation and 2, Japan has done this in the past and failed, instead the market called the BOJ’s bluff, which may put the ECB off taking such extreme action.

Next week could give us further clues as to whether the ECB will cut rates next year. Firstly the European Council meeting on the 13th and 14th December is expected to make progress on a roadmap towards genuine monetary and economic union. Draghi referenced this and said that reform of European governance should help to support financial market sentiment and improve the outlook for economic growth. This suggests that Draghi is yet again putting the ball in the politicians’’ court to try and sort out this crisis and promote growth in the currency bloc. If the meeting fails to deliver the goods, then the ECB may be forced into a rate cut to try and protect the economy from an even harder landing.

The second clue may come from the first readings of December PMI data released this week. The economic data out of Germany recently has been extremely weak. Industrial production fell and the Bundesbank revised down 2012 and 2013 GDP forecasts for Europe’s largest economy. The PMI data will give us an indication of how deep the expected contraction in economic growth in the fourth quarter may be. The November data saw the composite PMI for the currency bloc jump from 45.7 to 46.5. This suggests that the economy may be stabilising at a low level. The market expects a slight increase in December, but it is unlikely that the surveys will move out of contraction territory any time soon, which supports further action from the ECB.

Rate cut expectations weighed on EURUSD as we ended last week. After rallying 400 pips in a month, this cross closed the European session below 1.30 and at its lowest level for three weeks. The cross dropped below a key support zone at 1.2960 – the top of the daily Ichimoku cloud – on Friday, a further decline below 1.2820, the cloud base and then 1.2780, the 200-day SMA, would be a very bearish development for this cross. Overall, we could see EURUSD meander lower into year end. EURGBP is also at risk of a selloff in the medium term. It was testing support at 0.8050 on Friday, but the bearish crossover on the daily MACD suggests that we may see below 0.80 in the short term.

Also, watch German stocks. The Dax index reached its highest level since 2008 last week, however we expect the Bundesbank’s downward revision to growth for next year from 1.6% to a mere 0.4% to weigh on this index and knock it off its multi-year highs in the medium term. An import support level was 200 points away from where the Dax was trading on Friday afternoon at 7,285, the 50-day SMA.

Last week saw EURCHF jump a stunning 100 pips in a matter of hours. This is one of the biggest daily jumps to the upside in this cross for more than a year. The driver of this move was news that Swiss bank Credit Suisse was going to start charging other banks for holding their large Swissie deposits. Negative interest rates can cause a currency to go into free fall. If you are charged to keep your money in a bank then you may not keep it there. Credit Suisse’s move was most likely motivated by profit, to start charging other banks that are holding safe haven funds with it for the long-term. A similar move was under-taken by UBS, another large Swiss bank, last year.

Although this move only effects large deposits held by other banks and even though Credit Suisse was not the first bank to do this, it still had a big impact on EURCHF. Some may have interpreted the move as a precursor to negative interest rates from the Swiss National Bank (SNB); currently rates are 0%, or an increase in the SNB’s EURCHF floor above its current level of 1.20. However, we doubt this is the case. The SNB has had to amass nearly half a trillion CHF in FX reserves in an attempt to keep the peg between the Swissie and the euro, thus it may not be able to afford to comfortably keep growing reserves by raising the peg even further. Added to that, negative interest rates could cause more long-term damage to the Swiss economy, including the misallocation of resources sparking asset bubbles, that the SNB may want to avoid.

We will hear more from the SNB when it concludes its monthly meeting on Thursday. It is expected to reiterate that it will do everything in its power to limit Swissie strength against the euro. However if sovereign fears continue to rise in 2013, as we expect, this will become much harder to do.

Already by the end of the week EURCHF had started to give back some of its gains. We believe it will continue to do so and will return to 1.20 in the medium-term. Going forward, we think that gains in this cross are capped due to the risk of a flare up in sovereign tensions in Q1 next year as Spain tries to auction record levels of debt and as Italian election fears risk putting upward pressure on bond yields.

With investors concerned about the US fiscal cliff and the European debt crisis, China has become a source of hope for the global economy. Recent economic data out of the world’s second largest economy highlights a bottoming out of GDP growth in China, whereby Chinese growth stabilises at lower than pre-EU crisis levels but is more sustainable. Importantly, the metrics that have been improving are at the heart of the Chinese economy, namely its manufacturing, export and industrial sectors.

The most recent official manufacturing Purchasing Mangers’ Index (PMI) printed in expansion territory for the second month in a row and at its highest level in seven months at 50.6, compared with 50.2 in October. Furthermore, we have witnessed a small recovery in China’s export sector, as well as a turnaround in industrial profits. Overall, the data suggest China’s growth may be turning a corner. However, Beijing isn’t out of the woods yet, after all it has proven to be very susceptible to global sentiment as long as it remains an export based economy.

If more help is needed, the government will first assess if inflation provides scope for more stimulus. This is where next week’s CPI data comes into the equation. If consumer prices start to rise then the government may hold off on future policy loosening. Consensus estimates put headline CPI at 2.1% y/y in November, slightly higher than the prior month’s 1.7%.

Nonetheless, there may not be a need for policy loosening from Beijing if China’s economy continues to improve. The market largely expects to see Chinese growth stabilise from here, thus it isn’t anticipating large amounts of stimulus. But lacklustre levels of global growth will still affect the Chinese economy which, in turn, may require some policy fine tuning. We think Beijing has done all it is going to do for 2012 (apart from dipping into China’s financial market through open market operations), but there may be some required reserve ratio and/or interest rate cuts next year. Hence, if inflation in China appears to be running rampant, which is not our base case; we may see a sell-off in commodity currencies, especially the Aussie, as investors’ price out the chance of more stimuli next year.

However, next week’s trade balance data may prove to be more crucial to investor sentiment. The market is looking for a headline figure around 26.85bn for November, but it is going to be more focused on how exports performed. Expectations are for a 9.0% rise in exports and a 2.0% rise in imports. If it appears that China’s export sector is struggling more than anticipated, then investor sentiment may take a hit, especially if it is combined with a higher than expected inflation figure which would limit Beijing’s options to boost domestic demand.

Since Japan’s Prime Minister Noda’s announcement on 14 November that he would dissolve parliament on 16 November, the yen has lost around 300 pips against the US dollar. The reasoning behind this mass sell-off is the immense dovishness of the LDP party, which is anticipated to take power from the current administration during a parliamentary election on 16 December. The LDP have even gone as far as proposing to rewrite the Bank of Japan act, thereby bringing the BoJ under the direction of the government. At the very least, the LDP has stated it will find a new head for the BoJ when Shirakawa’s term ends next year.

Recent polls suggest the election is going to be a white wash, thus the current expectation of monetary easing from the LDP is now largely priced into the market. We can see this in USDJPY, which has remained around current levels since 22 November. However, there is the possibility of more weakness against the dollar once the LDP takes power, and promises become actions. We note that an increased level of dovishness from the LDP is unlikely, or even possible for that matter. Thus, we favour more sideways action in the near-term.

Against the euro, the yen’s weakness may be limited in the near-term as the European debt crisis continues to upset EUR on a regular basis, although you would have to be brave to look for yen strength. Technically, EURJPY is still in an upward trend, although it ran into a resistance level around 108.00 last week, before sinking lower on extreme euro weakness. However, a break above 108.00 may open the door for a push towards a resistance level around 109.90.

Last week the Reserve Bank of Australia (RBA) cut the official cash rate (OCR) in Australia by 25 bps, bringing it to an all-time low of 3.00%, a level unseen since the financial turmoil of 2009. This time around, however, things are different, and there is even more scope for looser monetary policy as the threats to the Australian economy are arguably greater than those faced during the financial crisis of 08/09. Not only does Australia face stagnant levels of global growth, particularly from Australia’s number one trading partner and the driver of global growth over the last decade, China, but the high level of the Australian dollar is compounding the problem. However, RBA Governor Stevens has created some doubt in the minds of investors about future OCR cuts with his speech following the RBA’s latest monetary policy meeting, which was less dovish than the market was anticipating. But even the RBA admits risk is still tilted to the downside.

Whilst AUD stubbornly refuses to depreciate significantly against the US dollar, it puts pressure on the backbone of the Australian economy. The mining sector in Australia has long been the driver of economic growth and has supported the Australian economy during times of financial crisis. Even now the mining sector is sustaining the economy, with job creation and investment in Australia broadly centred on this part of the economy.

However, mining investment is expected to peak in 2013 at around 0.5-0.7% of GDP. Once the mining sector starts to cool, the impacts on the boarder Australian economy may be severe. Chief amongst the areas of concern is the Australian labour market. Whilst we witnessed a surprise drop in the unemployment rate to 5.2% from 5.4% in November, it was predicated by a fall in the participation rate from a revised 65.2% to 65.1%. In fact, Australia’s participation rate has fallen 0.3% since this time last year. Also, most of the job creation is happening in the mining sector. Thus, as people start returning to the workforce, as they inevitably have to, and the mining sector starts to cool, we expect Australia’s unemployment rate to edge higher.

Furthermore, other economic data out of Australia last week also failed to impress. Retail sales remained flat and building approvals fell 7.6% during October, while company profits declined 2.9% and GDP was lower than expected at 0.5% in Q3. Overall, the data was less than impressive and it cemented the case for a rate cut from the RBA at last week’s meeting. Whilst there is no light on the horizon for the global economy, predicated by the European debt crisis and the fiscal cliff in the US, Australia’s economy will continue to suffer and the RBA may continue to loosen monetary policy next year.

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