Highlights

• Does the OMT need to be triggered?
• Should Greece stay or should it go...
• Putting faith in the unconventional at the Bank of England
• Fed communication back in focus
• Fiscal cliff fears growing

Another ECB meeting has passed and the Bank’s latest monetary policy stimulus programme has still not been activated. ECB President Draghi was very clear that there will be no bond purchases through the OMT programme without conditionality. He mentioned that the ECB stands ready to start making purchases; however the ball is in Spain’s court.

The problem is that Spain remains extremely unlikely to apply for financial assistance and expose the economy to more austerity in the near to medium-term. There is unlikely to be a sense of urgency in Madrid since even without official ECB purchases of its debt, Madrid still managed to sell a 20-year bond, the first bond with this maturity that it has sold in over a year. This doesn’t suggest stress in Spain’s bond market. Added to that after a spate of auctions last week, Spain has virtually fully funded itself for this year. It has some small bond redemptions due at the end of this month and the start of December, but it is practically fully financed. The real problem begins on 18^th January when its first major bond redemption of 2013 is due. Spain has a hefty debt schedule for 2013 – it needs to sell nearly EU140bn next year. Spain’s economy is mired in recession and its unemployment rate is above 25%, added to that fiscal consolidation efforts are likely to weigh on the economy for many years to come. This makes Spanish debt even less appealing, and without a firm backstop in the form of the ECB it is hard to see Spain avoiding asking for funds at some stage next year.

While Spanish 10-year bond yields are below the 7% line in the sand for now, other asset classes are showing signs of stress. The euro and European stock markets tend to react to improvements in the credit risk of the currency bloc. The ECB’s failure to provide any new policy support to reduce credit risk and boost growth in the region weighed heavily on the euro and stocks at the end of last week. As we start a new week EURUSD is hovering close to the base of the daily Ichimoku cloud at 1.2650. Below here is the start of a technical downtrend. The pan-European Eurostoxxx index fell below 2,500 last week and may test 2,380- the 200-day sma and the next major support zone, in the coming days if the selling pressure continues to mount. Worryingly, this index was led lower by the banking sector in Europe. This sub-index of the Eurostoxx fell through the top of the daily Ichimoku cloud, suggesting that the recovery in Europe’s banking stocks may be over for now.

This is the question that Europe’s politicians need to answer. The Troika’s latest review of Greece remains delayed and will not be available in time for the Eurogroup meeting of Eurozone finance ministers on Monday. A raft of European spokespeople on Friday prepped the market to not expect Greece to get its next tranche of bailout funds at this meeting. However, for now there is a stay of execution for Greece. Although it needs the bailout funds to pay a scheduled EU4 billion bond redemption this Friday, a spokesperson for the EU said that Greece will not default, the redemption will be paid and the Eurozone authorities are aware of Greece’s financing needs.

Although the Greek government passed a raft of pension and labour market reforms last week, and is expected to pass the 2013 Budget during a Parliamentary session on Sunday, the growth outlook is dire and fiscal targets look more unrealistic than ever. Industrial production declined 7.3% in September, and the unemployment rate broke above 25% to 25.4% in August. The latest EU growth forecasts for Greece for 2013 was downgraded to a 4.2% contraction, the original forecast was for flat growth next year. Now the EU doesn’t expect growth to return to Greece until 2014. It looks like Greece is moving closer to handing full budget sovereignty to the European authorities and the IMF, especially since it appears that these institutions will take over payment of Greece’s bond redemption this week.

While we think that Greece will manage to stay in the Eurozone for the medium-term, the power balance appears to be shifting away from Athens and towards Brussels.

The BOE left interest rates on hold at its meeting last week and did not add to its asset purchase programme, now attention is focused on the final Inflation Report of the year that is released on Wednesday and BOE Governor King’s press conference. The economic back drop remains cloudy. The strong pace of growth in Q3 is unlikely to be repeated in the final three months of the year, and growth signals for October suggest that the economy is growing at a flat to weak rate of approx. 0.1-0.2%. Inflation pressures are also starting to rise, the market is looking for a 0.2% rise in October prices and for the annual rate to jump to 2.4% from 2.2% in September.

The internal dynamics of the Monetary Policy Committee are also a challenge as the MPC seems fairly split on what action to take going forward. It appears that the doves lost their battle for more QE last week, and for now the money taps at the Bank remain turned off. There appears to be a growing belief at the BOE that QE is not working for the UK economy. MPC members Bean and Tucker have both expressed doubts about the effectiveness of QE in recent speeches, although Governor King remains in favour.

There are three things to look out for in the latest Inflation Report. Firstly, any changes to the growth and inflation forecasts. The BOE may forecast a modest recovery in 2013, but it is likely to add a massive caveat to this since if the US falls off the fiscal cliff or the Eurozone implodes then the UK economy is likely to be a major casualty. We believe the Bank will continue to expect inflation to fall throughout next year, which could open the way for more policy support in 2013.

The second thing to watch out for is what this potential support could look like. We expect to hear the BOE’s views on the Funding for Lending scheme, which is a joint venture with the government. So far the signs are good, with consumer lending picking up strongly in September. There is a chance that the Bank may ditch QE altogether next year and concentrate on yet more unconventional policy measures that target the economy directly.

The last thing we will be watching for is any sign of who has the upper hand at the BOE – the QE supporters, or those who view QE as ineffective. If those in favour of QE look like their numbers are dwindling then we could see a sharp reaction in the bond market and also a reversal higher in GBPUSD. 10-year Gilt yields have trended lower this week as risk sentiment drained from the market, but the Inflation Report could see a reversal back towards the 200-day sma at 1.86%. This could benefit GBPUSD, which was under selling pressure last week. 1.5890 – the daily cloud base and a key support zone – has held throughout last week’s sell off. We would be wary of going short here as any sign the BOE is ditching QE as its main policy tool could cause a short term recovery in this cross. 1.60 remains key near term resistance.

On Wednesday, the Fed will release the minutes from last month’s FOMC meeting. The October meeting kept policy on hold and left its statement relatively unchanged with the exception of a couple tweaks which indicated a slightly quicker advance in household spending and a marginal uptick in inflation. There have been few speeches from Fed members in prior weeks as the focus has been on presidential elections. The Fed has remained relatively muted as US elections played out and now with that we are past the uncertainty of who will be the president for the next 4 years, we see the Bank becoming more vocal. Next week sees a number of speeches from Fed officials on the calendar and we expect the communications to provide more clarity on the policy outlook as Operation Twist nears its end.

There are conflicting views within the Fed’s current stimulus program with members such as St. Louis Fed President Bullard expressing concern on Thursday that current monetary policy may be “too easy” while the Minneapolis Fed President Kocherlakota recently indicated that current policy may be “too tight”, citing a subdued inflation outlook. Several policy makers have also voiced their opinion on particular levels of unemployment and inflation that may trigger adjustments to the current stimulus program.

It is clear that many policy details need to be ironed out and we anticipate rhetoric to pick up ahead of the December FOMC meeting which is the last of the year before voting members rotate. Specific targets are not likely to be agreed upon any time soon and the current stimulus program is expected to remain in place for some time. After all, the Bank’s statement says that “the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens”. The more pressing issue is to address the conclusion of Operation Twist and potential increase the size and pace of purchases next year to include treasuries.

If communications indicate that the Fed is likely to engage in further balance sheet expansion to buy treasuries, the dollar could weaken and treasury yields may decline. This would likely weigh on USD/JPY as it traditionally has a close relationship to US treasury yields.

Vice Chair Yellen will speak on Tuesday follower by scheduled speeches from Williams (FOMC voter), Lacker (voter), Fisher (non-voter), Plosser (non-voter), and Dudley (voter) on Thursday. Fed Chairman Ben Bernanke is also due to speak on Thursday and Lockhart (voter) will round out the week with a speech on Friday.

With US elections out of the way, the fiscal cliff now looms. There are seven weeks left for politicians to negotiate a deal before tax cuts expire and spending cuts automatically trigger. The combination of higher taxes and reduced government spending will weigh on growth as consumers face a reduction in disposable income while cuts to government expenditure reduce demand. What politicians must do is come to an agreement on a long term plan to credibly reduce the national deficit without derailing the economic recovery.

This may prove challenging with a divided Congress. The House maintains a republican majority while the Senate strengthened its democratic hold. President Obama, a democrat, is scheduled to speak later today on the deficit after republican House speaker Boehner spoke earlier and indicated his stance that raising tax rates will harm economy and indicated the preference for closing loopholes.

Ratings agencies have expressed concern over the uncertainty with Fitch and Moody’s indicating that a US downgrade is possible next year if the fiscal outlook remains unresolved. Ratings agency S&P also noted an increased chance of the US falling over the cliff. Furthermore, the US Congressional Budget Office estimated that if there is no resolution, the country would fall back into a recession and unemployment rate would rise back above 9%.

Risk sentiment deteriorated significantly this week gained with concerns about the fiscal cliff as a key factory and we think that sentiment is likely to remain under pressure as the US nears the edge of the fiscal cliff. The US dollar and the Japanese yen have benefited this week as perceived havens and we expect this to be a driving factor moving forward. With both the Fed and Bank of Japan engaging in balance sheet expansion, gold has also regained its safe haven appeal and has performed strongly this week. If a resolution can be reached in a timely manner, risk appetite is likely to be given a boost however our base scenario is for a deal to come down to the wire.

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