Highlights

• US fiscal cliff, housing data in focus
• Bank of Japan likely to pause ahead of election
• Greece returns to haunt the markets
• Global uncertainty continues to weigh on stocks
• The Inflation Report vs. the Bank of England minutes

Federal Reserve Chairman Ben Bernanke said this week that weak housing is “a powerful headwind to recovery” and that the Fed will do what it can to back the housing recovery. The comments support the most recent round of QE undertaken by the Fed which targets the housing market with monthly purchases of $40B in mortgage-backed securities (MBS). In the week ahead, key October housing indicators will be released such as existing home sales, housing starts, and building permits. The November NAHB housing market index and weekly mortgage applications are also due next week. These data releases are becoming increasingly important as the Fed appears more concerned with the housing market to seek improvement in economic activity and the labor market.

FOMC minutes released this past week also indicate a potential shift in communications as members have discussed the idea of thresholds to replace the calendar approach to forward rate guidance. Furthermore, “a number” of FOMC participants favored more QE after the end of the Maturity Extention Program (aka Operation Twist). The minutes were inconclusive as to whether this view was in the majority, so we will be closely monitoring Fed speeches ahead of the December 12 meeting for more insight. The market impact of additional QE would likely be a weaker US dollar, lower UST yields, and a boost to equities. We note that each subsequent round of balance sheet expansion tends to have a diminishing impact and significant risks exist (i.e. US fiscal cliff, EU debt crisis) that can move markets.

Fiscal cliff negotiations began in earnest on Friday as President Obama met with key policy makers such as Boehner, Pelosi, McConnell, and Reid. The President said that he expects the beginning of a “fruitful” process. The market response has not been as optimistic as US equities have declined sharply in the aftermath of US elections as uncertainty over fiscal policy weighs on sentiment. Republicans and democrats appear far from reaching a deal at present as reflected by recent comments and general risk aversion. Democrats favor higher taxes for the wealthy, while republicans oppose this in favor of increased spending cuts. Our main scenario is for protracted negotiations, however if headlines suggest the two parties are moving closer to an agreement then sentiment is likely to be given a boost which could see the USD trade softer.

The Bank of Japan (BOJ) will announce policy at the conclusion of a 2-day meeting on Tuesday November 20. With increases to its Asset Purchase Program (APP) in 2 out of the last 3 meetings, we expect the Bank to remain on hold for now before it resumes balance sheet expansion over the coming months. The Bank last announced increases in purchases by about 11 trillion yen at the October 30 meeting and another ¥10T on September 19 (no change was made at the Oct 5 policy meeting). An increase to the APP at next week’s meeting would suggest that the expansion announced just a couple weeks ago was inadequate and could further erode the credibility of the BoJ.

A changing political landscape is increasing speculation of more aggressive measures to come from the BoJ in efforts to weaken the currency as a December 16 election looms. The main opposition leader, Shinzo Abe, is widely expected to win and has made very dovish comments in recent days. Abe has made calls for bold monetary easing such as unlimited easing by the BoJ until deflation is overcome, an increase of the inflation target to 3%, and policy rates at zero or below.

Abe’s comments disregard the independence of the Bank and he has mentioned that he will consider changing BoJ law. The Japanese yen has weakened significantly markets repositioned ahead of elections in anticipation of leadership under Abe. USD/JPY traded at 7-month highs despite lack of support from US treasury yields which have remained low amid risk aversion associated with the US fiscal cliff and the possibility of renewed treasury purchases by the Federal Reserve with an expansion of its current QE program. USD/JPY moved back above its weekly ichimoku cloud and looks set to close the week above the cloud top which is currently around 80.65. The last time the pair closed above the weekly cloud, it saw a move towards the 2012 highs of 84.00.

We anticipate profit taking to slow the JPY’s sharp decline, however it appears as though a shift in the policy response may be forthcoming. As such, we favor JPY downside and would view dips in USD/JPY as potential long opportunities. Key levels to the upside are the 61.8% Fibonacci retracement around 81.50 and 76.4% Fib retracement that is around 82.50. The 80.00 big figure may be supportive as well as the 200-day SMA just below at around 79.70.

For the last few months Spain has been the biggest headache for the currency bloc, but as we move towards the final few weeks of the year Greece is once again coming back to take centre stage. It is still waiting on its next tranche of bailout funds and only just managed to scrape together enough cash to pay a large bond redemption due on Friday. An extraordinary meeting of Europe’s finance ministers to specifically discuss Greece will take place in Brussels on Tuesday at 1600GMT/ 1100ET. There is a lot of pressure on the ministers to agree to disperse Greece’s next tranche of bailout funds. The head of the IMF (and former French finance minister) Christine Lagarde has said that she hopes that the uncertainty over Greece’s next payment is resolved on Tuesday and also that the Eurozone must put Greece’s finances on a sustainable path. The IMF wants Greece’s debt-to-GDP ratio to fall to 120% of GDP by 2020, the Eurozone wants to give Greece until 2022 to achieve this. The IMF would rather there wasn’t a two year delay, but to reach the target by 2020 it would most likely mean that Eurozone governments would need to take write-downs (or haircuts) on their Greek debt holdings, which the governments’ are loath to do for obvious reasons.

Thus, there are two things to look out for in Tuesday’s meeting: 1, If Greece gets its next tranche of cash and 2, if the finance ministers’ agree on how to reduce Greece’s debt load to 120% of GDP by 2020 as the IMF has requested. An adverse outcome would be no money for Greece and continued discord between the IMF and the EU, in this case we could see the euro suffer and drift back to the 1.2650 support zone, which is also the base of the daily Ichimoku cloud, below which is the start of a technical downtrend. Risk may rally if Greece gets its next tranche of funds as this would reduce the risk of a near term default. Greece has bond redemptions of more than EU 5bn due on 14th December, so if these can be covered by the bailout funds the markets may breathe a sigh of relief. The best outcome would be money for Greece and an agreement on getting Greece’s finances and debt to GDP ratio back on a sustainable path. This outcome, we believe, is fairly unlikely.

Of course, the longer term investor will be looking for traction on Greece’s long term debt problems, which European officials still seem happy to kick down the road. But with Greek GDP contracting at a 7.5% annual pace in Q3 and the unemployment rate surging above 25% in September we are likely to see more slippage of fiscal targets. The most effective way to achieve sustainable finances for Greece is debt forgiveness, but this is looking extremely unlikely as governments in Europe seem less on Greece’s side as time passes and fiscal targets continue to be missed. Thus, the Greek debt saga is unlikely to be over even if bailout funds are released next week.

Greek problems have helped Spain and Italy fade into the background. After debt auctions last week they are both virtually fully financed for 2012. Spanish and Italian bond yields trended lower last week after the successful debt auctions, however, we don’t think this is a sign that problems are over. Both Spain and Italy have large debt issuances next year of EU 137bn and EU284bn respectively including EU 33bn of issuance from them both in January alone. Thus it is easy to see how fragile sentiment could shatter when the market realises just how much debt Spain and Italy have to sell next year especially as the ECB’s OMT programme is not yet activated.

Seemingly never-ending sovereign debt problems combined with weak growth, the Eurozone slipped into a recession in Q3 after the economy contracted by 0.1%, could weigh on the euro in the long term. EURUSD rallied as high as 1.28 on Thursday last week, however selling pressure started to build on Friday. At the weekly London close EURUSD was just holding onto the 1.27 handle. 1.2653 – the base of the Ichimoku cloud – is key support as below here is the start of a technical downtrend. This level has so far held, suggesting that there is buying interest down here; however, if we get a negative shift in the macro back drop then we could see the bears take control once more. Thus, we would look to sell EURUSD on rallies. We believe that strength will be capped above 1.28 due to a cluster of daily moving averages between 1.2750 and 1.3000 and also the top of the daily Ichimoku cloud at 1.2925 acting as stiff resistance.

As we start a fresh week the same concerns are weighing on stock markets: will Greece get its bailout money? Will the US avoid the fiscal cliff? Will the tensions between Palestine and Israel develop into something more sinister? Last week stocks sold off on the back of these worries. If the situations don’t deteriorate then the markets may get used to this uncertainty and we could see a pullback after sharp sell offs across US and European equity markets last week. However, if the situation escalates then we may see further declines.

The S&P 500 looks like it is oversold and thus could be due a short term recovery. It fell through its 200-day sma at 1,380, which opens the way for a move to 1,300. However, the relative strength index is now in oversold territory, which may trigger algo buying as some investors’ judge this index to have moved too far too fast. Key resistance is now 1,353 – the 38.2% retracement of the up move from Nov 2011 to September 2012. This highlights how significant the recent decline in the stock markets has been. Unless there is an agreement on issues surrounding Greece and the fiscal cliff it is hard to see how stocks can rally into the end of the year.

Last week’s Inflation Report left the door wide open to more QE from the BOE. Governor Mervyn King was unusually explicit when he said that the MPC had not finished using QE as a policy tool. Due to this the market is pricing in the expectation of More QE at the February meeting when the first Inflation Report of the year is due. However, King is only one member of the MPC and may not be able to sway opinion. In recent weeks we have heard MPC members start to question the usefulness of more QE. Thus, the minutes from the BOE’s November meeting could contradict the Inflation Report and King’s sympathy towards more QE. We expect the minutes to note that a significant number of members are not convinced about the benefits of more QE. We think the MPC voted unanimously to keep rates on hold earlier this month, if so it suggests that the bar may be quite high for more QE next year.

We would expect some volatility in GBPUSD when the minutes are released on Wednesday at 0930 GMT/ 0430 ET. Cable declined sharply last week post the Inflation Report, but managed to find some support into 1.5850 – a cluster of daily smas and a key support zone. If the minutes suggest that the MPC has a more neutral stance on QE than Governor King suggested in the Inflation Report then we may see a rally in this cross back to 1.5900 – the top of the Ichimoku cloud, and then 1.5950.

The public finance data also released on Wednesday is worth looking out for as it is the last data on the government’s finances before the Chancellor’s Autumn statement on December 5th. Normally October borrowing levels are down due to high corporate tax receipts at this time of year and borrowing is expected to drop to GBP4bn from GBP10.7bn in September. But the public finance data has been pretty dismal in the last couple of months, so if we continue to see negative surprises in borrowing data then there is a chance that the Chancellor will overshoot his GBP120bn borrowing target for 2012.

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