Highlights

• Is the Eurozone turning a corner?
• Does the UK's triple A credit rating matter?
• USD under pressure as markets digest the Fed
• Japanese election could steal the BoJ's limelight

The ECB President Mario Draghi might be feeling rather content with himself after he received the FT person of the year award for 2012 on Friday. He took a risk when he said back in July that the ECB would do everything within its power to save the euro. That was a defining moment in FX markets. Since he said those words EURUSD has climbed nearly 10% and Spanish borrowing costs have slumped, 10-year yields have fallen by 200 basis points in the second half of the year. What’s even more impressive is that the ECB didn’t buy one bond during that period. The ECB has managed to save the euro, at the time of writing EURUSD had closed the London session above 1.31.

But lowering borrowing costs is only useful as long as it boosts growth. So far lower borrowing costs have not filtered through to the real economy. After recording three straight quarters of negative growth from Q1 –Q3, there are signs that growth may be stabilizing, albeit at a low level. The composite PMI for December rose to 47.3, the second consecutive monthly increase. The increases were fairly broad-based, although Germany’s service sector surged back into expansionary territory above 50. This data suggests that we may see continued signs of economic stabilization in the currency bloc in Q1 2013 as financial conditions pick up and there is a slight reduction in the fiscal drag.

This reinforces the ECB’s wait-and-see stance and is thus fairly currency neutral. EURUSD had a very strong end to the week, rising more than 2% over the week. The next major resistance level to watch out for is 1.3175 – the highs from September. If we can get above this level then 1.35 is on the cards, however we expect this to be a major resistance zone. Also there are many fundamental hurdles to a sustained uptrend in EURUSD, not least the US fiscal cliff which remains unresolved with two weeks to go before year-end. Thus, we believe there may be some selling pressure on the single currency at the start of this week, 1.3100 then 1.3050 should act as good support zones in the short term.

A pick-up in the global economy is good news for the Eurozone as peripheral economies, in particular, try to position themselves as export bases. This along with some signs of progress at the EU Council on banking union may be settling nerves about the financial crisis. While banking union (a pre-requisite before fiscal union) is still some way off, there have been some major developments – including that the ECB has been chosen as the banking regulator and only banks of a certain size will be included. There is still no decision on euro-wide deposit insurance or a fund to pay for future bank rescue schemes. Thus, these are only early steps. However, if momentum can be made then much-needed structural change to the union could be on the cards for 2013, which is positive in the long-term for EURUSD.

Rating agency Standard &Poor’s put the UK on negative credit watch last week.  Not even the government’s pledge to maintain is budget deficit target for the fiscal year 2012/13 in the Chancellor’s Autumn Budget statement was enough to placate S&P. In the next six months there is a high chance that the UK could lose its coveted triple A credit rating, which would be the first time it has lost triple A status since the 1970’s.

UK Gilt yields actually fell on the news and the pound continued its climb higher as risk sentiment picked up on Friday. As we have seen in the US and France, both countries who lost their triple A ratings in the last 18 months, the blow is more symbolic and has virtually no impact on the markets. Even if the UK does lose its triple A credit rating we don’t think it will dramatically alter borrowing costs or the strength of the pound, which are both impacted by external events more than domestic factors.

However, it is a timely reminder that the UK’s financial position remains perilous. This could be reinforced this week as the November borrowing data is expected to show another rise in government borrowing relative to 2011. The market expects that borrowing (ex. financial sector interventions) is expected to rise to GBP 16bn, which is GBP0.5bn larger than this time a year ago.  The Chancellor has been lucky that the deficit has been stable this year, but it mostly down to one-off factors and the truth is that the underlying rate of borrowing remains too high.

Already the public sector austerity drive is expected to last by one extra year to 2016/17, and if borrowing remains at this level then we could see deeper cuts between now and then that weigh on the economy.

The UK’s public finances are not a key driver of sterling or UK based asset markets at the moment, but they could be. The Chancellor is well aware that debt becomes an issue once it becomes an issue; Italy is a case in point. Thus we expect to see more austerity-rhetoric in the medium-term.

There is a hefty data schedule before things quieten down in the UK for the Christmas break. The minutes of the December BOE meeting are expected to show that David Miles was alone in voting for more QE, this suggests that the BOE remains in wait-and-see mode, which is mildly GBP positive in the short term. Retail sales for November are expected to rise by 0.4%; however this won’t fully reverse the 0.7% decline in sales in October. Thus, we may see a more frugal consumer in the UK this holiday season, which may weigh on Q4 growth.

Stock markets have backed off recent highs, including the FTSE 100. However, if we get back below 5,900 towards 5,830 in the near-term, this may attract some buying interest as Chinese growth is picking up, which may boost risk sentiment in the medium-term.  6,000 remains the key resistance level. A satisfactory outcome of the fiscal cliff negotiations could be enough to give risk a leg higher in the medium-term, in our view. Thus, when trading the FTSE 100 watch what is going on in Capitol Hill.

At its December meeting, the FOMC announced an expansion of its balance sheet to include $45B in monthly treasury purchases with an average duration of about 9 years to begin following the expiration of the Maturity Extension Program. This is in addition to the $40B in monthly purchases of mortgage-backed securities. What was more surprising was the removal of the calendar-date guidance to interest rates which were replaced by numerical thresholds of economic indicators. Specifically, the central bank noted that rates are anticipated to be exceptionally low “as long as the unemployment rate remains above 6.5%, inflation between 1-2 years ahead is projected to be no more than a half percentage point above the Committee’s 2% longer-run goal”. We noted in our 1Q Markets Outlook that Chicago Fed President Evans (2013 FOMC voter) suggested this approach “to keep interest rates near zero until the unemployment rate falls to 6.5% or below while inflation is under 2.5%”.

The move by the Fed to adopt numerical thresholds is being met with mixed interpretations. On the one hand, it can be seen as more hawkish if recent declines in unemployment can be sustained suggesting that the target will be met before the previous 2015 pledge. Alternatively, it gives the Fed some flexibility as Bernanke indicated that the Fed will judge if any job rate gain is sustainable. If the reduction in the unemployment rate is for the wrong reasons (i.e. falling labor force), then more stimulus may be warranted. Admittedly, the Fed’s projections indicate that the thresholds will be reached by mid-2015 which leaves the amount of stimulus more or less the same.

Despite a slight decline today following softer than expected consumer prices, Treasury yields are higher on the week. Equities are relatively flat and the dollar is under pressure as the Fed prepares to increase the pace of balance sheet expansion. The dollar index is currently trading below long-term bull channel support which converges with the 38.2% Fibonacci retracement of the rally from 2011 lows to 2012 highs. A close beneath this level seems likely and would suggest the potential for further declines from a technical perspective. A move back into the channel may indicate a false break and could see the dollar index resume its upward channel.

Japan has their Lower House election on December 16^th, whereby the Liberal Democratic Party (LDP) will most likely prevail. The leader of the coalition, Abe, has been very outspoken in his beliefs that the Japanese government has not done enough to elicit growth or boost sentiment and he has promised to do more to stimulate the economy. While Abe not only wants replace BoJ governor Shirakawa with a more dovish candidate in April, he has been pursuing a bill which is proposing revisions to current Bank of Japan law. Furthermore, he has been advocating substantial monetary policy easing, suggesting the introduction of a 2% inflation target – which implies an unlimited amount of asset purchases, as well as a policy rate of 0% or even negative rates to facilitate bank lending.

As it has become more evident that the LDP party could take power over the past few weeks, Abe’s comments began to carry more weight – Consequently, it has led to broad JPY weakness overall. It is interesting to note that nearly all of the popular JPY-crosses are either: approaching, testing or has recently broken above their previous 2012 highs in March. While there is certainly the possibility of additional Yen weakness once the election results become official, we believe the bulk of JPY’s decline has already been priced into the market. Technically speaking, it may be prudent to monitor the price action in two of the more prominent JPY pairs – USD/JPY which is nearing 2012 highs around 84.15/20 and EUR/JPY which is hovering just below the psychological 110 level. 

With that said, Japan’s political elections are not the only important event to be watching next week, as Wednesday/Thursday sees a Bank of Japan interest rate announcement. While some believe the BoJ will remain on hold in December, Friday’s Tankan survey highlighted the sharp deterioration of business conditions in the fourth quarter and this has increased the chances of another round of monetary easing this week. While another increase in their Asset Purchase Program of ¥5-10 trillion on Thursday could help to aid financial conditions, we would argue that it’s not the game-changing policies which the LDP’s Abe has market participants enamored with.

Service Note: There will be no weekly outlook next week due to the upcoming holidays. The Week Ahead will return on December 28. To all FOREX.com clients and regular readers of The Week Ahead, the Research team sends our best wishes for Happy Holidays.

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