Market Salutes Mass Confusion with Further Risk Rally

The coming “solution” to the EU’s debt crisis is creating ever mounting piles of research outlining the if’s, and’s and but’s – so the market shrugs its shoulders and says “they’ll figure something out.”

The discussion surrounding the potential form of the EFSF has become an endlessly confusing cacophony for which readers can find far better sources than this column to review and understand all of the various nuances of the proposed solutions and the questions outstanding. The bulls have largely made their case on the potential outcome for what is now next Wednesday (Summit, part Two) with the extensive rally in the rear view mirror. The bears are licking their wounds and still running for cover. The essential bottom for the bigger picture here boils down to three interlocking questions, none of which are likely to be answered beyond the next couple of weeks to couple of months, in my view.

Confidence? All of the solutions rely on the market’s confidence and the hope that officialdom has gone far enough in back-stopping sovereign debt to a sufficient degree far more than the actual deployment of funds. The solution is more one of – if something goes wrong, we’ll be there – trust us! It works as long as market participants believe it will work, in other words. But if enough confidence is lost and the actual mechanisms are being tested, is there really enough firepower in place? Which leads us to the next question…

Where is the money? The issue of leverage has not been resolved. Yes, an all-out money printing fiesta from the ECB or something closer to what the French wanted could have generated a more QE2-like large scale liquidity-induced rally, but none of the currently more likely sounding resolutions generate huge liquidity – only implied liquidity via backstopping. This is a highly complex, have-our-cake-and-eat-it-too tight money solution to the situation.

A closer union or not?  The risk at all times given the incredibly cumbersome EU framework is one of one more bad actor spoiling the party – Greek exceptionalism in this department is an awfully risky assumption. Most are discussing Greek defaults only. Every round of this crisis has shown how tenuous the political EU framework remains, and the trend doesn’t appear to be toward a firmer commitment to union, but rather the opposite. The framework may survive this round, but what about the next one?

These are awfully big questions. Yes, we could see confidence for a time because yes, there may be enough funding for the center to hold – but the third question is the real challenger down the line. If the confidence fails because more money is needed or more money is needed because confidence fails, the political will for another round of bailouts is unlikely to be there as our Chief Economist said in yesterday’s Chronicle – maximum intervention will eventually yield to Crisis 2.0, whether it is in this quarter or not until next year.

Meanwhile, back in the East
Two things going on in Asia at the moment: China’s equity market is looking very shaky and satellite indicators like the price of copper are a significant cause for concern, particularly given copper’s odd use in China’s collateralized credit market in recent years. Meanwhile, AUDUSD is following equity markets and the Euro-phoria rather than its more traditional orientation with industrial commodities – an awkward path at best for the currency. The direction of AUDUSD and copper/China indicators is unlikely to diverge for much longer – one of the two markets is “wrong”.

Elsewhere, complacent USDJPY longs were attacked in the early US hours as the USD was crumbling across the board in today’s trade as risk appetite stormed higher and 76.0 was taken out as USDJPY briefly touched a new all-time low. There is risk of further downside if Japanese officialdom prefers to wait for the other side of the G20 to make its presence more forcefully felt. The move lower is actually at odds with the interest rate spreads at the short end of the US/Japanese yield curves, though there has been a general move away from these kinds of correlations holding much sway of late.

Looking ahead
So what are the potential outcomes once we are on the other side of next week’s EU summit and the G20 in early November? A further extension of the rally for the shorter term is quite possible if the EU solution continues to generate more complacency – so we have to allow for, for example, EURUSD to challenge anything from its 55-day MA above 1.3900 to its 200-day MA above 1.40. But that’s our line in the sand, as we discuss in the chart below.

EURGBP pulled a number on the market today – as EURGBP took out downside stops before rallying well back into the range, a move that makes sense as GBP and USD are in similar boats and their general direction versus the EUR is likely to remain loosely correlated at minimum.

Chart: EURUSD scenarios
Assuming that the EURUSD isn’t preparing for a full trend change to the upside, the scenario indicated on the chart below is a possible trajectory for the pair – a brief further extension of the rally as we head into/out of the EU Summit followed by a reversal and then disappointment further down the line. If the pair remain above 1.40 for any length of time, we’ll have to reconsider our assumptions.

Have a great weekend and stay careful out there.


Economic Data Highlights

• Germany Oct. IFO out at 106.4 vs. 106.2 expected and 107.4 in Sep.
• Canada Sep. CPI out at +0.2% MoM and +3.2% YoY vs. +0.2%/+3.1% expected, respectively and vs. +3.1% in Aug.
• Canada Sep. CPI Core out at +0.5% MoM and +2.2% YoY vs. +0.2%/+2.0% expected, respectively and vs. +1.9% YoY in Aug.

Upcoming Economic Calendar Highlights (all times GMT)

• US Fed’s Kocherlakota to Speak (1700)
• US Fed’s Fisher to Speak (1720)
• US Fed’s Yellen to Speak (1900)
• US Fed’s Duke to Speak (Sat 1400)
• Japan Sep. Merchandise Trade Balance (Sun 2350)
• Australia Q3 Producer Price Index (0030)
• China Oct. HSBC Flash Manufacturing PMI (0230)

Action, not words, required to take pressure off the EUR

An element of doubt came back into the mind of market participants Monday as (in particular, German) officials began to raise the possibility that the much vaunted ‘grand plan’ (which the rhetoric and inference by eurozone leaders commentary has been since the initial formulation by Merkel and Sarkozy on the 9^th October) may not be the all-encompassing solution to the woes of the eurozone.
German Government spokesman Seibert stated “Dreams of a swift Euro solution won’t materialise”. In conjunction with the German Finance Minister’s statement that the “upcoming EU summit will not present [a] final solution for [the] eurozone debt crisis.”  Both comments added to the weigh of an already seemingly faltering EUR.
Broader risk assets also struggled yesterday as concerns filtered through into the banking sector, despite the significantly better than expected Q3 earnings figures from Citigroup. With little in the way of top tier data this week, headlines will continue to dominate sentiment. A clear example of this was seen yesterday when a Der Spiegel online article suggested that “top German economists are warning that France’s AAA rating could be in danger should additional measures become necessary to prop up indebted eurozone members of to save ailing banks.” This is not a new concept and, indeed, it is one which I have discussed on this page a number of times. But the timing of the story into a market already feeling vulnerable top bad news exacerbated the impact.
This morning the spread between French and German 10 year yields has hit another new record at 100bps and despite Finance Minister Baroin’s protestations that France will do “everything” to maintain its debt ratings, we have reached a pinnacle. We have reached the point at which the rousing, determined words of officials are no longer enough; a point where action is needed.  Schaeuble’s words yesterday, that seem to have undone all the calming work of the G20, could well see the EUR decline back to the lows, seen before the irrationally exuberant, Merkozy-inspired rally, over the next week.
In China overnight data came in better than broad expectations as Industrial Production and Retail Sales data picked up again in September after a decline in August.  Fixed Asset investment was broadly stable yet GDP for Q3 slowed to 9.1% (its slowest pace since 2009). Whilst GDP growth is the envy of the developed world it is widely believed that the structure of the Chinese Economy requires it to maintain growth above 8% to maintain stable unemployment. The current easing of growth saw interest rate swaps fall as, in addition to a marked slowdown in money supply and an easing in inflation, the market has begun to price in a halt to monetary tightening in order to support growth.
In the UK today we get CPI data for September, where the market is expecting a print close to the 5%, up from 4.5% in August. In the eurozone we await the ZEW economic sentiment index but as I suggested yesterday the current market is not driven by the data but predominantly by the politics and that will continue until we get a resolution in the eurozone.

For the rest of the week I would anticipate that the EUR, in particular, but broad risk assets (including the AUD) will underperform, and after the capitulative deleveraging rally of last week, the support on the downside is likely more fragile than before. I still favour EURGBP throughout this week, but risk off sentiment is likely to pick up as we approach the weekend.

Q4 FX Outlook: USD Rally to Extend

Waiting for a US dollar rally this year has felt like Waiting for Godot at times as we anticipated one for a long time before the greenback finally rallied sharply in late August and early September after a long period of stagnation over the summer, despite a number of market developments that have normally proven positive for the currency in the past. Those included falling equity markets, rising signs of worry in other risk indicators and in global growth concerns, particularly in Asia and emerging markets.

In our Q3 FX outlook, we discussed the “ugly horse-race” among the G-10 currencies because we felt that few if any of the major or minor developed economies would offer compelling reasons to buy their currencies and that it would be a question of which currencies appeared the least hobbled by fundamentals. The basic outlines of such a development have come to pass, though the USD was very slow to begin rallying as economic data out of the U.S. was terrible as well. But, the relative slowing in other economies and thus a tightening in interest rate spreads was indeed a positive driver for the eventual USD rally. And because U.S. rates were already so low, the tightening has even occurred despite Federal Reserve Chairman Ben Bernanke’s promise to keep the monetary pedal to the metal on low rates until at least mid 2013 – and despite hints that QE3 in some shape or form is on the way. To take the most pronounced example of falling yield spreads, the highest yielding currency among the G-10, the Australian dollar (overnight rate at 4.75 percent as of mid-September) saw its 2-year government bond yields drop from 4.75 percent at the beginning of Q3 to about 3.50 percent by mid-September, a 125-bp drop as compared with a drop in US 2-year rates of a mere 25 bps or so in the same time frame.

We suspect a further tightening in yield spreads between the USD and other currencies will continue to unwind the carry advantage built up against the USD last year and at the beginning of 2011 as economies around the world, particularly in Europe and to some degree in Asia and in developing markets, stumble through a soft patch in growth or worse. At the same time, yet another round of government stimulus and Fed QE could see a few quarters of solid GDP performance as US politicians pull out all the stops to get the economy going and then jostle to take credit for it ahead of the presidential election next November. Efforts in this direction will be aided by the long period of dollar weakness, which has made the U.S. extremely competitive for sourcing production and services and attractive for investment.

Chart: US 2-year yields vs. average G-10 currency yield. In the chart above we have plotted the spread of the 2-year swap rates for the USD vs. an average of the 2-year swap rates for the remainder of the G10 currencies. We’ve then compared this with the USD’s performance vs. an evenly weighted basket of the remainder of the G10 currencies. It is clear that from a yield perspective, owning the USD is far less unattractive than it was just a few months ago. It is also clear from the chart above that the USD has been slow to respond to this development.

There are two further potential sources of USD strength – one is the likely return of the Homeland Investment Act (HIA), the original version of which allowed U.S. companies to repatriate profits tax free back in 2005. Q4 would appear to be the most likely timeframe to discuss and enact an HIA2, which would then go into effect in the New Year. Estimates of the amounts that might be repatriated this time around are far higher than the original HIA and could reach far over half a trillion dollars.

The other potential source of strength for the USD is that there is simply no alternative in a deleveraging world going where participants are unwinding their previous bets on “everything up versus the USD”. The lack of credibility of the Euro as the single currency faces an existential crisis now and in the coming few quarters will also continue to delay the demise of the USD’s status as the world’s reserve currency. Of course, these developments will not boost the U.S. currency forever and we wonder how long it will be until the long run accumulation of the twin U.S. deficits eventually returns to haunt the U.S. debt market and its currency.

Europe - crunch time
As we discuss in our introductory article to this publication, it is crunch time for the European Union, as the efforts of the European Central Bank and EU politicians have failed to outrun the galloping problems caused by the awkward framework of a single currency and 17 finance ministries and 17 sovereign bond markets. As we are leaving Q3, the situation is fast reaching the ultimate crossroads: either the EU makes a strong show of solidarity or a solution will quickly be forced upon it by the markets. 
The Euro could see a relief rally if the EU manages to muddle through with the solidarity enforced by the market’s discipline, but a longer term solution to European debt woes would likely involve some form of QE by the ECB to keep bond markets orderly and dig European banks out of their liquidity pinch. And if the USD has been so punished for the Fed’s various rounds of QE, why shouldn’t a similarly dim view be taken of the Euro for also engaging in money printing? Of course, the immediate relief that sovereign debt investments won’t go immediately bad could offset some of the deleterious effects of a European version of QE (save for Greece, where a severe haircut or Greek exit is a question of time). And a more stable sovereign debt and financial services environment could see the Euro rewarded for its deep liquidity versus higher beta, more pro-cyclical currencies as global growth possibly hits a soft patch over the next couple of quarters.

The Scandies - safe havens?
There was a flurry of talk about the potential for NOK and SEK to become safe haven currencies in the wake of the Swiss National Bank’s frantic and so far successful efforts to put a floor in EURCHF at 1.20. Immediately in the wake of the SNB’s announcement in early September, the market drove both NOK and SEK sharply stronger, completely out of proportion to any other development that could have explained the situation besides the idea of safe haven seeking (or reversals based on positioning?). Afterwards, however, the strengthening in these currencies was erased. So are they potential safe havens or not? There are two important features a currency must have in order to be considered a safe haven in today’s environment – a superior sovereign balance sheet and deep liquidity. CHF used to be the best option until the franc’s incredible strength made the SNB and Swiss government “go nuclear” in their intervention. Sweden has a very solid balance sheet and Norway has an impeccable one, but both SEK and NOK fail the liquidity requirement for a true safe haven. Also, SEK is traditionally a pro-cyclical currency due to its economy’s dependence on export markets. NOK is similarly dependent on oil exports, though it tries to sterilise oil revenues with its pension fund. Of the two, NOK would appear a safer harbour than many of the rest of the G-10 currencies, but it would be surprising to see performance similar to the Swiss franc’s (where the oversized Swiss financial industry was an additional contributor to the franc’s aggravated rise).

The Antipodeans: still waiting for the fall
Last time around we asked whether the strength in the Aussie and Kiwi versus the rest of the market was a bit overdone. Both currencies have begun to trade a bit more sideways in Q3, including one particularly sharp sell-off as equities slid off a cliff in early August. The kiwi has been the stronger of the two due to a few months of perkier economic data and the belief that the Reserve Bank of New Zealand might unwind the emergency rate cut taken in the wake of the earthquake earlier this year. But both rather extremely overvalued – particularly the Aussie, given present market circumstances and our expected scenario for Q4. Because Australia has the highest policy rate among the G10 currencies, it also will likely have the highest beta to risk as the Reserve Bank of Australia has more potential for policy accommodation. The housing bubble appears to be in near full deflation phase now Down Under and could cause a considerable pinch in the Australian banking sector, suggesting that eventually even the RBA has to get in on the Maximum Intervention game in the quarters to come.

Chart: AUD and NZD against the rest of the G-10. Aussie and kiwi rose to new multi-year highs against the rest of the major currencies during 2011 and were remarkably resilient despite the heavy sell-off in risk and weakening emerging market currencies. Just before publishing time, however, they suffered a setback in the wake of the FOMC meeting, which may serve as a catalyst that pushes them lower to a fairer value, given the darkening clouds in the global economic outlook and their normal pro-cyclical correlation.

G-10: the bottom lines

USD: A lack of alternatives and Maximum Intervention gone global will make the USD continue to look less unattractive in Q4 and the currency has been so weak for so long that the U.S. economy could reap some of the benefit.
EUR: It is crunch time for the Eurozone, which will need to pull together or face a further – and this time more urgent – existential challenge. Will Germany step up to foot the bill for the periphery?
JPY: The government bond rally and declining interest rate spreads (the carry in the carry trade) are the only real supports, as the domestic Japanese economy is relatively moribund. If bond markets pivot some day, so will the JPY, until then, it could remain strong for a while yet.
GBP: Sterling shows us the degree to which the Euro’s woes are driven by its untenable political and central bank framework rather than by the absolute magnitude of its sovereign debt as the UK debt load and deficits are far worse. Yet, GBP has already been endlessly punished, and similar to the USD, could rally “by default” due to dimmer prospects elsewhere relative to previous expectations.
CHF: The Swiss franc has become the latest, most impressive victim of maximum intervention, which makes the world believe that no fiat currency can be a true safe haven forever. We assume that the determination of the SNB and Swiss Government will keep the CHF weaker.
AUD: Aussie did sell-off when risk appetite swooned in early August, but it is far too resilient given risk averse circumstances, prospects for slower growth in Asia, and on the risk of a disorderly unwinding of the domestic housing market. A heady adjustment lower could finally arrive in Q4 for the Aussie.
CAD: It will continue to trade as an “in-betweener” – a lower beta risk currency that may find resilience in its exposure to a less weak than feared U.S. economy. Still, the currency has only so much upside despite the solidity of the sovereign balance sheet and banks, as Canada features the world’s most overleveraged consumer.
NZD: Some of its strength has derived from economic activity from earthquake rebuilding and some of it from Chinese diversification interest (which throws huge weight around in the less liquid kiwi). The rally could falter in Q4 on weaker than expected Asian growth prospects and as the RBNZ stays pat.
SEK: Likely to remain a pro-cyclical currency – the country could face a slowdown that could be multiplied by a European demand slowdown. In addition, Sweden’s housing market is a raging bubble, though the signs of strain have yet to show much. Could they begin to do so in Q4?
NOK: Rate expectations have tumbled as with most other currencies where there is enough rate to cut. NOK may find a safe harbour bid to a degree due to the country’s unmatched sovereign balance sheet, so strength versus the most pro-cyclical currencies might come into play in Q4 and Q1.

Q4 Monetary Policy

U.S. monetary policy
As we had previously suggested was possible at its 20/21 September meeting, the Federal Reserve announced that it would indulge in a so-called ‘Twist’ operation-selling $400 bn of its holdings of under 3-year Treasuries and buying $400bn of 6-30 year maturities in an attempt to lower long-term yields - given their direct correlation with mortgage rates and also the discount rates used by commercial enterprises to evaluate the viability of long-term business ventures.

The post-meeting statement noted “continuing weakness in overall labour market conditions” and “only a modest pace” of growth in consumer spending and repeated the committee’s belief that inflation will “settle...at levels at or below those consistent with the Committee’s dual mandate”. As a result, 30-year yields fell below 3.00 percent - one of our ’10 Outrageous Predictions for 2011’, made last December.

Our feeling continues to be that risk markets will continue to be underwhelmed by the Fed’s actions and that ‘Operation Twist’ is but the next step in an inexorable move towards what we long ago dubbed ‘QE Infinite’- repeated QE’s with diminishing returns.

The next instalments in the saga will be QE3 - probably in Q1 2012, as the economy fails to revive and stock markets languish. A reduction in the rate the Fed pays banks on excess reserve holdings from 25 bp to 10 bp is also highly likely within that timeframe, in a desperate attempt to encourage banks to lend to the real economy.

Eurozone monetary policy
As predicted in our Q3 Outlook, the ECB duly raised its main refinancing rate to 1.5 percent at its July meeting and, at the time, markets expected that this was the beginning of an inexorable march higher in rates over the coming months and years. However, unfortunately the world economic situation in general and that of the Eurozone in particular, has exhibited a marked deterioration since then.
In addition to the general gloom which has descended upon the world’s largest economy, as discussed above, the main developments in the Eurozone have been as follows:

• July saw the announcement of a further package of measures from the European Council aimed at easing the Greek crisis and halting contagion into Spain and Italy. As has become the norm over the last 18 months the market was at first reasonably impressed, but enthusiasm quickly evaporated. This was principally because the European Financial Stability Facility (although newly authorised to intervene in the secondary bond markets of all European Monetary Union countries if the European Central Bank judged that ‘exceptional financial market circumstances’ posed a threat to financial stability) was not increased in size, and so would be completely inadequate should it become necessary to support Spain and Italy.
• Therefore, it finally dawned on the markets that the only solution that would bring an end to the debt crisis was a fiscal union, and speculation quickly arose that the natural precursor to this, the issuance of Eurobonds for which EZ governments would be jointly and severally liable, was now on the cards.
• Germany quickly and resolutely made it clear that it would not support the issuance of Eurobonds and the German Constitutional Court ruling on 7 September also underlined this position.
• A surprise fall in EZ core CPI in July from 1.6 percent to 1.2 percent, a level maintained in August.
• Weak business sentiment surveys.

Given the climate created by all of the above, it came as no surprise when fear did indeed spread to Spain and Italy (taking their 10-year bond yields well above 6 percent), so the ECB had to reluctantly revive its bond buying programme or securities markets programme (SMP) in the face of a divided ECB Governing Council, with the Bundesbank implacably opposed to the measure.
It therefore also came as no surprise when ECB President Trichet adopted a much more dovish tone at the news conference following the 8 September meeting of the Governing Council. Although it was apparently too embarrassing to reverse the recent rate hikes so soon, he made it clear that further increases were now firmly off the agenda and left the door wide open for decreases in the near future.

We now expect that, at the very least, before year-end the ECB will reintroduce the provision of unlimited, fixed rate, long-term liquidity to banks, thus flushing the system with liquidity and forcing actual market rates lower than the refinance rate, if it chooses to keep this at 1.5 percent to save face, but probably also a reduction in same back to 1 percent and in the deposit rate from 0.75 percent to 0.25 percent. If the real economic decline accelerates, or the EZ debt crisis spirals out of hand, or interbank funding dries up, then these moves could come very quickly and we may even see the refinance rate reduced to 0.5 percent.

Japanese monetary policy
Mindful of the worsening economic situation, The Bank of Japan increased its Asset Purchase Programme by Yen 10 trn at its meeting on 4 August. The measure was also no doubt intended to reinforce that day’s foreign exchange market intervention, aimed at weakening the yen. Although this achieved initial success, with the yen dropping from approx 77.00 to the dollar to 80.24 on the day, global financial turmoil has since fostered investors’ continued search for safe-havens, quickly taking the dollar back below 77.00.
We maintain our call for unchanged Japanese rates throughout 2011, and indeed also through 2012, and feel further quantitative easing is very likely.

UK monetary policy
The minutes of the 8 September Bank of England’s Monetary Policy Committee (MPC) meeting revealed that the decision to leave rates unchanged at 0.5 percent was of course unanimous. This came as no surprise to us or to the markets and, although Adam Posen remained the only member calling for increased asset purchases, (voting again for an additional £50 bn), “some” other members also moved towards QE2 - “This meant that the balance of risks to inflation in the medium term was likely to have shifted further to the downside. Most of these members thought that it was increasingly probable that further asset purchases to loosen monetary conditions would become warranted at some point”
As a result, we now feel that QE2 before Christmas is extremely likely, and rates are certainly not going to rise before 2013. 

Market Preview - 11 October 2011

Forex Overnight: EUR trading weaker against USD
The EUR has weakened against the USD, this morning, ahead of Slovakia’s final vote on the enlarged European Financial Stability Facility later in the day. Reports suggest that Slovakia’s ruling coalition was unable to end a dispute over participation in the euro-area bailout fund. The GBP has lost ground against the USD, this morning, ahead of a report, scheduled for release later today, which is expected to show that the U.K. industrial production declined in August. At 6 am, the EUR and the GBP have declined 0.1 percent and 0.3 percent against the USD, to trade at $1.3632 and $1.5618, respectively.
The JPY is trading 0.1 percent higher against the EUR, while it has edged marginally higher against the USD, ahead of the release of the minutes of the Federal Reserve’s (Fed) September meeting, later today.

UK Stocks: Likely to open in negative territory
The FTSE 100 is likely to open 6 to 8 points in the red.
Key economic indicators scheduled for release today include Industrial & Manufacturing Production, NIESR Gross Domestic Product Estimate and DCLG U.K. House Prices.
N Brown Group, Edinburgh Dragon Trust, Epistem Holdings and Fusion IP are scheduled to report their results later today.
Royal Dutch Shell has announced force majeure on its exports of Nigerian Forcados crude, following a leak on the Trans Forcados pipeline.
In an interview with the Financial Times, Steve Bertamini, the Head of retail and SME banking at Standard Chartered, has criticised western regulators for using the wrong mechanisms to handle the financial crisis.
Ian Cheshire, the CEO of Kingfisher, has forecast a “broadly flat” retail market in the U.K. for 2012, and added that it would be “more robust” in France.

Asia: Trading in the green
Asian markets are trading in positive territory this morning, amid continued optimism that European leaders would be able to stem the region’s debt crisis.
In Japan, markets are trading higher, with Sumitomo Mitsui Financial and Mitsubishi UFJ Financial Group trading up, amid renewed optimism over the prospectus of a solution to the European debt crisis. Toyota Motor has jumped, after it reported a rise in Chinese sales in September. Nidec Corporation has soared, after it announced an increase in its share buyback plan. At 6 am, the Nikkei 225 is trading 2.1 percent higher, at 8,787.5.
In China, Industrial & Commercial Bank of China, China Construction Bank Corporation, Bank of China and Agricultural Bank of China have added value, after state-run Central Huijin Investment bought shares in these banks. In South Korea, Shinhan Financial Group and KB Financial Group Inc have risen, amid optimism that the Eurozone debt crisis will be resolved. Shinsegae Company and Hyundai Department Store have gained, after South Korean wholesale inflation in September eased. In Hong Kong, markets are trading in positive territory, following China’s support for banking stocks.

US Stocks: Futures trading in the red
At 6 am, S&P 500 futures are trading 3.1 points weaker.
NFIB Small Business Optimism and IBD/TIPP Economic Optimism are the key economic indicators scheduled for release today. Investors also await the release of minutes of the Fed’s 20 September 2011 FOMC Meeting.
Alcoa, WD 40 Co, Synergetics USA, Century BanCorp, and Joe’s Jeans are scheduled to announce their results later today.
Felcor Lodging Trust, the top gainer in after hours trading session yesterday, soared 7.0 percent. Standard Pacific, Amylin Pharmaceuticals and Sotheby’s featured amongst the other major gainers, advancing 5.6 percent, 3.9 percent and 3.9 percent, respectively. Mistras Group advanced 3.3 percent, after its first quarter results surpassed market expectations. Sally Beauty Holdings declined 4.3 percent, after it announced a secondary offering of 15.0 million shares of common stock. Amongst the other key laggards, GNC Holdings, La-Z-Boy and CME Group plunged 9.8 percent, 9.3 percent and 4.6 percent, respectively.
Yesterday, the S&P 500 index surged 3.4 percent, after German and French leaders pledged to present a comprehensive plan to tackle the Eurozone debt crisis and recapitalise European banks. Denbury Resources, the top gainer on the S&P 500 index, rallied 9.6 percent. Record breaking pre-orders for iPhone 4S helped Apple to climb 5.1 percent. Higher metal prices led Alpha Natural Resources, Cliffs Natural Resources and Freeport-McMoRan Copper & Gold to surge 8.9 percent, 8.6 percent and 5.9 percent, respectively. Banking sector stocks, Citigroup, Morgan Stanley, Wells Fargo & Co and Bank of America Corporation soared 7.6 percent, 7.4 percent, 6.5 percent and 6.4 percent, respectively, as risk appetite amongst investors increased. Micron Technology jumped 4.2 percent, after a broker upgraded its rating on the stock to “Buy” from “Hold”. Sprint Nextel Corporation plunged 7.9 percent, after a broker downgraded its rating on the stock to “Neutral” from “Buy”. Netflix declined 4.8 percent, even as it abandoned plans to breakup its DVD-by-mail and online streaming services.

European Stocks: Expected to open marginally higher
The DAX and CAC are expected to open 7 to 8 points and 3 points, firmer, respectively.
No major economic indicators are scheduled for release today.
Givaudan SA, Banco Espanol De Credito SA, Vilmorin & Cie SA and CropEnergies AG are scheduled to report their results later today.
Roche Holding AG has indicated that a small early-stage study has revealed that its experimental drug showed promise in the treatment of Alzheimer’s disease.
Louis Gallois, the CEO of EADS, has stated that the company has not been affected by the difficulties French banks are facing in securing dollar financing.
Reuters has reported that the European Commission would not include over-the-counter derivatives in its review of Deutsche Boerse AG’s planned takeover of NYSE Euronext.

Macro Update
Japan's current account surplus drops
Japan's current account surplus has dropped 64.3 percent Y-o-Y to ¥407.5 billion in August, and sharply lower from the ¥990.2 billion surplus in July.
UK retail sales increase
On a monthly basis, overall retail sales in the U.K., as measured by the British Retail Consortium, have climbed 2.5 percent in September, compared to a 1.5 percent rise in August.
Optimistic on stimulus impact, says Miles
Bank of England policy maker, David Miles, has stated that there are “good reasons” to think that the Central Bank’s expansion of stimulus will aid economic recovery.
ECB backs bond guarantee option
The European Central Bank (ECB) has indicated that it favours government guarantees rather than the Central Bank’s money market operations to strengthen European bailout fund.
Greece pledges to keep creditor promises
The Greek Finance Minister, Evangelos Venizelos, has stated that the Greek government will keep promises to international creditors on pension and wage cuts.
European leaders postpone summit
European leaders have pushed back a debt crisis summit from October 18 to October 23, amid opposition to the German Chancellor, Angela Merkel’s drive for deeper-than-planned write-downs of Greek bonds.

Positive Start to the Week But Still Many Unanswered Questions

As London left for the weekend on Friday, ratings agency Fitch was busy downgrading Italy by one notch to A+ (outlook negative) and Spain by two notches to AA- (watch negative). Further warnings for Portugal and Belgium added to the gloom and after a day of what had been relatively positive (from a risk point of view) after a better than expected employment report from the U.S., sentiment soured into the close.

Q3 earnings focus - impact of slowdown on corporate America
In reality, whilst the U.S. data was above expectations a monthly payroll rise of 103k is only at half the level needed to keep the unemployment rate static and hence any relief rally on the back of the data should have been just that – a relief – however the backdrop is still fragile. As the week progresses the focus will move clearly towards equity market sentiment as the Q3 earnings season in the U.S. begins in earnest and the market gets the chance to digest the ‘real’ impact on corporate America of the global economic slowdown that has plagued confidence and consumer spending.

Righting the wrongs of the Eurozone
The real news over the weekend however was the Franco German summit where once again Merkel and Sarkozy met with the aim of righting the wrongs of the Eurozone (despite the fact that until now all they have succeeded in doing is ‘writing’ the wrongs of the Eurozone).
Merkel and Sarkozy claimed that they have a plan ready for the G20 summit on 3 November, a plan that “will confront the crisis”.  Germany and France declared their will to turn the Eurozone into a ‘stability union’, agreeing to defend banks, keep Greece in the Eurozone and have joint responsibility for the euro.  Herein lays the issue – responsibility. 

Potential hurdles ahead
Whilst the ‘Merkozy’ plan to solve the banking crisis appears acceptable to them, the market will quickly want comprehensive answers to many questions surrounding the ‘plan’.  Initially a couple of potential hurdles spring to my mind (i) Merkel stated that “EU treaty changes will be required” – This in itself leads to uncertainty as we have witnessed with the ‘agreement’ on the expansion of the flexibility of the EFSF, which was agreed on 21 July and has still not been ratified through the EU national parliaments. (The Slovakian vote will be watched very closely this week in this regard.); (ii) Merkozy has also stated that they have agreed on a bank capital ‘total’. This invites the market to dream up scenarios where the ‘total’ will not be sufficient – much like the EFSF and the concern that it would not be big enough to support Italy or Spain (let alone both); (iii) Finally, in financial markets, three weeks is a very long time and until a plan is announced and the implications can be understood by the markets, uncertainty remains and as I have discussed on many occasions over recent weeks, uncertainty is the biggest drag on confidence and hence global activity at the moment. Fear will remain.
“Mismanagement of Europe’s Sovereign Debt crisis may cause a regional slump worse than a regular recession” – Fiat CEO
Initially, the announcement that there ‘is’ a plan for Europe (and the action taken on Dexia to nationalise and split the bank up), has been seen as a positive for risk assets. As the week progresses I would imagine that the market will begin to need more detail on the proposals and U.S. earnings data will become the key focus for risk assets. On the data front U.S. retail sales and the U.K. employment report will also be keenly watched.

ECB Likely Unch, but Raft of Other Measures Possible (Desired)

Despite the fact that Friday we will witness the US employment report, today is undoubtedly the most important day of the week and will likely shape the dynamic for EUR and GBP (in addition to UK and eurozone assets) over the coming weeks. The focal points obviously being the interest rate meeting decisions from the Bank of England and the ECB.
In the UK speculation will be on the initiation of a further tranche of quantitative easing.

Having seen a significant swing in the MPC last month towards the dovish end of the recent spectrum I still think that it is a little early for the MPC to embark on the next stage of QE. It is true the economic backdrop has deteriorated further yet the most recent activity surveys in both manufacturing and service sectors in the UK showed a modest improvement back into moderate expansion. Confidence data, and admittedly the consumer activity (as indicated in the Q2 GDP revision yesterday), has remained weak. But the predominant driver of global confidence remains at the hands of European policy makers and the implications for global confidence.

As I see it, expanding the money supply in the UK may be successful in pushing interest rates lower, but this impact will be minimal when you consider where they are already. Gilt yields are already trading around historic lows and whilst I understand the desire to give confidence a boost, QE (which is largely already priced in by the market) at this stage may be a waste of bullets – at least until there is a resolution to the eurozone crisis, of some form. Back revisions to the economic growth data by the ONS released yesterday showed that the peak to trough drop in UK output was 7.1% rather than 6.4%, but there were upward revisions to 2009 and 2010. Ultimately there is little in the data to impact on the current policy debate, as I see things.

In the eurozone the question mark will be on whether Trichet, in his final meeting as head of the ECB, sanctions an interest rate cut. Whilst the economists are estimating no change in rates, the interest rate market has priced in around a 50% probability of a 25bp cut in the benchmark rate.  Whilst I view a rate cut from the ECB as unlikely, a raft of further measures including a 1 year LTRO, a revival of covered bond buying and or further liquidity provision commitments are distinctly possible as the much more is still needed from Europe in terms of supporting, liquidity, European banks and, ultimately, global confidence.

Whatever the outcome of the two seminal meetings today, there is likely to be a sharp pick up in volatility as the market repositions. With the US employment report tomorrow and a US market holiday on Monday, liquidity will likely be reduced, which will likely add further to the volatility.
Elsewhere, EURCHF has traded above its 200 day moving average this morning for the first time in around 2 years, and with bounce being supported by official suggestion (not action at this stage) that the ‘peg’ may be moved up to 1.3000 or even 1.4000 in due course.

The other news of note overnight was the proposition of a second Homeland Investment Act in the US, or effective tax amnesty for USD repatriation. Whilst the announcement gave a short-lived bid to the USD, the likelihood of passing the bill is very remote in my view as the figures from the first act (2004) suggested that the 5.25% amnesty rate, reduced the effective tax intake over the following 10 years by around USD80 billion – not something that would be seen as prudent in the current fiscal deficit reduction debate.

A Period of Policy Dithering?

Liquidation and de-risking was the order of the day yesterday, as equities, commodities, currencies (except the USD) and confidence fell broadly and sharply across the globe. The Federal Reserve’s assessment of the current economic situation continued to resonate and with a further deterioration in the PMI data for the Eurozone and the preliminary HSBC measure for China, uncertainty continued to rise.

There is no doubt that the global economic backdrop has deteriorated so sharply that it warrants a correction in the equity and broader ‘risk assets’, however, the most recent deterioration in global consumer and business sentiment has been a function of rapidly declining confidence.  Declining confidence has been a function of increasing uncertainty over the future economic (and political) outlook and this looks set to continue. Insurance against sovereign default (CDS) has surged as a result of this uncertainty with the CDS of Germany, France, Italy and Spain all hitting record highs yesterday.

Goodhart’s law suggests that using one economic indicator as a target for the purpose of conducting economic policy, causes the indicator to lose the information content that would qualify it to play such a role. In financial market terms, all traders across all asset classes will have a number of variables that they will use as barometers of sentiment or direction (‘economic indicators’); whether this is the S&P or gold, or oil, (or any number of indices rates or spreads) to gauge current market sentiment. Volatility has picked up markedly over recent days and I would caution against any overreliance on an ‘indicator’ in the current risk averse climate.

An interesting example of this in yesterday’s trading was that commodities were also hit hard, even the traditional safe haven plays of Gold and Silver, as position unwinding in commodities, and more significantly in emerging market (EM) currencies over this month (which really capitulated after the FOMC) played out. I would expect some further capitulation in commodities and EM currencies as position unwinding continues over the coming days but would caution against being too ‘short of risk’ or risk assets into the weekend as the possibility of an event such as French Government recapitalisation of its banks, is not negligible.  

Rhetoric and accusation continue to be the preference of global policymakers when action is needed. I have suggested before on this blog that it is the ‘INaction of governments and not the actions of markets’ that have driven the crisis (in response to accusations by officials that it is financial market speculators that have been responsible for various market anomalies).  Pimco’s El Erian said yesterday that “the world has gone through a period of policy dithering” and that “the world is on the eve of the next financial crisis”.  His first point I couldn’t agree with more, his second, in my view, is still avoidable. Just. 
International Monetary Fund head Christine Lagarde mirrored the sentiment in reiterating that the “world economy is entering a dangerous phase” and that she sees “a narrower path for recovery”.  

Now is the time for policy makers to stand up and take action within the eurozone or the implications for global confidence (and by default economic activity) could be extreme.
A Bloomberg survey of economic confidence, released yesterday showed that the percentage of Americans with a positive outlook currently stands at a mere 12 percent. This is likely to be mirrored across the globe, showing the extent of the impact recent events have had on confidence and it will take more than a letter signed by six of the G20 leaders urging action to be taken to reverse it.

Until decisive action is taken to resolve the imbalances in the Eurozone, and to a certain degree the ongoing political impasse in the U.S., uncertainty and lack of confidence will continue to dominate the global economy and the recent trends in FX and broader financial markets are likely to continue.