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.
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.
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.
- 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)
