Daily Report: Dollar Weak as Risk Appetite Lifted by Solid Asian Data

Dollar remains broadly weak as the week starts as markets sentiments are boosted by solid Asian economic data. The preliminary HSBC China Manufacturing PMI rebounded from 49.9 to 51.1 in October, back in expansionary territory for the first time since July. HSBC noted that the data confirmed their view there is no risk of hard landing in China. Japan trade deficit narrowed to JPY -0.02T in September. Impressively, exports rose 2.4% yoy, marking the second month of growth following five month decline after the March natural disaster. Asian stock indices are broadly up today, partly following the QE3 triggered rally in US last week. Nikkei is up 1.9%, HSI up over 4%, Aussie All Ordinaries up 2.62%, crude oil is back above 88 level while dollar index is pressing 76.

After the EU summit on Sunday, no agreement was made on major issues including bank recapitalization, private sector involvements in Greece second bailout and the way to boost the EFSF. Though, one thing seemed to be sure is that using ECB to leverage the bailout fund is ruled out. The latest news flow said that policymakers are threatening to trigger a formal default on Greek debt unless banks accept losses of as much as 140B euro on their holdings or a haircut of around 50%. Both Reuters and Bloomberg also quoted the need of around 100B euro for bank recapitalization. The Reuters report also mentioned a haircut of 50% but emphasized that 'several major areas of disagreement remain', especially in the EFSF plan and 'it will require vast amounts of hard negotiation between Sunday and Wednesday to strike a deal that convinces financial markets and Europe's major trading partners that the crisis is in hand' while according to the Bloomberg report policymakers are heading toward using the EFSF to 'guarantee bond sales as a way to extend its reach. A second option is to set up an EFSF-insured fund that would seek outside investment in troubled bonds'. 

Data from Australia saw PPI rose less than expected by 0.6% qoq, 2.7% yoy in Q3. The year over year rate was much lower than Q2's 3.4%. The data is arguing inflationary pressures have eased further in Australia. RBA would be on hold for longer than expected and is raising the prospect of a rate cut if global economic conditions deteriorate further. Though, the CPI data to be released later this week will be more crucial in near term rate outlook.

Looking ahead, Eurozone PMI data will be the main focus. German PMI manufacturing is expected to drop slightly to 50 in October PMI services is expected to recovery to 49.8. Eurozone PMI manufacturing and services are expected to drop to 48.1 and 48.5 respectively. Eurozone industrial orders are expected to rise 0.1% mom in August.

EUR/AUD Daily Outlook

Daily Pivots: (S1) 1.3350; (P) 1.3424; (R1) 1.3463;

EUR/AUD's fall from 1.4086 resumed by taking out 1.3368 and reaches as low as 1.3327 so far today. Intraday bias is back on the downside and further decline should be seen to retest 1.3022 support next. On the upside, note that break of 1.3497 resistance, though, will indicate short term bottoming, possibly on bullish convergence condition in 4 hours MACD, and will bring stronger rebound.

In the bigger picture, price actions from 1.2926 are treated as a medium term consolidation pattern, which is still in progress. Such pattern might extend further in range of 1.2926 and 1.4341. Nevertheless, we'll stay bearish as long as 1.4341 resistance holds and favor an eventual downside breakout. Sustained trading below 1.2926 should pave the way to 1.2 psychological level next. 

Economic Indicators Update

MT	Ccy	Events	Actual	Consensus	Previous	Revised
23:50	JPY	Trade Balance (JPY) Sep	-0.02T	-0.11T	-0.29T	-0.27T
0:30	AUD	PPI Q/Q Q3	0.60%	0.80%	0.80%
0:30	AUD	PPI Y/Y Q3	2.70%	2.90%	3.40%
4:00	CNY	HSBC Flash China Manufacturing PMI Oct	51.1		49.9
7:30	EUR	German PMI Manufacturing Oct A		50	50.3
7:30	EUR	German PMI Services Oct A		49.8	49.7
8:00	EUR	Eurozone PMI Manufacturing Oct A		48.1	48.5
8:00	EUR	Eurozone PMI Services Oct A		48.5	48.8
9:00	EUR	Eurozone Industrial New Orders M/M Aug		0.10%	-2.10%

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)

Daily Report: Sentiments Reversed Again as Expectations for EU Summit Change

News from Eurozone continues to drive markets up and down. This time, sentiments were hurt by reports that France and Germany are clearly still having diverged stance on the role of ECB in solving the debt crisis. France is still pushing the proposal to have the EFSF turned into a bank licensed with ECB for leveraging the capacity. But Germany maintained its opposition to this idea. And European officials are playing down the expectation for this weekend's EU summit. German Chancellor Angela Merkel stated that 'it won't be the final point where we regain the confidence of others, but it will be a stepping stone, a marker on the road' and 'all of the sins of omission and commission of the past cannot be undone by waving a magic wand'. EC President Jose Barroso also said that 'even if we do arrive at a political decision on everything that's on the table, which I hope we will, that doesn't necessarily mean that there will not then have to be an implementing phase'.

The US monthly Beige Book covering the period on the before October 7 indicated that many districts described the pace of growth as 'modest' or 'slight' and there was higher uncertainty for business decision making, although economic activities continued to expand. Consumer spending improved 'slightly' in most districts as driven by auto sales and tourism. Business spending also increased due to the rise in expenditure in construction and mining equipment and auto dealer inventories. Yet, restraints in hiring and capital spending remained. While the October report may be slightly better than the previous one, economic outlook on the US remained uncertain and is highly determined by global factors. 

It's reported that Japan will set up a task force to tackle the problems caused by yen's persistent strength. The task force will involve vice cabinet ministers and a BoJ deputy governor. The fund shifted to state-run Japan Bank for International Cooperation to help exporters would be boosted by 25% from JPY 8T to JPY 10T. In addition, there was also call for BoJ to use "bold" monetary policy in close coordination with the government to manage the yen.

On the data front, UK retail sales will be a main feature in European session, together with Swiss ZEW expectations. From US, initial jobless claims are expected to remain elevated at 400k. Existing home sales is expected to drop to 4.90m in September, leading indicator rose 0.2%. Philly Fed survey is expected to improve to -9.5 in October.

EUR/JPY Daily Outlook

Daily Pivots: (S1) 105.15; (P) 105.84; (R1) 106.36; 

At this point, we're still favoring the case that EUR/JPY's rebound from 100.74 is finished at 107.67 already. Below 104.77 will extend the fall from 107.67 to retest 100.74 low first. On the upside, though, above 107.67 will invalidate this immediate bearish view and bring another rise. But upside should be limited by 38.2% retracement of 123.31 to 100.74 at 109.36 to finish off the rebound.

In the bigger picture, whole down trend from 2008 high of 169.96 is still in progress and is building up downside momentum again. Sustained trading below 100 psychological level should pave the way to 100% projection of 139.21 to 105.42 from 123.31 at 89.52, which is close to 88.96 all time low. On the upside, break of 111.93 resistance is needed to be the first signal of medium term reversal. Otherwise, we'll stay bearish. 

Economic Indicators Update

MT	Ccy	Events	Actual	Consensus	Previous	Revised
0:30	AUD	NAB Business Confidence Q3	-4		6	5
6:00	EUR	German PPI M/M Sep	0.30%	0.20%	-0.30%
6:00	EUR	German PPI Y/Y Sep		5.50%	5.50%
6:00	CHF	Trade Balance (CHF) Sep		1.37B	0.81B
8:30	GBP	Retail Sales M/M Sep		0.20%	-0.10%
8:30	GBP	Retail Sales Y/Y Sep		0.60%	-0.10%
8:30	GBP	Retail Sales w/Auto Fuel M/M Sep		0.00%	-0.20%
8:30	GBP	Retail Sales w/Auto Fuel Y/Y Sep		0.60%	0.00%
9:00	CHF	ZEW Survey (Expectations) Oct			-75.7
12:30	USD	Initial Jobless Claims		400K	404K
12:30	CAD	Wholesale Sales M/M Aug		0.40%	0.80%
14:00	EUR	Eurozone Consumer Confidence Oct A		-20.1	-19.1
14:00	USD	Existing Home Sales Sep		4.90M	5.03M
14:00	USD	Leading Indicators Sep		0.20%	0.30%
14:00	USD	Philly Fed Survey Oct		-9.5	-17.5
14:30	USD	Natural Gas Storage		111B	112B

GBPUSD - Cautiously Bearish below 1.5787

Wednesday’s reversal of initial downside was extended yesterday but this demand stalled ahead of last week's highs. The subsequent setback corrected half of early gains for GBPUSD and this change in investor sentiment has continued in Asia, with positive momentum showing signs of reversal too. In view of this our call is Cautiously Bearish while below 1.5787. The immediate objective is 1.5711 with a move beneath that point targeting yesterday's 1.5697 low or even towards this week's bottom at 1.5632.
The risk to this call is that selling pressure stalls although a fresh outright Buy signal would only be generated by a move through 1.5787, the overnight high. Prices and sentiment should then improve to 1.5811 then last week's 1.5854 top.

Weekly Preview & Outlook : Forex Currency Pairs

EUR/USD Weekly Outlook

EUR/USD's rebound from 1.3145 short term bottom extended further to as high as 1.3893 last week and closed strongly. Initial bias remains on the upside this week and current rise should target 61.8% retracement of 1.4548 to 1.3145 at 1.4012, which is close to 1.4 psychological level. On the downside, break of 1.3685 minor support will indicate that such rebound has likely finished and should flip bias back to the downside for retesting 1.3145 low.

In the bigger picture, as this point, we're still favoring the case that whole rise from 2010 low of 1.1875 has completed at 1.4939. Fall from 1.4939 is viewed as resuming the whole corrective fall from 2007 high of 1.6039 ad should eventually take out 1.1875 support. However, the stronger than expected rebound from 1.3145 reduced our confidence on this scenario. Sustained trading back above 1.4 psychological level will argue that fall from 1.4939 is finished and the corrective nature in turns indicate that rise from 1.1875 is not over.

In the long term picture, EUR/USD turned into a long term consolidation pattern since reaching 1.6039 in 2008. Such consolidation is still in progress and we'd expect range trading to continue for some time between 1.1639 and 1.6039.

USD/JPY Weekly Outlook

Much volatility was seen in USD/JPY last week but the pair's rally attempt was limited at 77.48. Also, there is no follow through buying to help USD/JPY sustain above near term falling trend line yet. More choppy sideway trading could be seen between 76.11 and 77.48 initially this week. But we'll remain slightly bearish in USD/JPY as long as 77.48 resistance holds and favor an eventual downside break out through 75.94 support. Nevertheless, sustained break of 77.48 will argue that whole decline from 85.51 is possibly over and further rise would be seen back towards 80.23 resistance.

In the bigger picture, USD/JPY is still staying well inside the falling channel that started back in 2007 at 124.13. There is no indication of trend reversal yet even though medium term downside momentum is diminishing with bullish convergence condition in weekly MACD. Such down trend is still in favor to continue to 70 psychological level. In any case, break of 80.23 resistance is first needed to indicate completion of fall from 85.51. Secondly, break of 85.51 is needed to be the first signal of medium term reversal. Otherwise, we'll stay cautiously bearish in the pair.

In the long term picture, current decline suggests that the long term down trend in USD/JPY is still in progress. Such down trend is expected to extend further into uncharted territory with 70 psychological level as next target. In any case, we'd at least need to see sustained break of 85.51 before considering trend reversal.

GBP/USD Weekly Outlook

GBP/USD's rebound from 1.5271 short term bottom extended further to as high as 1.5817 last week and closed strongly. Initial bias remains on the upside this week and current rally should continue towards 61.8% retracement of 1.6618 to 1.5271 at 1.6103. On the downside, below 1.5666 minor support, though, will indicate that such rebound is likely finished and should flip bias back to the downside for retesting 1.5271 low first.

In the bigger picture, price actions from 1.3503 are treated as consolidations to long term down trend from 2.1161 and should be near to an end, if not finished at 1.6476. Near term outlook is quite mixed as the nature of the rebound from 1.5271 has many possibilities of roughly equal chance. But in any case, upside should be limited below 1.6618 resistance. Eventually, we'd expect a break of 1.4229 support to signal resumption of the down trend from 2.1161 and that should send GBP/USD through 1.3503 (2008 low).

In the longer term picture, the corrective nature of the multi-decade advance from 1.0463 (85 low) to 2.1161 as well as the impulsive nature of the fall from there suggests that GBP/USD is now in an early stage of a long term down trend. Another low below 1.3503 is anticipated after consolidation from 1.3503 is confirmed to be completed. 

USD/CHF Weekly Outlook

USD/CHF's fall last week confirmed short term topping at 0.9315. Initial bias remain son the downside this week and the pull back from 0.9315 should extend to 0.8647 and below. Though, we're expecting strong support above 0.8246 (50% retracement of 0.7065 to 0.9315 at 0.8190) to contain downside and bring resumption of rebound from 0.7065. On the upside, above 0.9039 minor resistance will argue that such pull back is finished and flip bias back to the upside for retesting 0.9315 first.

In the bigger picture, medium term down trend from 1.1730 is already completed at 0.7065. But there is no indication of long term reversal yet. Rebound from 0.7065 is treated as part of a medium term consolidation pattern. Such rebound would possibly extend to 0.9916/1.1730 resistance zone. But strong resistance should be seen there and bring reversal. On the downside, break of 0.8246 resistance turned support will indicate that rebound from 0.7065 is finished and should turn outlook bearish for a retest on this low.

In the longer term picture, long term down trend from 2000 high of 1.8305 is still in progress and there is no indication of a reversal yet. Such down trend would still extend to 100% projection of 1.8305 to 1.1288 from 1.3283 at 0.6266 after finishing the consolidation from 0.7065.

AUD/USD Weekly Outlook

AUD/USD rebounded further to as high as 1.0345 last week and closed strongly. Initial bias remains on the upside this week for near term falling channel resistance (now at 1.0389) first. Break there should pave the way to 1.0764 resistance and above. On the downside, below 1.0104 minor support will turn bias neutral and bring consolidations. But another rise will remain in favor as long as 0.9865 support holds.

In the bigger picture, AUD/USD drew strong support from 0.9404 despite a brief breach and the development retained bullish outlook in the long term. Whole up trend from 2008 low of 0.6008 is still in progress and price actions from 1.1079 should merely be a consolidation pattern. Having said that, though, we'd be cautious on reverse signal as AUD/USD enters into 1.0764/1079 resistance zone and there would be another near term decline before consolidation from 1.1079 finishes. But in any case, we'll stay bullish as long as 0.9387 support holds and favor an eventual upside break out.

In the longer term picture, whole up trend from 0.4773 (01 low) extended to a point where it just missed 100% projection of 0.4773 to 0.9849 from 0.6008 at 1.1084. While AUD/USD might be reversing in medium term, there is no signal of long term topping yet. We'd stay bullish as long as 0.9404 support holds and expect an eventual break of 1.1084 to 138.2% projection at 1.3023, which is close to 1.3 psychological level, in the long term.

USD/CAD Weekly Outlook

USD/CAD's fall from 1.0656 short term bottom extended further to as low as 1.0096 last week. Initial bias remains on the downside this week for 50% retracement of 0.9406 to 1.0656 at 1.0031. But we're expect strong support from there, which is close to 1.0009 support, parity and 55 days EMA (now at 1.0039) to contain downside and bring rebound. Above 1.0272 minor resistance will suggest that pullback from 1.0656 is finished and flip bias back to the upside for retesting this high.

In the bigger picture, that down trend from 2009 high of 1.3063 has finished at 0.9406 on bullish convergence condition in weekly MACD. Rise from 0.9406 should at least be part of a long term consolidation pattern from 2007 low of 0.9056 and should extend through 1.0851 resistance (38.2% retracement of 1.3063 to 0.9406 at 1.0803), possibly to 61.8% retracement 1.1666 and above. However, break of 1.0009 support will dampen this view and firstly, suggest that rebound from 0.9406 is finished. Secondly, such development will also argue that price actions from 0.9406 are merely consolidating the down trend from 1.3063. In such case, focus will be turned back to 0.9406 low in near term.

In the longer term picture, there is no clear indication that the long term down trend from 2002 high of 1.6196 has reversed even though bullish convergence condition was seen in monthly MACD. The fall from 1.3063 to 0.9406 looks corrective and could either be part of a sideway pattern from 0.9056, or a corrective to rise from there. The long term outlook, i.e., the possibility of taking out 1.3063 high, will depend on whether rise from 0.9406 would eventually develop into a strong impulsive wave. We'll wait and see.

EUR/GBP Weekly Outlook

EUR/GBP rose further to 0.8786 last week but lost momentum ahead of 0.8795 resistance. Initial bias remains neutral this week and some sideway trading could be seen first. Note that while another rise cannot be ruled out, we'd maintain that outlook will remain bearish as long as 0.8795 resistance holds and the whole decline from 0.9083 is still in favor to continue lower. Below 0.8687 minor support will flip bias back to the downside for retesting 0.8529 first. Nevertheless, break of 0.8795 will dampen the bearish view and turn focus back to 0.8884 key near term resistance.

In the bigger picture, price actions from 0.9799 (2008) should be unfolding as a consolidation pattern in the long term up trend. The first leg is completed with three waves down to 0.8067. Second leg should also be finished at 0.9083. Fall from 0.9083 is treated as the third leg and should target 0.8067 first and possibly further to 61.8% projection of 0.9799 to 0.8067 from 0.9083 at 0.8013 (which is closes to 0.8 psychological level). Nevertheless, we'd expect strong support from 0.7693/8186 support zone to contain downside to finish off the consolidation. On the upside, break of 0.8884 resistance is needed to invalidate this view or we'll stay bearish now.

In the long term picture, long term up trend from 2000 low of 0.5680 shouldn't be over yet and the choppy fall from 2008 high of 0.9799 should be a correction only. We'd expect such correction to be contained by 0.7963/0.8186 support zone and bring up trend resumption. Rise from 0.5680 is still expected to extend beyond 0.9799 high eventually

USDCAD - Very Cautiously Bullish above 1.0133

In line with yesterday's bearish outlook for sentiment, Tuesday’s limited rally was entirely overturned by fresh selling interest. Steady losses throughout the day took USDCAD to the most bearish levels traded for three weeks. The speed and scope of this decline also took the currency pair to oversold intraday extremes and overnight trading has seen the market attempt to correct that situation. This rally is likely to be temporary but it does leave the immediate bias positive. In view of this our call is Very Cautiously Bullish above 1.0133 The immediate objective is 1.0208, the overnight high, with a move beyond that point targeting 1.0239, half of yesterday's net fall, or even towards  1.0281.
Selling through 1.0133, yesterday's low,, is the risk to this call as it signals that selling pressure is greater than currently assessed. The market should then decline to 1.0108 then towards 1.0035.

Daily Report: Risk Appetite Continues on European Optimism, But Losing Momentum

Risk appetite continued on optimism on European bank recapitalization plan. European Commission president Jose Manuel Barroso presented a "comprehensive package" yesterday and urged immediate actions from European policymakers to resolve the current crisis. The recommendations include "decisive action" on Greece including the next tranche of bailout fund and a second "adjustment program" with private sector involvement. Banks should be strengthened "urgently" as sovereign contagion and banks are now "linked". Barroso also called for another assessment of the banking system and "fast track" policies of enhancing stability and recovery in Europe. Finally, Barroso said European Union should complete the "monetary union with a real economic union". Also, markets are also hopeful that Slovakia will finally become the last country in Eurozone to approve the EFSF expansion today or tomorrow. The opposition party made an agreement with parties in departing the Slovak coalition that they'll vote to pass through the EFSF expansion in exchange for early elections in March.

Some new information was delivered in the September FOMC minutes published overnight. First, most policymakers lowered their forecasts for the rest of 2011 and 2012. Yet, recession is not their concerns. Second, most members saw advantages in improving communication regarding the goals for inflation and unemployment. However, there were concerns about a proper mechanism to avoid misunderstanding. Moreover, 3 policy options for managing the size and composition of the System Open Market Account (SOMA) were discussed during the meeting: a reinvestment maturity extension program, a SOMA portfolio maturity extension program, and a large-scale asset purchase program. While the second option, known as operation twist, has been chosen, 2 members favored stronger action while 3 members dissented to take additional accommodation'.

On the data front, New Zealand business manufacturing index dropped to 50.8 in September. Japan Tertiary industry index dropped -0.2% mom in August. China trade surplus narrowed to USD 14.5b in September. Australian job market expanded more than expected by 20.4k in September while unemployment rate dropped to 5.2%. Swiss PPI, UK trade balance, Canada trade balance, US trade balance and jobless claims will be released later today.

While risk appetite extends further this week, note that DOW is starting to lose some momentum ahead of 11716/11862 resistance zone. We'd be cautious on reversal signal with focus on 11261 minor support. Break of which will at least trigger a pull back, with prospect of near term reversal for a test on recent low at 10400. Dollar index 

AUD/USD Daily Outlook

Daily Pivots: (S1) 0.9945; (P) 1.0076; (R1) 1.0286; 

AUD/USD rises further to as high as 1.0232 so far today and intraday bias remains on the upside for near term channel resistance (now at 1.0412). Sustained break there will pave the way for 1.0764 resistance and above in near term. On the downside, below 1.0104 minor support will turn bias neutral and bring consolidations. But another rise will remain in favor as long as 0.9865 support holds. However, break of 0.9865 will suggest that rebound from 0.9387 has completed and will bring retest of this support.

In the bigger picture, focus remains on 0.9404 key support level. As long as this support holds, price actions from 1.1079 is treated as a correction, or part of a consolidation pattern to the up trend from 0.6008 only. And, in such case, AUD/USD should still made another high above 1.1079 before forming an important top. However, sustained break of 0.9404 will indicate that rise from 0.6008 is already finished and would possibly bring deeper fall towards 61.8% retracement of 0.6006 to 1.1079 at 0.7945.

Storming Aussie Employment Data, but China trade Data Halts AUD

Asia saw a busier day on the macroeconomic front Thursday, and though there were arguments for both risk-on and risk-off, currencies remained at the top of their ranges.

For the pro-risk brigade, Australia’s employment data was a stormer with 20.4k jobs added in September, more than the 10.0k expected and more than compensating for the revised 10.5k jobs lost in August and halting a 2-month declining streak. Jobs gains were spread almost evenly between full-time and part-time workers and an unchanged participation rate of 65.6% was enough to tilt the unemployment rate a tad lower to 5.2% from 5.3%. Seen as a solid number, the AUD rocketed higher across the board with AUDUSD reaching 3-week highs.

After we had settled at higher levels, the China trade data was released and slightly disappointed. The trade surplus shrunk for the second successive month, declining to +$14.51 bln from +$17.76 bln with a drop in exports seen as the main culprit. Exports grew “only” 17.1% y/y and, perhaps more disappointingly, growth in imports fell to +20.9% y/y after recording 30.2% y/y in August. This took some of the shine off the AUD’s gains and AUDUSD retreated sub-1.02 again.

During the session we had additional dovish comments from BOE’s Bean who felt the outlook for the UK economy had worsened in the past 3-4 months which, if prolonged, would need an additional round of QE. He was of the opinion that inflation will cool in 2012, just in time for the Olympics! His comments on the economy echoed those we heard from BOE’s Dale who expressed concern about UK growth prospects for the rest of the year. GBP traded sidelined for most of the Asian session though.

The broader risk-on trade had extended overnight to the detriment of the greenback with a number of events forcing the EUR squeeze higher. Slovakian leaders said a second EFSF vote was likely by week-end and expected to pass while the EU Commission offered a framework for a European bank recapitalization plan. Euro-zone data was also impressive with industrial production up 1.2% m/m, 5.3% y/y, well above forecasts and higher than the previous month. EURUSD squeezed up to 1.3830+, one-month highs, before finding some resistance.

Economic Data Highlights

• CA Aug. New Housing Price Index out at +0.1% m/m, +2.3% y/y, both as expected and unchanged from prior
• US Aug. JOLTs Job Openings out at 3,056 vs. revised 3,213 prior
• NZ Sep. Business PMI out at 50.8 vs. revised 52.7 prior
• JP Sep. Bank Lending out at -0.3%y/y vs. -0.5% expected and -0.5% prior
• JP Aug. Tertiary Industry Index out at -0.2%m/m vs. -0.3% expected and revised -0.3% prior
• AU Oct. Consumer Inflation Expectation out at 3.1% vs. 2.8% prior
• AU Sep. Employment Change out at +20.4k vs. 10.0k expected and revised -10.5k prior
• AU Sep. Unemployment Rate out at 5.2% vs. 5.3% expected and 5.3% prior
• China Sep. Trade Balance out at +$14.51b vs. +$16.3b expected and +$17.76b prior
• China Sep. Exports out at +17.1% y/y vs. +20.5% expected and +24.5% prior
• China Sep. Imports out at +20.9% y/y vs. 24.2% expected and 30.2% prior

Upcoming Economic Calendar Highlights
(All Times GMT)

• GE CPI (0600)
• Swiss PPI (0715)
• Sweden Unemployment rate (0800)
• UK Trade Balance (0830)
• CA Int’l Merchandise Trade (1230)
• US Trade Balance (1230)
• US Initial Jobless Claims (1230)
• US Bloomberg Consumer Comfort (1345)
• US Fed’s Kocherlakota to speak (1830)

Return to 50% retrace Could Create Long Opportunities in EURGBP

For the last week or so our charts have been bullish on the EURO/STERLING. The rally has been quite strong and may continue towards the 8800 area and beyond in the coming days. Longs could be taken while we are above the 8710 area. A break down through this level and we may see a fall back towards the lovely 50 percent retrace line we have been trading off lately. With the recent volatility in all pairs we haven't ruled out a return to that area at some point soon. If that did happen, it could create another chance to re-enter low risk longs again. 

Daily Report: Euro Rebound Stalls on Slovakia, Weakness Limited

Euro's rebound against dollar and yen stalled after Slovakia parliament rejected the expansion of the EFSF. The country failed to pass the plan with 55 lawmakers voting for the measure, 9 against it and 60 abstaining. The expanded EFSF plan will increase the size of the facility from 440B euro to 780B euro and Slovakia will be required to contribute roughly 10B euro in debt guarantees. It's reported that the junior ruling coalition Freedom and Solidarity party, one of the four parties in the coalition, has refused to participate in the vote, making the final result hardly a majority. Slovakia is the only country in the seventeen-nation Eurozone that has not yet ratified the beefed-up plan agreed in July. Nevertheless, the negative impact on Euro and market sentiments in general is limited. That's because firstly, Slovakia is expected to pass the re-vote later this week as the government resigned. Secondly, investor's main focus remain on the bank recapitalization plan led by Germany and France that's to be finalized later this month.

Greece is set to receive the EUR 8b tranche of bailout fund as troika, the inspection team of EU, IMF and ECB, said the country has made "important progress" in fiscal consolidation after completing the review. The fund would likely be approved by EU finance ministers later this month and made available to Greece in early November. Though. troika also note that Greece will miss its 2011 deficit target and it's "essential that the authorities put more emphasis on structural reforms in the public sector and the economy more broadly". And, it stressed that "the success of the program continues to depend on mobilizing adequate financing from private sector involvement and the official sector".

In US, the Senate passed a bill to punish China for currency manipulations by 53-35 vote. While the bill doesn't specifically talk about China, it allows the Treasury to label a country's currency misaligned and thus impose tariffs on its imports to make up the currency under-valuation. China responded by claiming that the so called currency misalignment is "protectionism" and a serious violation of WTO rules. The were also criticism from US that the bill could eventually hurt US companies in China's markets, which is a rate bright spot for in the global economy. Nevertheless, note that the bill might not become law easily for the lack of support in the lower House.

On the data front, Australia Westpac consumer confidence rose 0.4% in October, home loans rose 1.2% in August. UK job data is the main focus in European session and is expected to show 24k rise in claimant counts while unemployment rate is expected to rise to 8.0%. Eurozone industrial production and Canada new housing price index will be released too. FOMC minutes from September meeting will also be released and should show the details of the discussion on Fed's operation twist move.

Dollar index tried to draw some support from 77.30 and recovered this week. But recovery is so far very weak and fall from 79.838 is in much favor to extend. 77.30 would likely be taken out later this week and the pull back from 79.838 should extend to 55 days EMA (now at 76.575) and below. But strong support should be seen at around 76.06 to bring near term rebound to extend the consolidation pattern from 79.838.

EUR/JPY Daily Outlook

Daily Pivots: (S1) 104.06; (P) 104.48; (R1) 104.94;

EUR/JPY's rebound stalled after breaching 104.92 resistance briefly and with 4 hours MACD crossed below signal line, intraday bias is turned neutral. Nevertheless, another rise remains in favor with 102.54 minor support intact. Above 104.98 will extend the rebound from 100.74 short term bottom towards 38.2% retracement of 117.74 to 100.74 at 107.23. On the downside, below 102.54 will indicate that rebound from 100.74 is finished and would flip bias back to the downside for retesting 100.74.

In the bigger picture, whole down trend from 2008 high of 169.96 is still in progress and is building up downside momentum again. Sustained trading below 100 psychological level should pave the way to 100% projection of 139.21 to 105.42 from 123.31 at 89.52, which is close to 88.96 all time low. On the upside, break of 111.93 resistance is needed to be the first signal of medium term reversal. Otherwise, we'll stay bearish. 

EURUSD - Cautiously Bearish below 1.3685

The market was unable to extend Monday’s powerful gains yesterday with demand stalling near 1.3700. Although initial downside found buying interest, the highs were not maintained. The net unchanged close highlights a degree of investor uncertainty but gradually lower intraday highs give the immediate outlook a mildly negative bias. In view of this our call is Cautiously Bearish below 1.3685. The immediate objective is 1.3610 with a move beneath that point targeting 1.3565, yesterday's bottom, or even towards 1.3516, half of Monday’s net upside.
 

The risk to this call is that selling pressure is weaker than currently assessed although a fresh outright bullish signal would only be generated by a move through 1.3685, yesterday's peak. Prices and sentiment should then improve to 1.3701, this week's top, then 1.3747.

Q4 Asia Feature: Is China Losing its Competitive Edge?

In the run up to the 2008 global financial crisis, China’s manufacturing sector was epitomised by a predominant focus on exports resulting in a constantly rising trade surplus and a hefty accumulation of FX reserves. In the aftermath of the crisis however, the situation has dramatically changed, partly due to a lack of external demand but also amid rising concerns that China appears to be losing its global competitive edge.

The main draw card for Chinese manufacturers to focus on these so-called “low-end”, labour-intensive production lines was the abundance of a readily available, “cheap” workforce and, as some would argue, a competitive advantage from an artificially suppressed currency.

A recent “Blue Book” report from China’s Academy of Social Science (CASS) acknowledged that since late 2008 China’s exports to the U.S. have been in decline (China was knocked off its perch as the lead exporter) and eventually China saw its first trade deficit in six years in March 2010. But what were the reasons behind this decline?

In its Blue Book report, CASS suggested the major factors were government policy directives, which increased the cost of manufacturing in China, and escalating raw material/energy costs. This forced a number of manufacturers out of business and hence exports suffered. Indeed, if we take a quick, broad look at some of the inputs for end-product pricing - cost of raw materials is one but wage costs, shipment costs and currency pricing can also all be influencing factors, though some of these are not particularly unique to China. Specifically, raw materials and shipment costs are the same for all exporters, regardless of location, so does it boil down to wages and currencies being the major influences for end-product pricing? The USA certainly has a view on this especially if you have been listening to the constant commentary about China’s undervalued currency for the past few years.

Overall Chinese exports to the US averaged $30.41 bn in 2010 and $31.15 bn in the first 7 months of 2011 (Source US Census Bureau) yet the CNY has risen 5.7 percent  versus USD in the same period – hardly a compelling argument that the exchange rate is a dominant factor affecting exports. However, when the trade surplus is compared as a share of GDP it has actually been falling since 2007 (some two years after the first “de-pegging” of the USDCNY rate).

Yet, if we were to break down the exports in the so-called “light manufacturing” sector, one that is perhaps more susceptible to labour issues, then China’s market share of US imports has been in steady decline (as mentioned above) with a noticeably faster decline since late 2010.

A report from the Boston Consulting Group in May this year suggested that the wage gap between the U.S. and China is currently shrinking rapidly and is expected to converge within the next five years. Chinese wages are currently rising between 15-20 percent per year and any other workplace with more flexible practices could eat further into China’s competitiveness. But is the U.S. the only “threat” to China’s competitiveness? In the above-mentioned “low-end” manufacturing categories, it would appear that China’s lower-income neighbours such as Vietnam, Bangladesh and to a lesser extent Indonesia are slowly eating into China’s export pie (with regard to the U.S. and European export destinations) while Mexico is also seeing greater gains in certain “higher-value” categories such as furniture and precision instruments. So it would appear that wage costs are playing a significant role in affecting China’s competitiveness and, with inflation currently running above 6 percent annually, the pressures are unlikely to disappear soon.

When it comes to the Chinese economy, exports have accounted for as much as 42 percent of China’s GDP in 2008 (subsequently easing to 37 percent in 2010) (source US BEA) and loss of competitiveness may have serious growth implications. Is it possible that the Chinese recognised this and that is why they have switched to lower, more sustainable growth targets in the country’s latest five-year plan?

The 12th Five-Year-Plan has shifted focus from “quality growth” to “inclusive growth”. Outright promotion of exports has been dropped as a byline (in response to declining competitiveness?) and replaced by enhancing households’/citizens’ abilities to consume, redistributing wealth and aiming for slower but higher quality growth. Investment in industry is now targeted towards the energy generation and alternatives (sustainable power bases rather than pure manufacturing) and is perhaps testimony to Chinese authorities acknowledging falling external competitiveness and recognising the need for more internal-focused policies.

In summary, China is facing an erosion of its global competitiveness with wage pressures linked to high-flying inflation being the dominant factors. The Chinese currency, and its gradual revaluation, is also playing its part and China’s loss of competitiveness may be seen as a helpful factor in the global rebalancing process. But Chinese authorities do not see any need to panic. If (and some may argue it is a big “if”) they can succeed in pulling off the latest Five-Year-Plan then this development, and its impact on the trade balance, will not be a major issue.

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.