USD/CHF – 0.9047
Most recent candlesticks pattern : N/A
Trend : Near term up
Tenkan-Sen level :0.9039
Kijun-Sen level :0.9004
Ichimoku cloud top :0.8982
Ichimoku cloud bottom :0.8958
Original strategy :
Buy at 0.8970, Target: 0.9100, Stop: 0.8935
New strategy :
Buy at 0.8970, Target: 0.9100, Stop: 0.8935
Dollar’s intra-day rally to 0.9086 after breaking previous resistance at 0.9022 suggests the decline from 0.9183 top has possibly ended at 0.8918 and consolidation with upside bias is seen for further gain to 0.9100 would be seen, however, it is necessary to see a breach of previous resistance at 0.9144 to retain bullishness and signal early upmove has resumed for eventual retest of 0.9183.
In view of this, we are still looking to buy dollar on pullback as 0.8958-65 (current level of the Ichimoku cloud bottom and previous support) should limit downside. Only below said support at 0.8918 would extend the decline from 0.9183 towards previous support at 0.8886 before prospect of another rebound later.
Risk markets attempted a recovery last week on some positive news as Germany and Finland approved expansion of the EFSF while Troika returned to Greece finally. However, strength of the recovery was far from impressive and lost momentum towards the end of the week. While major US and European stock indices managed to hold well above recent low, the CRB commodity index made a new low on Friday and closed below 300 level for first in almost a year. Dollar index’s retreat was rather shallow and was contained at 77.30 while Friday’s rally put the index back pressing recent high of 78.86. This could also be reflected in major dollar pairs which lost momentum. Commodity currencies also turned weak with Canadian dollar and New Zealand dollar making new record low against US dollar.
Markets are facing a number of even risks this week and it’s great opportunity for traders to watch the reactions, and thus, get a sense on the underlying sentiments. China manufacturing PMI was released on Saturday and has surprisingly rose to 51.2 in September. More importantly, this marked the second consecutive months of increase, though little. There have been much worries on hard landing in China. While PMI only showed little improvements in the outlook, at least, it’s not deteriorating and indicates that economic development is stabilizing.
EU finance ministers are not likely to approve the disbursements of next EUR 8b tranche of Greece bailout this week. However troika, the EU/IMF/ECB inspection team will complete an evaluation as early as on Monday and thus give the signal on whether Greece has done their austerity jobs satisfactorily. Also, as the Bundestag has now passed the bill for expanding the EFSF, there would possibly be some news on how the fund would be enlarged to a size that’s capable to contain Italy and Spain eventually.
While the surprised surge in inflation dented hope for a rate cut from ECB, the bank would nonetheless announce new stimulus measures in Trichet’s last meeting as President this week. The unconventional measures to be adopted would include resumption of the one-year refinancing operations and restart of covered-bonds purchase. These should be positive to the markets.
While these events might trigger some recovery in risk markets, we’d anticipate that the impact would be short-lived. We’re staying bearish in risks and bullish in dollar. The technical developments suggest that dollar is ready for another round of rally this week while stocks would likely revisit recent lows. Market sentiment would once again be proved to remain bearish if the above mentioned events fail to provided sustainable boost to risk markets. And, extension in decline in the CRB, if accompanied by a break of 10600 level in dow, and a sustained break of 79 in dollar index, should confirm the trend of risk selling in the first half of Q4.
The week ahead
In addition to the above events, Fed will also start the operation twist program on October. Fed will purchase a total of $44b of longer-mautrity treasuries and sell that same amount of short term debts. Four central banks will meet including RBA, ECB, BoE and BoJ. In addition, there will be key economic data release including Japanese Tankan, UK PMIs, US ISM indices and Non-farm payroll, Canadian job report. So, be prepared for a busy and volatile week.
- Monday: Japanese quarterly Tankan; Swiss retail sales, SVME PMI; Eurozone PMI manufacturing final; UK PMI manufacturing; US ISM manufacturing
- Tuesday: Australian building approvals, trade balance, RBA rate decision; UK construction PMI; Bernanke speech, US factory orders
- Wednesday: Australian retail sales; Eurozone PMI services final, retail sales; UK services PMI, GDP final; US ADP job, ISM services
- Thursday: BoE rate decision; ECB rate decisions; Canada building permits, Ivey PMI; US jobless claims
- Friday: BoJ rate decision; Swiss unemployment; UK PPI; Canada employment; US non-farm payrolls
Dollar index’s strong rally on Friday suggests that recent rise from 72.69 is ready to resume. Initial focus is on 78.86 resistance today and break there will confirm this bullish case and should send the index through 80 psychological level to 50% retracement of 88.70 to 72.69 at 80.69 next. Break of last week’s low of 77.30 will delay this case and bring more consolidations but we’ll stay bullish as long as 76.06 support holds.
The CRB commodity index extended recent down trend to close at 298.15. Near term outlook will remain bearish as long as last week’s high of 312.26 holds and further fall should be seen to 50% retracement of 200.15 to 370.70 at 285.43. The main focus would indeed be on whether the current decline would accelerate again. That’s crucial in determining whether CRB could draw support inside 247.25/293.75 zone and rebound.
S&P 500 stayed in recently established range last week but felt strong pressure well ahead of 55 weeks EMA at 1230.3. While the 38.2% retracement support at 1101.7 might provide some more support in near term, it shouldn’t last long. Friday’s fall puts initial focus this week on 1101.54 recent low. Break there will resume whole decline from 1370.58 and should send the index through 1010.91 support within October. In any case, we’ll stay bearish as long as 1258 head and shoulder resistance holds.
EUR/USD turned into brief recovery last week but such recovery was likely finished at 1.3689 already. Initial bias is mildly on the downside this week for 1.3362 first. Break will confirm resumption of recent decline and should target 161.8% projection of 1.4939 to 1.3969 from 1.4548 at 1.2979, which is close to 1.3 psychological level. On the upside, above 1.3689 will delay the bearish case and bring more consolidations. But recovery is, nonetheless, expected to be limited below 1.3936 resistance and bring another fall eventually.
In the bigger picture, current development indicates that medium term rise from 1.1875 has completed with three waves up to 1.4939 already. That also suggests that it’s merely part of the consolidation pattern that started back in 2008 at 1.6039. Further decline would now be seen to 1.2873 support first and break will target 1.1875 and below. On the upside, above 1.4548, resistance is needed to confirm completion of the fall from 1.4939 or we’ll stay bearish in EUR/USD.
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.
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EUR/JPY – 102.98
Recent wave: wave (i) of 3 ended at 105.44 and wave (ii) has ended at 123.33
New strategy :
Sell at 104.50, Target: 102.50, Stop: 105.15
Despite intra-day resumption of recent decline to 101.95 (lowest since 2001), the subsequent quick rebound from there suggests a minor low is formed and retracement to intra-day high of 103.80 cannot be ruled out, however, upside should be limited to 104.45-50 (50% Fibonacci retracement of 107.00 – 101.95) and bring another decline later. A break of said support would extend recent downtrend to 101.41 (50% projection of 107.00-102.22 measuring from 103.80), however, reckon downside would be limited to 100.85 (61.8% projection).
Our latest preferred count is that wave (ii) is ABC-X-ABC which ended at 123.33 and wave (iii) is unfolding with diagonal (1) ended at 108.01, followed by wave (2) at 111.93 and wave (3) is unfolding for weakness to 101.00 but psychological support at 100.00 should remain intact.
On the downside, indicated downside target at 101.98 (1.618 times projection of 114.16-108.01 measuring from 111.93) has already been met and further subsequent weakness to 100.85 would be seen. In view of this, would be prudent to wait for such recovery and sell at a higher level. Only above 105.07 (61.8% Fibonacci retracement of 107.00 to 101.95) would signal a temporary low is formed and risk test of resistance at 105.40.
Our preferred count is that the decline from 139.26 is wave C and is sub-divided into (a): 127.00, (b) 138.49 and wave (c) has commenced from there with a diagonal wave 1 (i: 126.95, ii: 134.37, iii: 120.70, iv: 125.24 and then wave v at 119.66). The rebound from 119.66 to 127.95 was an a-b-c wave 2 and wave 3 is taking place from 127.95 with minor wave (i) ended at 105.44. The wave (ii) correction commenced from 105.44 and has ended a 123.33 as a complex correction ABC-X-ABC, so wave (iii) should extend towards psychological support at 100.00.
On the bigger picture, we are treating the rally to 169.97 as end of wave A, then selloff from 169.97 (July 2008) to 112.08 is wave (A) of B instead of end of entire wave B and then the rebound from there to 139.26 is wave (B), hence, wave (C) has commended from there with minor wave 1 ended at 119.66 and wave 2 at 127.95. This wave (C) of B should be limited to psychological support at 100.00 and reckon 95.00 would remain intact.
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EUR/USD has been under pressure over the past several weeks as the debt crisis intensifies and the ECB becomes increasingly dovish. The pair has consolidated higher over the past day in what appears to be a bear flag as seen below on hourly candlesticks. A break of the bear flag
In recent months, various observers pointed to strains in the inter-bank funding markets. Headlines warning of financial calamity resurfaced. We have a laundry list of complaints ourselves. Remember, though, that Al Capone was convicted for tax evasion, not for his activity as a mobster. Credit Default Swaps (CDS) on Greece may be triggered not by Greece’s inability to pay, but because of Finland’s insistence that collateral be posted in return for the next tranche of European Financial Stability Facility (EFSF) payment. Along similar lines, select banks may have funding strains, but don’t count on a lack of liquidity breaking their backs.
Anyone who has read a basic accounting book recalls the equation Assets = Liabilities + Owner’s Equity. While specifics might get a bit complex (they shouldn’t, but when regulators and lobbyists collaborate, the result is not necessarily the most obvious), banks face the same accounting realities. A customer’s loan shows up as an asset on a bank’s balance sheet. Equity may be paid-in capital by shareholders. And liabilities are the loans the bank itself takes out in order to pay for (fund) its loan portfolio (assets). Unlike non-financial corporations, banks are highly leveraged institutions (low equity compared to liabilities); moreover, banks have an inherent maturity mismatch. A maturity mismatch means that banks tend to borrow short-term money, while financing long-term projects. Some of the key risks banks face are interest risk (the risk of rising short-term interest rates may create problems for institutions with a maturity mismatch) and credit risk (the risk of creditors not paying back their loans). By promising to keep interest rates low until at least the middle of 2013, the Federal Reserve (Fed) has substantially reduced interest risk for banks. The risk of creditors (think Greece’s sovereign debt; think sub-prime mortgage-backed securities, to name two of the more obvious risks), however, persists.
In order to finance their loan portfolios (a bank asset), banks have substantial funding risk. Funded can be sourced through customer deposits (a fairly stable source of funding; a customer deposit shows up as a liability on a bank’s balance sheet), by issuing various forms of debt (e.g. including longer term bonds or shorter term commercial paper) or by obtaining a loan from another financial institutions, the inter-bank lending market.
The obvious challenge in the interbank lending market is that if a bank does not trust another institution’s financial health, they are unlikely to give that institution a loan, even if it is just overnight. The financial institution seeking to secure financing may have its funding costs soar as a result. The important thing to remember, though, is that banks have access to funding from their respective central banks. The days are over when investment banks had neither customer deposits, nor access to a central bank window. Goldman Sachs, as well as the other remaining large investment banks, have converted to commercial banking charters. As such, they can tap into the same unlimited piggy bank as other banks. Importantly, the European Central Bank (ECB) has been providing unlimited liquidity to the European banking system. That’s unlimited, as in no limits. The banks are depositing part of their loan portfolio as collateral; in return, they receive cash. That cash may literally be printed out of thin air; central banks don’t need to find that money somewhere, they just need to enter a credit into the account that bank holds at the central bank.
It turns out the ECB model is rather flexible: when the crisis flares up, banks require more liquidity; when the crisis ebbs down, those facilities are wound down. The ECB has been adamant that their measures are temporary by design and independent of its broader monetary policy. While one can argue about the severity of the crisis or the quality of the collateral, it is correct that the ECB approach is more robust than that of the Federal Reserve (Fed). By buying trillions in mortgage-backed securities (MBS) and government bonds, the Fed has a bloated balance sheet that is cumbersome to manage. In contrast, the ECB has only printed a fraction of the money and could phase out its facilities within months (one year for the longest facility). The ECB is also providing unlimited U.S. dollar liquidity to European banks through swap arrangements with the Fed in cooperation with the Swiss National Bank (SNB) and Bank of England (BoE). Importantly, these facilities are designed to carry financial institutions through the New Year. Towards the end of the year, a lot of window dressing takes place, where financial institutions like to show “good” securities on their books. As a result, every year, there is concern that those issuing less desirable securities might get squeezed from the funding markets. While not without political risks in the U.S., it shows the determination of central banks to keep plenty of liquidity in the markets, and is a key reason why we believe a liquidity driven financial meltdown is off the table.
In the 1990s, the Bank of Japan showed that even a technically insolvent banking system could be kept afloat. Similarly, there may be solvency issues at some institutions, but central banks can keep them afloat.
When funding costs are too high, financial institutions have to de-leverage or raise more capital. The former can be expensive; indeed, banks have great leeway with regards to keeping securities at cost on their books, rather than adjusting them to market value. Part of the rational behind such regulation is that the maturity mismatch inherent to the banking industry means banks should be able to take a longer-term view. The markets have shown they have little sympathy for such twisted logic. The trouble is that, if indeed banks de-leveraged, they would have to recognize their losses, possibly wiping out substantial portions of their capital.
The latest round of European stress tests did something fabulous: the stress tests provided unprecedented transparency, listing the sovereign debt holdings of financial institutions. The market doesn’t need the regulator to tell them what’s good or bad; the market needs transparency. The market is now able to target what are deemed weaker institutions and “encourage” them to raise more capital or de-leverage. That ‘encouragement’ by the market is what has been driving both policy makers and bank executives. In many ways, it’s a wonderful dialogue. Policy makers and CEOs may be able to influence the timing of when governments and banks clean up their books / get their act together, but the action is firmly driven by the bond markets. However, there is one region where this “reform process” is sorely lacking with regards to sustainable fiscal policy: the U.S. It’s not a coincidence: the bond markets in the U.S. have not forced policy makers into action. Obviously it would be preferred to have policy makers and bank CEOs be ahead of the curve.
When it comes to financial institutions, the inherent design of bank regulation carries much of the blame. It’s not just the fact that banks are not required to mark down assets to market value; it’s also that national regulators typically consider their own government debt risk free. In the U.S., Treasures are risk free by regulation. Similarly, European banks ought to carry much of their capital in sovereigns, as those securities are acceptable to comply with capitalization rules; in contrast, corporate securities must be heavily discounted. In a world where some corporations may be less risky than their governments, those rules are outdated. Indeed, at times, there is a risk that inter-bank lending of corporate (financial institution) paper dries up, because regulation discourages taking on the counter-party risk of a bank and incentivizes more risky government securities instead. In Europe, where each Eurozone government regulates its own banking system, it’s urgently necessarily to centralize bank regulation, so that each member country’s bank is not ex-ante over-exposed to their own government paper. Naturally, the respective governments are opposed to such moves, as it may increase the cost of government funding if banks actually had to evaluate (and take seriously) the creditworthiness of their own governments.
What does it mean to investors?
- Banks that are under-capitalized may not lend as much, reducing economic activity. That may be a negative for equities. For currencies, however, it depends. In Japan, the yen has been benefiting from economic contraction: in the absence of a current account deficit, consumers save more as economic activity slows down. In the U.S., it the opposite: it easier to finance the current account deficit with economic growth, providing an incentive to policy makers to grow at just about any cost. Looked at it differently, the U.S. dollar may be much more sensitive to a misbehaving bond market; while it is behaving for now, the U.S. dollar may be under pressure should the market take a different view on long-term fiscal sustainability. Caught in the middle is the euro: with the current account roughly in balance, the euro can fare okay in an environment where banks restrict their lending and economic activity stalls.
- Volatility is likely to remain elevated as long as investors remain skittish regarding the amount of liquidity provided. However, keep in mind that central banks can act much faster than politicians. As liquidity concerns are addressed, the market will move towards focusing on solvency issues. The lines may be blurred at times because of above mentioned regulations and lack of transparency. It would be most helpful if policy makers decided to embrace transparency. Note, by the way, that there is nothing inherently bad about a bank de-leveraging; but by postponing the inevitable, stress is created in the system that benefits no one (except those shorting those banks, I suppose, which is then made banned by the regulatorsut I digress).
Because of the scale of the issues, policy makers have taken an ever more active role in the markets; we don’t see that trend abating. As a result, securities may increasingly be trading based on the next perceived move of policy makers, rather than on fundamentals. It’s a key reason why we focus on currencies, as, through the currency markets, investors can take positions on what we call the mania of policy makers. This Thursday, September 22, 2011, we are hosting a webinar discussing how investors may be able to manage the currency risk of their U.S. equity portfolio. According to our analysis, investors may be able to improve risk-adjusted equity returns by taking a pro-active approach to currency risk.
Axel Merk, Portfolio Manager, Merk Funds
- Last Candlesticks pattern: Hammer
- Time of formation: 12 July 2011
- Trend bias: Sideways
- Last Candlesticks pattern: Shooting star
- Time of formation: 19 Aug 2011
- Trend bias: Near term up
GBP/USD – 1.5703
The British pound opened lower again this week and adding credence to our bearish view that the major decline from this year’s high of 1.6747 to retracement of medium term uptrend and indicated target at 1.5750 and 1.5650/55 (100% projection of 1.6747-1.5781 measuring from 1.6618) had been met. As price is still trading well below all Tenkan-Sen, Kijun-Sen and Ichimoku cloud, bearishness remains for further fall towards 1.5550/60, however, near term oversold condition should prevent sharp fall below 1.5488 (50% Fibonacci retracement of 1.4228-1.6747) and risk from there has increased for a corrective rebound later.
On the upside, whilst recovery back to 1.5800 cannot be ruled out, reckon 1.5858-69 (current level of the Tenkan-Sen and previous resistance) would limit upside and bring such decline to aforesaid downside targets. Only a daily close above 1.5900 would suggest a minor low is in place and risk retracement to psychological resistance at 1.6000 but reckon resistance at 1.6084 would limit upside and 1.6126-28 (current level of the Kijun-Sen and Ichimoku cloud bottom) would limit upside, bring another selloff.
Recommendation: Sell at 1.5800 for 1.5550 with stop above 1.5900
On the weekly chart, a series of windows were formed since the decline began from 1.6618 and as price has clearly traded inside the Ichimoku cloud area (indicated downside target at 1.5650/55 – 100% projection of 1.6747-1.5781 measuring from 1.6618 had been met last week), bearishness remains for further fall to 1.5550 and possibly towards 1.5488 (50% Fibonacci retracement of 1.4228-1.6747). Having said that, near term oversold condition should limit downside to previous support at 1.5345 and the Ichimoku cloud bottom (now at 1.5317) should hold from here.
On the upside, expect recovery to be limited to last week’s high of 1.5869 and bring such a decline. Only above 1.5920 would suggest a minor low is formed and risk test of the Ichimoku cloud top (now at 1.5975) and then towards resistance at 1.6084, however, upside should be limited to the Tenkan-Sen (now at 1.6126) and the Kijun-Sen (now at 1.6190) should remain intact, bring another decline later.
- At the beginning of the year, we presented three debt crisis scenarios. In this document we look at the recent economic and political developments and present an update of our scenarios.
- Our main scenario is that the debt crisis will continue for a couple years and that we slowly will move towards a quasi-fiscal union. We expect the financial markets to continue scanning the systems for weaknesses and when it finds them rising yields are likely to force politicians to respond.
- Currently there are too many risk factors for things to calm down. The core countries are likely to take advantage of the high-risk environment to push through necessary reforms in the periphery countries. The response to the crisis is also likely to result in a continued gradual move towards more fiscal integration.
- The risk of a very negative scenario materialising, which would include a sovereign default and maybe even a euro area break-up, has increased but we still assess the risk to be low. The commitment among the euro leaders remains intact but the public opposition has risen.
- The main risk is a continued increase in public opposition. It is fuelled by the bailout bills in the core countries and further austerity measures in the periphery countries. The euro area has so far delivered decent growth despite the ongoing debt crisis. Looking ahead, we expect modest growth as the unwinding of imbalances in the public and private sector takes place. We expect growth of 1.7% this year and just 1.2% in 2012.
- Fifth review of Greece by end- September.
- ECB buying through the Securities Market Programme (SMP).
- Ratification of EFSF enhancement in local parliaments by end- September.
- Recapitalisation of Spanish bank sector to be done before end- September.
- Spanish parliamentary election in November.
- French general election in spring 2012
Status on debt crisis scenarios
In January, we published Research Euroland: Debt crisis scenarios, 25 January 2011. The document contained three debt crisis scenarios. Nine months have passed and the debt crisis is even more intense now than it was then. We therefore find it appropriate to give an update on our view on the future of the euro area. The three possible scenarios outlined in January were as follows.
- Crisis contained.
- Euro bonds and quasi-fiscal union.
- Default or euro break-up.
In January we said “We believe a scenario in which the crisis can be contained to be the most likely outcome of the European debt crisis but we should expect continued high market volatility for some time”. Currently the debt crisis is moving more in the direction of scenario two.
The crisis has clearly not been contained. Portugal has received an aid programme and the euro area leaders have endorsed a second bailout package for Greece (this package still needs to be ratified in member states). The debt crisis has spread to Spain and Italy where rising government bond yields have caused the ECB to reactivate the Securities Market Programme and purchase large amounts of mainly Italian government bonds. The fiscal boundaries as set out in the Stability and Growth Pact were never enforced and the irresponsible financial policy in many countries and reluctance to enforce harsh measures has sparked and fuelled the crisis.
No quantum leap has been taken with regard to fiscal integration but step by step we are moving towards closer co-ordination and more surveillance. Agreement has been reached to give the EFSF more flexibility and increase its actual lending capacity (awaiting approval by national parliaments). The Euro-Plus-Pact was endorsed in March and, among other things, obliges countries to incorporate the EU fiscal rules set out in the Stability and Growth Pact into national legislation. It has been agreed that the ESM will be an international financial institution based in Luxembourg with a EUR700bn capital base and that it can even intervene on an exceptional basis in the primary market subject to strict conditionality under a macroeconomic adjustment programme. In June it was agreed that the EFSF can also intervene in the secondary markets on the basis of an ECB analysis in order to avoid contagion. It was also agreed that the funds can be used to finance recapitalisation of financial institutions through loans to governments including in non-programme countries.
The six pack that should strengthen the Stability and Growth Pact has not yet been adopted because the European Parliament is asking for a reverse qualified majority voting but when agreement is reached on the final details the six-pact will also be a notable step towards closer co-ordination and more surveillance.
The move towards a quasi-fiscal union is a long and slow process – often delayed by national interests or the need to get consent from the European Parliament – but the direction is clear. Each time a crisis hits, the solution has been to come a little bit closer together. We expect this process to continue in the future.
New crisis scenarios
On the basis of recent political and financial market developments, we have updated and adjusted our debt crisis scenarios.
- Debt crisis slowly calms down as austerity measures begin to work and a situation where Italy needs a rescue package is successfully avoided.
- Turmoil continues and pushes a move towards a quasi-fiscal union and possibly at a later stage euro bonds.
- Default or euro break-up.
It seems unlikely that the debt crisis will calm down any time soon. Removing the uncertainties surrounding the next rescue package for Greece should help but uncertainty remains about the possible need for a third Greek rescue package or help for Italy remains. Turmoil is thus likely to continue for quite a while and this would push the euro area even further in the direction of scenario 2, which has become our main scenario. Eventually we expect austerity measures to calm markets down but we do not expect this to happen until the more distant future. The risk that we end up in scenario 3 with some kind of euro break up has also increased due to a deterioration in the general support for further belt-tightening in periphery countries and in particular an increase in the resistance to further financial support in core countries. We still assess the risk to be low. The commitment among the euro leaders remains intact and the main risk is a continued rise in public opposition.
Case by case approach
Our main scenario is thus scenario two – that the debt crisis will continue while we move towards a quasi-fiscal union. We expect financial markets to continue scanning the systems for weaknesses and through pricing, force politicians to respond or as ECB President Jean-Claude Trichet recently stated, “When serious crises arise, such as the one that we have been in since 2007-08, they expose weaknesses as sure as x-rays show up the skeleton inside the body. A good way of not letting speculation take hold is to identify one’s own weaknesses upfront and to correct them. In the years that preceded the crisis, countries in particular had a false sense of security…Once again, the lesson that we Europeans must draw from this is to strengthen the governance and monitoring of economic and fiscal policies. That does not mean to say that the functioning of the financial markets does not need to be substantially improved. At the moment, the key word for all industrialised countries is confidence.”
Recently we saw an example of this in Italy, see Flash Comment: ECB expected to start buying Italy today, 8 August 2011. The Italian 10-year yield rose by more than 150bp in less than two months. Italy was forced to present a very ambitious plan. The first plan presented aimed at balancing the budget by 2014. This was not enough to calm the markets. The austerity measures were frontloaded aiming at a balanced budget in 2013. This was welcomed by the ECB, which responded by including Italian and Spanish government bonds in the SMP purchases pushing 10-year yields below 5%.
Also, France has been in the spotlight, which has forced the French government to present austerity measures that are expected to more than fulfil the targets set out in the French Stability Programme. This implies reducing the budget deficit from 7.0% of GDP in 2010 to 4.5% of GDP by 2012
In a crisis environment, the euro area leaders will continue to use a case-by-case approach in an attempt to prevent an escalation of the crisis. It is difficult if not impossible to predict where the next ‘blowout’ will be but we can highlight potential triggers and monitor developments very closely. There are simply too many risk factors and the member states’ economies are still not sufficiently strong to expect smooth sailing from here. The euro area leaders need to continue the process towards more economic integration and we expect Germany in particular to take advantage of the leverage from the financial markets to push through much needed reforms in the peripherals.
Putting more money in the EFSF would be a plausible next step towards further integration. A strict implementation of the six pact and the Euro-plus-Pact would also push the euro area in this direction.
Giving the European Court of Justice more powers to give verdicts in the case of violations of the Stability and Growth Pact as suggested by Angela Merkel in her speech on 7 September would be another possible move towards further integration. This would demand treaty changes, which Angela Merkel has also said should not be taboo.
Euro bonds – maybe in the distant future
Euro bonds is a possible end solution but we do not expect euro bonds to become reality until integration has been extended much further – if ever. Angela Merkel is against “collectivising risks”. In addition, the German constitutional court’s ruling on bailout packages, which also says that the German parliament is “forbidden from setting up permanent legal mechanisms resulting in the assumption of liabilities based on the voluntary decisions of other states” seems to be a no-go for euro bonds.
Euro bonds are attractive to indebted countries because they can secure cheap funding for all euro area countries. But it also means that market pressure on individual countries to deliver sound fiscal policies would disappear. When the debt crisis eventually calms down, this is an important mechanism to avoid future crisis. President Van Rompuy put it this way “It is the overall combination of institutional pressure, peer pressure and market pressure that will help to avoid getting into such difficulties again. All three have been enhanced…In the first decade of the euro, the markets were asleep. Now they are awake – and even if they are sometimes overreacting, they will not go back to sleep again. Market signals were not being transmitted in an early and more gradual way to states whose debt levels rose dangerously high or whose current account deficits were unsustainable.” So institutional pressure and peer pressure may have to take over successfully the role played by market pressure today before euro bonds would be a success. We believe getting there will require more turmoil, with high market volatility and a continued focus on the ongoing debt crisis.
The financial system is very vulnerable to negative surprises. Should one of these take place, it could set off a chain reaction with increased financial turmoil with rising tensions in money markets, a further increase in credit spreads and an additional fall in equity markets. Although it is difficult to pinpoint exactly what could trigger this, there are a number of candidates.
- Renewed pressure on the Italian bond market, for example on negative budget news or political instability.
- Greek vote on tough new austerity measures expected in early October
- Uncertainty over the size of EFSF if it is necessary to buy continualsly in the secondary market to keep yields down in Spain and Italy.
- Problems in finding agreement among EU leaders on further measures in the event of renewed tensions.
- A negative event at a larger European bank.
- Negative surprise on losses in the Spanish banking sector and problems with recapitalisation of this sector.
- Increased focus on the burden sharing in Europe through EFSF could trigger downgrades of AAA countries, for example France (see Research France: No downgrade in 2011 – but small margin for error (24 August 2011).
- France is coming under pressure, due to a sharp drop in houses prices, which would weigh on the French banking sector.
The news coverage and market dynamics appear to play an important role in adding inertia to the debt crisis. The tendency for both media and market participants to focus mainly on the negative aspects is noteworthy. We have seen this recently in Italy and Greece where, for example, ambitious new austerity measures have attracted little attention.
Ireland stands out as a good example of how markets can begin to regain confidence. Since it received the bailout package, it has improved its public finances considerably and is now broadly following the bailout plan. This was also supported in the third IMF review. S&P has confirmed that Ireland’s rating is stable and has said that it does not expect Ireland to need a second rescue package. As a result, Irish yields have clearly drifted downward and the Irish 10-year yield is currently 8.5%, down from close to 14% in July.
We expect to see similar dynamics for other countries. We expect hard data to begin improving eventually and news flow to turn positive slowly – but it will take some time.
Despite all these risk factors, we do not expect a recession as our main scenario. However, the risk of recession has been rising and we assess the probability to be around 20% currently. The euro area has previously delivered decent growth despite the debt crisis. Looking ahead, we expect very modest growth as the unwinding of imbalances in the public, private and financial sector takes place. In 2011 and 2012 we expect growth of 1.6% and 1.1%, respectively. This is a significant downward revision from the 2.2% in 2011 and 1.9% in 2012 published in our June global scenarios.
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GBP/USD has come under pressure in recent weeks and has been trading in a bearish channel since the end of August. This can be seen by a series of lower highs and lower lows as identified in the chart below. The pair has tested resistance on Aug 29, Sep 6,
USD/CHF – 0.8828
Most recent candlesticks pattern : N/A
Trend : Near term up
Tenkan-Sen level :0.8821
Kijun-Sen level :0.8819
Ichimoku cloud top :0.8839
Ichimoku cloud bottom :0.8817
Original strategy :
Buy at 0.8710, Target: 0.8850, Stop: 0.8675
New strategy :
Buy at 0.8710, Target: 0.8850, Stop: 0.8675
Although the greenback has rebounded after yesterday’s fall to 0.8758, a sustained break of indicated resistance at 0.8880/85 is needed to signal the pullback from 0.8927 has ended there and bring retest of this level, above there would extend upmove from record low of 0.7068 to 0.8950 and possibly 0.8970, however, reckon upside would be limited to psychological resistance at 0.9000, bring correction.
If said resistance continues to hold, then further consolidation would be seen and another corrective fall cannot be ruled out. A break of 0.8758 would bring retracement to 0.8730 but reckon 0.8706 (previous support) would attract renewed buying interest and bring another rise later.
In view of this, we would look to buy dollar on next corrective fall. Only below 0.8688 (61.8% Fibonacci retracement of 0.8540-0.8927) would abort and signal a temporary top is formed, then stronger correction to 0.8630 (previous resistance) would follow.