Marc To Market's blog

The underlying trends seen this year have continued, but after strong follow through in Asia, a more subdued tone has been seen in Europe. The US dollar is generally softer, except against the yen and sterling. Japanese markets were closed for holiday, but the MSCI Asia-Pacific Index rose almost 0.3%, lifted by more than a 3% rally in China on speculation that there may be a sharp increase in the cap on foreign investors' ability to invest in Chinese equities. In Europe, the Dow Jones Stoxx 600 is hp about 0.4%, led by a rise in financials. Spanish stock market is at its highest level in almost a year (Feb 2012) and Italy's market is at its best August 2011, though their bond markets are seeing some profit-taking today. With a light economic calendar in North America today, Bernanke's speech in Michigan after the markets close may be the highlight. We identify six key factors shaping the investment climate.

There have been some large moves in the foreign exchange market in recent days.  The euro posted its largest rally in four months last week.  The yen has fallen to its lowest level against the dollar since June 2010 and extended the declining streak to nine consecutive weeks, something not seen since 1989.  The Canadian and Australian dollar rose to multi-moth highs, as did the Mexican peso.  

In last week's technical note, we suggested the key question whether the sharp drop in the major foreign currencies following the avoidance of the full fiscal cliff in the US was trend reversal or overdue correction.  We favored the latter and looked for the underlying trends to continue.   They did.  

Now market participants face a different question.  Given the out-sized moves, have the trends become stretched?  The answer, we propose, is more nuanced than last week.  There is not one answer for all the major currencies we review here.

After out sized moves in the foreign exchange market yesterday, a consolidative tone has emerged with a few exceptions. The big winner yesterday was the euro and with a narrow range of about a third of a cent today, the market seems as if it is catching its breath before assaulting important resistance near $1.33, which capped it in mid-December and at the very start of the new year. Sterling recovered from a test on $1.60 at mid-week, but lagged behind the euro. The pullback today is also more pronounced after the disappointing industrial output figures. Industrial production rose 0.3%, half the recovery the consensus expected after the 0.9% decline in October. The key disappointment was in manufacturing, which contracted 0.3% compared with consensus expectations for a 0.5% gain, following the 1.4% slide in October. The increases concerns that the UK economy slipped back into contraction following expansion in Q3. Support is now seen near $1.6080.

European officials have impressed upon investors that the tail risks of a EMU break up have receded markedly. Some officials talk even that the crisis is over. The premium Italy, and to a less extent, Spain, pay over Germany have narrowed to levels that had previously thought possible only if the ECB were to make good on its promise of unlimited (ex ante) purchases. There have been some signs that foreign investors are participating in the primary and secondary sovereign European bond market. Ireland is returning to the capital markets.

To be sure, challenges remain. Greece's will and ability to impose more austerity is questioned. Spain has relied on cuts in public investment over the last several years while other spending has actually risen. With high issuance this year than last, apparently without the help of another LTRO (with some borrowing, perhaps around 100 bln euros expected to be paid back early--beginning as soon as the end of Jan), Spain's funding challenges are likely to resurface. Italy's elections next month could still result in a hung parliament, with Monti's centrist movement seemingly contributing to the fragmentation. However, it is Cyprus that may be the most pressing issue. Yes it is small and few international investors have any exposure. Its significance extends beyond its size.

It is widely recognized that the agreement to mitigate the fiscal cliff neither puts the US on a sustainable fiscal path nor lifts much policy uncertainty. At the same time, minutes from the latest FOMC meeting showed that several members anticipate ending QE3+ before the end of the year, seemed to cloud the outlook. Seeking to avoid partisanship of the heated debates, we offer the following overview of the outlook for US policy, free of hyperbole.

There are seven items that will be on the radar screen of global investors in the week ahead. 1. There is confusion over Fed policy. Despite the leadership (Bernanke, Yellen and Dudley) demonstrating their unwavering commitment to use heterodox monetary policy in an attempt to promote a stronger economy in the face of household de-leveraging and fiscal consolidation, many have read the FOMC minutes to imply an early end to the $85 bln a month in long-term asset (MBS and Treasuries). That December meeting was historic not because it marked the beginning of the end of QE, but the exact opposite, the nearly doubling monthly purchases and the adoption of macro-economic guidance (6.5% unemployment and 2.5% inflation) before rates are lifted.

The ascent of the Democratic Party of Japan marked the end of Japan's one-party state, dominated by the Liberal Democratic Party since the 1955.  However, the DPJ was unable to address the challenges Japan faced, was internally unstable, as illustrated by the revolving door in the prime minister's office, and spent scarce political clout to support a controversial retail sales tax increase.  

The LDP has returned to power.  Its ascent is a victory for the old elite.  Reports suggest that half of the cabinet positions were given to members of parliament who had inherited their Diet seats from their families.    The LDP's program, or Abenomics as it has been dubbed, seeks to strengthen the domestic economy and enhance Japan's ability to project its power internationally. 

One of the most important decisions participants in the foreign exchange must make is whether to view the dramatic pullback in most of the major foreign currencies seen in the early days of the new year as a reversal of the trend or as simply an overdue correction.   Our technical analysis sides with the latter and we anticipate renewed dollar weakness in the period ahead. 

We would be forced to reconsider if the euro fell through the $1.2980 area or if sterling fell below $1.60.  Although the dollar's sharp gains against the yen have left it over-extended, we see no compelling technical sign that a reversal is at hand.  Just like ECB's Draghi wielding Outright Market Transaction scheme drove down Spanish and Italian yields, Japan's Abe's rhetoric has been sufficient to drive the yen down without lifting a finger or spending cent.

US dollar gains have been extended for the third session. The euro has been sold down to almost $.1.30 after testing $1.33 on Wed. More stale longs may be forced out on a break of $1.2985, which corresponds to a 50% retracement of the advance from the mid-Nov low near $1.2660 and the 50-day moving average. Sterling's decline is even more dramatic. It has come off hard since setting a 17-month high on Wed near $1.6380. It has now been pushed below $1.6040, which the 61.8% retracement of its rally from mid-Nov low near $1.5830. Sterling has also slipped below the 50 and 100-day moving averages for the first time in seven weeks.

The IMF reported Q3 currency composition of foreign exchange reserves at the start of the week when many were on holiday. We offer the following observations. 1. As a whole, central banks drew down reserves during the financial crisis and have been rebuilding them. Total fx reserves stood at $10.78 trillion at the end of Q3 2012. This compares the estimated value of all above-ground gold (@~$1670 an ounce) of $8.49 trillion. 2. This represents a $610 bln increase over Q3 2011. This compares with the estimated value of the new gold produced in 2011 of about $125.5 bln. The bulk of the increase in currency reserves (~3/4 or $414 bln) came from countries that report the allocation of their reserves. China and some Middle East countries are strongly suspected not to report the allocation of their reserves.

US Vice President Biden and Senate Minority leader McConnell brokered an agreement that was approved by the Senate that seems to avoid the full fiscal cliff.  It now is before the House of Representatives.  

While the Jan 1 deadline is passed, the more significant one, we had argued was Jan 3, when a new Congress is sworn in.  A failure by the 112th Congress to finalize the legislation would mean that process would have to begin anew with the 113th Congress. 

After what is likely to be intense though short debate, the House of Representatives can either approve the same exact bill the Senate approved, which be the quickest resolution.  It can seek to amend the bill, in which case it must return to the Senate for their approval.  The process could be cumbersome and require reconciliation and would risk the Jan 3 deadline.  Alternatively, a majority of the House could fail to ratify the Senate bill, in which case, it will be up the next Congress to claw back from the other side of the cliff.

The holiday week saw the dollar consolidate against most of the major currencies.  The yen was the main exception as its losses were extended under the aggressive signals coming from the new Japanese government.   

At the end of the week, the other key consideration, the US fiscal cliff made its presence felt.  The recent pattern remained intact.  News that gives the participants a sense that the cliff may be averted encourages risk taking, which means in the foreign exchange market, the sale of dollars and yen.  

News that makes participants more fearful that the political dysfunction failed to avert the cliff and send the world's largest economy into recession, generally see the dollar and yen recover.  This is what happened in very thin markets just ahead of the weekend as Obama's ling last ditch negotiating stance seemed to reflect a retreat from his earlier compromises.

The relatively calm foreign exchange market and equity market in Asia ended abruptly in Europe. It is difficult to find the culprit, other than position squaring in thin markets, but the euro has come off a cent, dragging the franc. The MSCI Asia Pacific Index gained more than 0.5%, while European bourses are broadly lower, with the Dow Jones Stoxcx 600 off 0.3% near midday in London, led by utilities and financials. Fixed income markets are subdued. Italy's bond auction was adequately received, especially holiday conditions. There have been a few developments to note. First Japan's data was disappointing and this can only bolster the new government's attempt to stimulate the economy both monetarily and fiscally. Worker cash earnings fell a whopping 1.1% in November, nearly three times larger than the consensus. This may have been a factor behind the poor retail sales, which were flat. The consensus had expected a 0.4% increase. Weak incomes and domestic demand may have, in turn, weighed on output. In November, industrial production fell 1.7%, more than three times the decline expected.

The main feature in the foreign exchange market continues to be the yen’s weakness. This weakness, based on expectations that the new Japanese government will succeed in driving the dollar to JPY90 with a combination of more aggressive monetary and fiscal policy (“Abenomics), is offering support to the other currencies. The yen sales are a combination of momentum and carry strategies. There are two other forces in the market as well. First, the market is anticipating a further reduction in tail risks in Europe. Of course the large moves away from the abyss this year are clearly the doing of the ECB with its long-term repos and offer of (conditional) outright purchases.