FX Outlook

The week begins off with a consolidative tone.  It was the alignment of technical and fundamental factors following the election results earlier this month that allowed for the strong trend moves in the foreign exchange market.  Arguably the most important consideration is that the divergence between the two has emerged.  While a resolution of the European crisis is not imminent, the combination of extended positioning, the price action before the weekend, and official attempts to talk the market away from the edge of the abyss, warns the short-term momentum and trend following participants may be further squeezed, creating a new opportunity to medium term investors.    

Since the middle of last week,  we have warned of heightened risk of a technical correction.   We see the euro having scope toward $1.2850-$1.2900.  This gives sterling space toward $1.5880-$1.5930.  Provided the JPY79 are holds, the dollar can recover toward JPY80.00-JPY80.50.  The initial pullback against the Canadian dollar can see CAD1.01, while the Australian dollar already tested initial resistance near $0.9880.   

Market participants remain fixated about the possibility; some would say likelihood, of a Greek exit from monetary union.    Some of the recent speculation has focused not on Greece pulling out but being pushed out. 

Although there is no formal mechanism to eject a member, there are ways that life can be made unbearable.  The ECB is the key.  It can do two things.  First, it can stop lending to Greek banks.  Second, it can deny the central bank of Greece the ability to provide Emergency Lending Assistance (ELA).  It is widely thought that most Greek banks have run out of collateral that ECB is willing to take, which limits the ability to take the first step.  That leaves preventing an extension of the ELA.  The ECB, to the contrary, has moved in the opposite direction.  Reports indicate that early last week, the ECB agreed to increase Greece’s ELA ceiling to 100 bln euros from 90 bln.  Recall that that Greek bank recapitalization is to be funded by the second aid package and an 18 bln euro payment is expected by mid-week. 

The recent events in Greece and Spain have fanned concerns that depositors will flee and trigger an old fashioned bank run.  The Financial Times reported that some 5 bln euros have left Greek banks since the election, which is about 3% drawdown.   If this were to continue, it underscores our warning that a part of the Greek economy may remain euro-ized even if it leaves EMU.   Spain’s Bankia was subject to rumors of depositor flight last week and although they were met with denials by Spanish officials, investors remain on edge.   The LTROs reduced the roll-over risk that the euro area banks faced.  That has little to do with an institution’s ability to withstand large scale withdrawal by depositors.   

The EU informal summit this week will likely see old issues re-opened, including a common deposit insurance, allowing ESM to recapitalize banks directly, common European bonds, and the dramatically ramped up efforts by the ECB to backstop Spanish and Italian bonds (as argued by the Polish foreign minister in today’s Financial Times). 

Supportive comments from the G8 meeting, news that Germany’s I.G. Metall reached an agreement with employers in Baden-Wuerttemberg for a 4.3% wage increase (which technically covers 13 months, as contract starts May 1, previous contract expired at the end of March), which is well above the German inflation rate, and the realization that the ECB is not cutting Greece off (ELA, Target 2) works in line with the technical correction we envision.   

The main data this week is the flash euro zone PMI, which is expected to stabilize albeit at levels consistent with a recession regardless of the fact that Q1 GDP was flat.   In the UK, soft inflation data may encourage speculation for another round of gilt purchases.   Meanwhile, the a story still unfolding is French mortgage lender Caisse Centrale du Credit Immobilier de France (3CIF), which Moody’s downgraded on a standalone basis last Thursday has speculation of an imminent nationalization. 

We note that Japanese banks failed to sell sufficient 1-2 year bonds to the BOJ last week and this raises the specter of the BOJ announcing a lengthening of maturities under its JGB purchase plan at the conclusion of its two-day meeting on Wednesday.   While the recent string of US economic data seems consistent with a downward revision to Q1’s 2.2% initial estimate, a better showing is now expected for Q2. The Philadelphia Fed report was disappointing, but investors will watch carefully if it is repeated in this week’s reports. 

Finally, we note that the European debt crisis appears to be having an impact on Treasuries of a QE operation.   Ten year yields are near record lows and yields have fallen for nine consecutive weeks.  The seven year note yield did fall to record lows last week.  The 2-10 yr curve has flattened and is near its flattest since the end of 2008.