FX Drivers in the Week Ahead

The US dollar's recent losses are being extended at the start of the new week.  The announcement of the details of the Greek bond buy-back scheme has triggered a sharp rally in peripheral bond yields, while the euro area Nov manufacturing PMI is reported at 8-month highs, even if still below the 50 boom./bust level at 46.2.  The euro has completely recouped the knee-jerk losses scored in thin activity just before the weekend when Moody's announced a cut in the ratings for the EFSF, which follows its recent downgrade of France.

 In addition, we note that the weekend press shows little progress in the US deficit talks.  Asian equities eked out a minor gain, though of note the rise in China's PMI did not bolster the Shanghai Composite, which lost 1% to close at new multi-year lows.  European bourses are higher and the Dow Jones Stoxx 600 is up about 0.4%, led by technology, basic materials and industrials. 


We see five main drivers of the foreign exchange market, and capital markets more broadly in the week ahead.

Central Bank Meetings:  Five central banks meeting in the coming days.  They are the Reserve Bank of Australia, the Bank of Canada, the Reserve Bank of New Zealand, the European Central Bank and the Bank of England.  The only central bank that appears poised to move is the RBA.  A weakening of forward looking indicators, a deterioration in the terms of trade, and official discomfort with the over-valued exchange rate makes a compelling case of a 25 bp rate cut that has largely been discounted in the forward market.

Such a rate cut will still leave Australia with the highest real and nominal policy rate.  While there has been some talk of a 50 bp cut, such a move would come as a surprise.  Not only would it likely spur a sell-off in the Aussie, but would have knock-on effects on the New Zealand dollar as well, as the market moves to discount some chance of a rate cut there as well.

The series of soft Canadian data could see the BoC adopt more neutral language as it explains keeping rates steady.  The ECB is still focused on its transmission mechanism and OMT.  If a rate cut is forthcoming, it seems far more likely in Q1 13 than now.

The Bank of England balked last month in extending its gilt purchase program.  Very little has changed since then.  Like the ECB, a move from the BOE is more likely next year than now.   More importantly are two events prior to the BOE meeting.  The BOE provided little insight into its Funding-for-Lending Scheme (FLS), which is another unconventional way to ease credit conditions.  Some 35 institutions participated, although only six have actually borrowed (total of GBP4.4 bln).  Seems less than inspiring, but it is admittedly a bit early to reach any hard and fast conclusions.  The day before the BOE meeting Chancellor Osborn will deliver his Autumn Statement on fiscal policy to the House of Commons.   With Moody's and Fitch having a negative outlook for the UK's debt rating, its AAA status looks increasing vulnerable.  

US:  The fiscal cliff remains a key concern of investors.  The verbal jousting create headline risk, which we suspect is diminishing as it becomes clearer that no agreement is likely until the very last minute, if even then. We continue think the political incentives are such that a resolution is more likely after going over the cliff for a short period of time. In the meantime, the US economy is slowing markedly from the 2.7% revised pace in Q3.  Growth may be halved, if not more.   Part of this, like the decline in personal consumption expenditures, is picking up the impact of the east coast storm. 

On the other hand, November auto sale sales may have been buoyed by the storm and may be near their best levels of the year.  Americans may not be as fortunate with the employment report at the end of the week.  The employment report is notoriously difficult to forecast and the impact of the storm only compounds that difficulty.  The October job growth was put at 171k.  The early consensus is for about 90k.  In any event, the risk appears on the downside, though the BLS will likely try to estimate the impact of the storm.

Even without the storm's disruptions, the key troika at the Federal Reserve, Bernanke, Yellen and Dudley, were still unsatisfied with the pace of job growth.  With Operation Twist nearly complete, and the Fed's holdings of short-dated coupons minimal, we expect the FOMC to announce on December 12 that will roll into QE3+ the $45 bln a month in Treasury purchases, bringing the monthly total purchases to $85 bln.

Japan:  The rhetoric of Shinzo Abe, who most likely will be the next Japanese prime minister in a couple of weeks, has been more successful in changing market sentiment toward the yen than the $100 bln-plus intervention in Oct-Nov 2011.  That intervention drove the dollar up about 5.5% against the yen.  The dollar has risen 7.2% against the yen since Abe began threatening to debase the currency.

As the Commitment of Trader's report illustrates speculators have amassed a large net and gross short yen position.  Foreign investors, as we have noted,  are also favoring Japanese equities over bonds, unlike earlier this year.  The return on Japanese equities tends to be greater than the return on fixed income in a weak yen environment.  

We do not see the incentives to fight the weakening trend in the yen.  However, this will leave the market vulnerable to profit-taking or "sell the rumor and buy the fact" type of activity after the election on December 16.  

China:  While the world's largest economy is slowing in Q4, the second largest economy appear to be poised to snap a seven quarter slowdown.  The official manufacturing PMI was reported over the weekend.  It rose to 50.6 from 50.2 in October, for the third consecutive monthly gain and now stands at its highest level since April.  Importantly, the headline was driven by the forward looking new orders component, which is at seven month highs, and exports, which rose above 50 for the first time in six months.  Output itself also rose to its highest level in six months.  

The yuan has appreciated about 2.25% against the dollar in the past four months, but may now consolidate for into next year.  Despite the yuan's appreciation, it has lagged behind several key Asian currencies, including the South Korean won and Taiwanese dollar.  Coupled with the yen's depreciation, the South Korean and Taiwanese producers are being squeezed from both directions.  This may reinforce official efforts to cap further currency appreciation.  

Separately, while China's territorial dispute with Japan continues to simmer, tensions with others in the South China Sea have escalated.  China recently claimed the right to board and search vessels that pass through the disputed area, which is nearly the entire sea. Several countries, including the Philippines have protested.  Last week, China's passport maps which depict the disputed islands as all belonging to China irked the Philippines, Taiwan, Vietnam and the Indonesia.  

Europe:   Details of Greece's bond-buy-back scheme have  announced and will conducted by December 7 in time for the next EU Summit to secure the funds that will be used to pay back the country's mostly official creditors.  The voluntary nature of participation is suspect as the finance minister claimed Greek banks should participate out of patriotism.  Greek pension funds will not have to participate following comments by the prime minister indicated that those obligations are regarded as "arrears" of the state.

Greek banks appear willing to participate, in part, because they are carrying the bonds on their books at lower prices that will prevail in the buy back (which cannot be above the Nov 23 closing price).  Some hedge funds hat bought the bonds at rock bottom prices can nearly double their return.  If participation is poor and Greece cannot reduce its outstanding debt by 20 bln euros, the entire deal, recently struck after protracted discussions, may fall apart.  .  

Following the recent election, coalition talks in Catalonia may be an important consideration for if and when Madrid formally requests aid.  A coalition that would strengthen the drive toward a referendum and a confrontation with Madrid would be the center right nationalist CIU and the center-left ERC.  Mas and the CIU called for a referendum in 4 years, while the ERC wants it by September 2013.   The CIU is also holding talks with the Socialists, but in either configuration, it is difficult to see much enthusiasm for the CIU's austerity agenda.