FX Drivers in the Week Ahead

The last week of November has begun with a mildly consolidative tone in the foreign exchange market.    The US dollar is trading in relatively narrow ranges around its pre-weekend lows.  Its performance against the yen is the exception.  It has traded on both sides of last Friday's range. A close below Friday's low just above JPY82.00 would increase the risks of a deeper correction after the 4.6% advance in the past week and a half.

Consolidation is also the flavor of the day in the other capital markets.   MSCI's Asian-Pacific Index closed fractionally higher and most European bourses are paring last week's gains.  In in the debt market core bond yields are mostly softer, while Spain and Italian benchmark yields are 3-7 bp higher.


The Eurogroup of euro area finance ministers are meeting today for the third time to figure out a way that Greece can be given funds so that it can pay its mostly official creditors in the coming years.  

They are scrambling for an alternative to the haircut of the official sector the IMF was pushing for, though it insisted that it had to be kept whole. It looks likely a combination of debt buy backs reduction in rates and a recycling of the profits earned by the Eurosystem of central banks from the ECB previous bond buying program (SMP).  

There are no assurances that today's meeting will succeed where the previous two have failed.  If no final agreement is struck today, upon which a few parliaments, including the Bundestag, have to approve, attention will turn to the next regular Eurogroup meeting scheduled for Dec 3.  We are not convinced that euro's advance last week was really spurred by optimism over a Greek deal.  What we found most striking was the euro's advance despite a series of disappointing developments and the flash PMI which warn that the area's two biggest economies are likely contracting.  

Although the deal on Greece proved elusive, as did the next EU 7-year budget, and the Bundesrat, rejected a landmark tax deal with Switzerland and would have protected the anonymity of tax evaders, there was one modest success.  It appears the general framework under which Cyrpus will become the fourth euro zone country to get a broad aid package was agreed upon.  The package will reportedly be between 14-17.5 bln euros.  Roughly half will go to bank recapitalization and half to finance the government for four years.   The precise details will be worked out in early December.  

Catalonia's regional election resulted in a somewhat larger majority for the center-right and center-left nationalist parties, though Catalonian leader Mas' party did significant worse than expected, losing about 20% of its seats.   Roughly 2/3 of the 2/3 of the people that voted, cast their lot with the nationalist parties and all those votes cannot be rightly regarded as supporters of secession.  It may force Rajoy (and Mas) back to the negotiating table.   

Meanwhile, Spain's bank rescue fund will reportedly receive 35 bln euro in funds from Europe.  The conditions will include dramatic cuts in head count at the nationalized banks. Up until now, layoffs at Spanish banks have been minimal, but in order to receive aid, the nationalized banks, including Bankia, may have to cut their work forces by nearly a third.  More than a thousand branches may have to be closed.  

We have argued that the aggressive stance by the head of Japan's Liberal Democrat Party, and likely the next prime minister, triggered the slide it yen, which in turn may have been the catalyst for unwinding of positions that resulted in broad based US dollar losses.  Abe appears to have softened his stance.  The LDP platform, for example, calls for increasing the BOJ's inflation target to 2% from 1%, instead of 3%, which Abe had previously suggested.   

Abe reportedly was more respectful of the nominal independence of the BOJ, which needs to be understood in the context of Japanese institutional arrangements.  These allow, for example, government representatives to attend central bank meetings.  Nevertheless Abe's point was made, even if clumsily.  

The next government, most likely a coalition led by the LDP will name the next BOJ governor and deputies in the coming months.  There is no need to formally alter the BOJ charter and have to face criticism about encroaching on BOJ's independence.  Abe can achieve his results, arguably more effectively, through the appointment process. 

Abe suggested that the controversial retail sales tax might not be implemented in 2014, suggesting that the opt-out clause due to a weak economy, could be exercised.  Abe, of course, is risking a credit downgrade.   There is much speculation of which major country will be next following the recent French downgrade.   

The UK must be considered a prime candidate.  Two of the three rating agencies have it on negative outlook.  Osborne, Chancellor of the Exchequer, delivers his Autumn Statement on December 5.  Barring a major shift in the government's fiscal strategy, a downgrade seems increasing likely.  

The US also appears to be risking a downgrade with its seeming inability to find a politically agreeable medium term fiscal consolidation strategy.  At the first meeting between the two sides almost two weeks ago, some observers expressed optimism and even suggested market moves were related to it. 

We were always skeptical and the weekend talk shows support our view that there has been little progress from initial positions.   It is in the interest of both sides to take this to the wire, or a little more.  Both sides have to make concessions and to do so before the last possible minute is understood as a sign of weakness to one's own base.  

On a more positive note, revisions to Q3 US GDP will be released  on Thursday November 29.  Due to subsequent trade and inventory data, the consensus expects growth to be revised to 2.8% from 2.0%.  This would be the second strongest quarterly performance in three years, behind Q4 11's 4.1% annualized pace.   

There have been several developments in the emerging markets space that will likely influence activity in the days ahead.  The Taiwanese stock market has been bolstered by the government indicating that it will announce measures to support equity prices by year-end.   It extended late last week's gains with a gap higher opening and a 1% gain and closed at the highs of the day, suggesting the upside momentum is intact despite a 5% gain in three sessions.   

Hungary's debt rating was cut two notches to BB by S&P.  The outlook is now stable.  A day before the downgrade, the government sold a record amount of 12-month bills in anticipation of a rate cut this week. The Russian ruble rose by the most in two months last week (~2%), driven largely by domestic businesses converting buying rubles for tax purposes.  Foreign investors appeared to book some profits following Fitch's decision to grant Turkey investment grade status.  Israel's central bank meets today and is expected to leave the base rate unchanged at 2.0%.  The shekel is consolidating its recent gains that carried it to one month highs.  Dollar support is see near ILS3.85.   

Brazil's central intervened to calm the market after the real hit 3-year lows against the dollar.    It is not immediately clear what this means about the currency war that Mantega likes to cite.  Columbia unexpectedly cut interest rates before the weekend.  Separately it is considering cutting taxes on foreign investors' bond profits to 14% from 33%.