An Accident Waiting to Happen?

Yesterday was an extremely quiet start to the week. Flows were light but with a risk negative bias, as a Chinese trade deficit at the widest level since 1989 added concerns to the global growth slowdown story. The reality, however, was that seasonal distortions due to the timing of the Lunar New Year celebrations meant that we will have to wait for further Chinese data before we can paint an accurate picture of the Oriental growth dynamic. After a disappointing Bank of Japan meeting overnight where, despite the announcement being an hour late, they did not announce any new monetary easing measures, it is left to the Occident to drive sentiment and flow for the rest of the day.

Eurozone leaders gave the green light to the Greek bailout plan yesterday following the IMF recommendation to sanction a EUR28 billion loan as part of the package on Friday.  But despite the months of hard work and the commitment of a huge amount of funds from fellow eurozone sovereigns, the IMF and private investors, Greece’s brand new long term bonds opened at a discount of over 75% yesterday, effectively pricing in another default!

In addition to this, calls from the Eurogroup for additional deficit reduction measures in Spain - and the empirical evidence that Italy is in technical recession - highlight the fact that the problems facing the eurozone are certainly not over. Upcoming French and Greek general elections add a political risk to the eurozone's troubles, and rising oil prices are not going to help the much-needed quest for growth.

“The biggest challenge for Europe is to get out of [the] debt trap” – Angela Merkel

In FX terms, I see this as leaving the EUR on the back foot. However market positioning is arguably already short, and therefore it is not likely to be a one-way move ceteris paribus. The case for the USD, however, is also mixed. There has been widespread discussion about the (at least relative) strength of the US economy; however, the improved situation has not been driving US yields higher, at least not yet significantly. The fact that yield spreads have moved in favour of the USD have been more of a function of falling rates elsewhere. If we combine this with the fact that USD strength has been apparent in a broader ‘risk off’ environment it could be argued that the USD’s correlation to risk remains negative.

In this regard, the FOMC meeting this evening will be of particular importance and while it is generally accepted that there will be no change to policy, despite some suggestions of a move towards sterilized bond purchases (or a sterilized twist!).  The committee is likely to acknowledge the stronger labour market data and the upward pressure on headline inflation, which will undoubtedly be characterized as temporary.

However, any further acceptance of the strength of the economic recovery or improvements in the staff forecasts or projections will potentially have a large positive impact on the USD by removing the probability of QE3.  Any form of clarification of the ‘extended period’ language may also have a similar impact.

In Japan whilst no new monetary easing emanated from the meeting, it is becoming increasingly clear that a weakening of the JPY is an intended consequence, if not an intended driver, of the government and central bank fight against deflation. Seasonal history would suggest a potential for significant JPY demand into the end of the Japanese fiscal year this month. Beyond there however, the JPY depreciation story could very well extend substantially. Any move higher in USD rates from here, particularly a rise in the 2 year rate above 0.35%, could further add weight to the JPY decline.

For the day I continue to favour a gradual decline in the higher yielding currencies (which in real terms includes the JPY) and those currencies that are positively correlated to risk.