The Year of the Dragon, the Bull and the Spider?

Historically the direction of the S&P equity index in January has a high correlation to the direction of the index for the full year.  Moving into the last full week of the month with what is a commanding lead (+4.59%), the bulls are in a strong position.

Last week I warned that the market was mispricing the risks to the near term environment and that in effect the current view was ‘too rosy’ (Risk: a wolf in sheeps clothing).  However on the face of things there does seem to be a reasonable rationale for the bullish case and as such this mispricing may continue for a while longer.  Despite the fact that there has been a significant amount of disappointment so far in the US Q4 earnings season it is the work of (Super) Mario Draghi that seems to have brought life back into the financial markets and investors alike.

The non-standard measures which are of course “temporary in nature”, have made a significant contribution to a number of financial market indicators, or barometers of risk sentiment.  The EUR/USD cross currency basis swap, which was viewed intently prior to the 3y LTRO’s and the USD swap line extension, as highlighting the funding stresses of several European banks, has clearly eased back and with it so to have concerns about the immediate funding stresses of those institutions.  Sovereign bond yields have also normalised to a certain degree, with the 2y yields of Spain and Italy now clearly below their respective 10 year yields.  Pressure remains in Portugal and of course the situation in Greece still remains on a knife edge but fear of contagion beyond the current ‘programme countries’ has waned.  It even appears that the recent flood of liquidity from the ECB measures has begun to see US banks re entering the European Commercial Paper market after a long absence.

So where does this leave us?
After the long drawn out issues of the eurozone and the uncertainties that have surrounded Greece (and contagion to the rest of the PIIGS) there is an element of calm to markets at the moment but significant uncertainty still remains.  This is where the concept of relative value or economic differentiation that I have mentioned so often should begin to emerge as the dominant theme.

In FX terms what this means is that we are likely to see currencies that have historically been highly correlated to risk (such as the AUD, or my preferred vehicle at this point GBP) outperforming.  However, historically in this environment risk currency strength would have been expressed via the USD, in this instance I feel that the funding currency of choice for risk positive trades in the current environment (given its very weak growth profile as a result of high indebtedness, greater uncertainty and coordinated austerity across the region) will be the EUR.  A higher GBPEUR remains my core view.

On the data calendar this week whilst there are monetary policy meetings in the US, Japan and New Zealand, the momentum and impetus for the markets is likely to be driven by the eurozone business survey data on Wednesday and Thursday (PMI’s and IFO – strong numbers may offer an opportunity to enter a short EUR position) and the continued investor sentiment towards US equities.  In the UK, the Bank of England Minutes and public sector finances will clear the stage for Q4 GDP, which will undoubtedly drive expectations for further QE in the UK at the February meeting.  Whilst a bias towards a positive risk backdrop will, at times, benefit the EUR, the data releases (at the very least when put into context) should continue to weigh and of course any further complications with the Greece debt swap talks will have a disproportionate negative affect in the current environment.