Euro Smothered by Weak Italian Bond Auction, Downgrade Rumours

The Euro squeeze reversed before developing much beyond a dead cat bounce after a poor showing at an Italian debt auction today. Meanwhile, Chinese reserves fell – why?

Risk has drifted lower today on the weak Italian bond auction (more below) and after the US financial giant JP Morgan reported slow revenues to kick off the earnings reports for financial companies in the US. It’s also tough to get excited about the immediate prospects for the US economy when the latest Retail Sales report is showing weak demand and the expiration of incentives to purchase capital goods will mean at least a few months of weaker demand. Later in the European session, the Euro weakness picked up pace on rumours that the S&P bond ratings agency will soon downgrade several Euro Zone countries (hard to see why the ratings agencies really matter anymore, but there you go…)

Weak Italian bond auction
While yesterday’s auctions of 6-month  and 12-month Italian bills and 3- and 4-year Spanish bonds saw very strong demand, today’s auction of 2- and 3-year Italian bonds fared relatively poorly, only attracting a bid to cover ratio of 1.2. After slipping below the 4.0% level earlier today, the Italian 2-year benchmark quickly snapped back higher to above 4.15% as of this writing. EURUSD reversed course from the day’s highs close to 1.2880.

Norway housing bubble – the one to rule them all?
Due to the response to the global financial crisis back in 2008-09 (central banks flooring yields to save growth) there are still numerous countries featuring housing bubbles. Some, like China’s and Australia’s, appear to be beyond the tipping point and Sweden’s appears to be tipping over as well. Interestingly, there are two other prominent bubbles where few signs of the inevitable implosion have appeared  - and they are also the two bubbles that have seen the greatest increases since 2004, according to the data series we employed to investigate and compare. (We don’t include China because of the lack of a reliable data series, lack of secondary housing market in China, etc.). Indeed, Robert Shiller commented in an interview with Bloomberg that “it looks like a bubble” to him. And although the housing market has yet to correct, the Norges Bank has already begun to aggressively ease (-50 bps at its last meeting in mid-December) due to worries over the Euro Zone economy, suggesting the scope for a correction in the near term may be delayed.

To get to grips with the bubble and prevent its extension, the government will have to look at other ways to limit lending, some of which are in circulation. But to a very large degree, it is far too late, as price appreciation long ago exceeded the trends in the US housing bubble. Unlike Greenspan or Bernanke, common sense observers can identify a bubble when they see one, and Norway qualifies. Could a housing catastrophe threaten Norway’s status as a potential safe haven? Possibly to a degree at some time in coming quarters, though the country’s unmatched fiscal position and sovereign balance sheet will weigh against extreme outcomes. In EURNOK, the 7.65 area is rather interesting for whether NOK safe haven potential has any legs from here. EURNOK has been in a 7.90 – 7.65 range for most of the last year.

GBPUSD bears down on final support
The pound has been weak over the last couple of days as first the Euro recovered smartly before fading again (driving EUR/GBP higher) and as today’s PPI Output showed producer output price inflation easing rapidly. After peeking out at 6.3% last September on a year-over-year basis, the December data saw an actual fall month-to-month for the third time in a row and the year-on-year comparison has already dropped to 4.8%. The CPI release for next week is expected to show a drop to 4.2% after topping out above 5.0% last September. If a strong trend of disinflation is established, it may help the Bank of England feel justified in announcing yet another round of asset puchases at its next meeting.

Chart: GBP/USD
Yesterday’s low in GBP/USD has continued to weaken and is bearing down on the lowest levels it has seen in about 18 months. 1.50 is the next obvious target if the head and shoulders neckline area gives way in the days ahead.
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Chinese reserves shrink
China’s foreign exchange reserves fell quarter-on-quarter for the first time since 1998 in December, a development that demands an explanation. One reason they have traditionally grown so persistently is due to hot money inflows and the weaker USD, which requires that the government constantly intervene to keep the yuan sufficiently weak. Now, with the USD strong, the pressure on reserve growth has eased. The fall in reserves also suggests low to non-existent capital in-flow pressures into China (in fact, actual significant capital flight may be underway for those fearing a hard landing). Could the yuan be overvalued? And is the capital flight one of the main reasons for the incredible performance of the Aussie of late? Stay tuned.

Looking ahead
Next week is the beginning of traveling season in China ahead of the New Year celebrations on the 23rd and for the week and more following that date. Watch for signs/reports of what the Chinese regime plans to do as the country gets back to work after the holiday season is complete. In the middle of that period, we’ve got the EU summit coming up on January 30, and we’ll need to watch for whether political solidarity is sufficiently strong for the EMU nations to hammer out a new deal. The ECB has shown that it retains enough firepower to keep a lid on things for now, but confidence in that ability will quickly crumble if the politicians don’t show sufficient signs of cooperation and movement towards not only endorsing the much discussed fiscal compact, but more importantly explicitly endorsing a heavier involvement for the ECB in keeping the financial system liquid. The other focus in Europe is on Greece and the degree of private sector involvement (PSI) in the debt restructuring there.