London Session: Risk Appetite Slips Away

After a strong start to the London session risk appetite has ebbed away this afternoon. The chief cause has been a renewal of concerns about the European sovereign debt crisis. Although Germany and Portugal managed to hold strong debt auctions today, the markets focus was on Spain and the news out of Italian bank Unicredit.

A media report suggested that Spain is toying with the idea of applying for a bailout to help re-capitalise its weak financial sector, which spooked the markets. Then Italian bank Unicredit announced it would issue new shares to help boost its capital ratios, although these new shares would be issued at a near 50% discount to the bank’s current trading price, which caused its stocks to sell off sharply and trading was suspended at one stage.

Interestingly, we had another Wednesday sell-off for the euro on the back of data out of the ECB. It reported that banks deposited EUR 453bn with it overnight, up from 446bn the previous night, which is a euro-era record. Thus, banks are only getting 0.25% on money they leave with the ECB, which is a negative real rate of return, rather than lend it to their peers. Last week there was similar concern about the lack of inter-bank lending in the currency bloc and EUR/USD dropped as low as 1.2858. Today the cross has come under intense pressure falling from 1.3073 to just below 1.2900. However, it found good support at 1.2900, and has since bounced back to 1.2920.

So what does this tell us? Firstly that the markets are extremely sensitive to any negative data coming out of the Eurozone and is less sensitive to good data. Today we saw the currency bloc’s composite PMI reading for December get revised up to 48.8 from its original figure of 48.3, which is weak but at least moving in the right direction. However, the market shrugged this off and instead concentrated on the deteriorating situation in the Eurozone. The Vix, Wall Street’s fear index, has dropped to just above 20 yesterday, but it rose sharply today as investors took fright.

Today’s move also tells us that the banks in Europe could become the focus of concern as they try to re-capitalise in the next 6 months. Banks are competing for funding with Europe’s sovereign nations and cheap share issues are unlikely to boost sentiment to financials since, like Unicredit, these issues are offered at such a cheap discount to the pre-issue selling price. Due to this Unicredit saw its shares plunge more than 14% today and the financial sector of the pan-European Eurostoxx index is down more than 1%.

There has been a sharp reversal in the dollar’s fortunes, and the dollar index is back above 80.00 today. However, just as EUR/USD failed to sustain losses below 1.29, DXY is running into resistance at 80.30 and as the London session comes to a close the rout could be running out of steam. However, an auction of long-term French debt tomorrow is likely to keep investors jittery. It is no surprise that the ECB was rumoured to be buying Spanish, Italian, Irish and Portuguese bonds today in a bid to keep a cap on yields. However, it has only had limited success, Spanish 10-year yields are back are above 5.42%, and Italian yields recently spiked to 6.93%. The ECB may choose to stay active in the secondary market ahead of tomorrow’s auction in Paris.

All of this bond buying could give one the impression the ECB is embarking on QE…. Although SMP is QE by the backdoor, the head of the Bundesbank Jens Weidman seems to be in denial after he said yesterday that the ECB as lender of last resort was “wrong”. The currency markets thinks it already is the lender of last resort, hence the sharp sell offs when the ECB releases details about deposits held in its accounts and the size of its balance sheet.

We still believe that the euro is a sell on rallies. Yesterday we were a bit concerned that this rally had legs, however this jitteriness is causing choppy ranges to pervade. AUD/USD is trading 1.0300 to 1.0370 today, however it has staged a recovery late afternoon; and this may push other risky assets higher with it. Added to this, US stocks are recovering. The SPX 500 is back at 1,275, close to its highest level since the summer.

Oil has been particularly volatile today. The EU has moved towards an embargo on Iranian oil, following its move on the straits of Hormuz and EU foreign ministers are expected to announce tough sanctions on Iran’s energy and banking sectors when they next meet on January 30th. Since Iran is the world’s third largest oil exporter this embargo could have major implications for supply dynamics. This caused Brent oil to shoot to $114.00 per barrel at one stage today, $2.50 per barrel higher on the day. Then the International Energy Agency (IEA) came out and said that firstly the Iranians are unlikely to block the straits of Hormuz and secondly that if it did and the EU’s embargo went ahead essentially oil exports from the Gulf would grind to a halt, but the IEA could wait in the wings to release some of its stockpile.

Overall, the news coming out of Iran and Europe is confusing and uncertain. However, geopolitical tension could help to cancel out some of the dampening effect of weaker European growth on the oil price, soon balance while this tension continues the bias for the price of crude is higher.

After a brief lull yesterday volatility has made a comeback and it looks like we are back to pre-Christmas choppy ranges and continued concern about Europe.