Markets to remain in limbo until next week’s FOMC?

The Euro continues to test how many lives this dead cat bounce might have as we look for resistance levels. Meanwhile, we’ve got the RBNZ on tap shortly after the US session and the SNB up tomorrow as EURCHF has gone quiet.

There was an extension of the bloodletting in pro-risk currency trades in Asia, with USD/Asia pairs particularly feeling the pain, but the European session today saw some of the USD strength partially reversed, particularly against the European currencies. Equity markets in Europe managed to shake off the negative vibes from Asia and put on a brave face as the US session approached and financial shares were well off their lows despite the intense focus on the European debt situation the downgrade by  Moody’s of France’s Societe Generale (though the good news is that the rating was lowered less than expected as it had been previously flagged as slated for adjustment).

Sovereign bond spreads in Europe also tightened slightly on the recent news of Chinese buying interest (though China’s follow up statements look a bit clumsy as it sees these purchases as a tool of influence for WTO status, etc.) and complacency was creeping back into the market a bit by mid-day in London as the market awaited US data.

An important point on the entire Euro situation that I have touched on before, but which I am reminded of as I am putting together thoughts on FX for our Q4 outlook: the EU is faced with an existential crisis, with the feared default scenario plaguing the market at present. But let’s also consider what would happen if Europe manages to pull itself back together and starts showing the required political solidarity that has so far not been much in evidence and manages to establish a true monetary union/issuance of EuroBonds, etc., that would solve the essential problem dogging the Euro at present (impossibility of one currency and 17 unaccountable finance ministries with domestic bond markets). The ECB would still need to engage in significant QE to ensure that the creaking European financial system remains sufficiently afloat on a sea of liquidity even with those caveats – and why would QE be damaging for the US dollar only? We are in a different world than the one we inhabited when QE2  - the rest of the world is struggling far more than it was in November of last year.

Chart: Euro outlook
EURUSD has managed a fairly smart follow-on rally today and the incredibly deep and steep sell-off of late suggests that the pair has room to rally further if market complacency remains high and/or the market holds its breath in anticipation of next Wednesday’s FOMC meeting and how much nearer it takes us to QE3. Possible resistance areas include the previous low above 1.3800 and then the 1.4025 area 200-day moving average. The downtrend die is cast as long as the pair remains below that MA.



US Data
The US data was weak, with the weak Retail Sales particularly of concern. With the downward revision of the July data, the August data was actually nominally flat relative to the expectations coming into today and the headline data (revised down -0.2% from +0.5% to +0.3%) was slightly negative. The PPI data was slightly lower than expected and in another month or two, the year on year comparisons for energy will begin to be flat, suggesting that we could see inflation readings heading lower still. The CPI is up tomorrow

RBNZ preview – the last hike expectations among G10 CB’s
Just after the US market close today we have the RBNZ announcement. The kiwi has been quite resilient of late, avoiding most of the collateral damage inflicted on many of the Asian countries overnight. Forward expectations from the RBNZ have cooled considerably from over 100 bps in late July to under 50 bps recently. Still, it is the very last of the G10 central banks with any upside at all left in its year-forward expectations and therefore the surprise side may be more to the downside than to the upside if it begins to feel uncomfortable with the kiwi’s strength.

Looking ahead
Tomorrow we’ve got another batch of interesting data out of the US, with the initial jobless claims and more importantly, the Empire Manufacturing and Philly Fed surveys. The latter two have been very weak of late, but the overall ISM manufacturing fell far less than expected the last time around as the comparatively resilient Chicago Fed proved more prescient for the overall ISM reading. Could we see some mean reversion (higher) in the Empire and Philly numbers?

We’ve also got the SNB up tomorrow as EURCHF has gone quiet since the 1.20 floor was announced. What will they have to say?

We’ve got the FOMC meeting up next Wednesday, an event that may give the recent sharp USD rally some further pause until it is in the rear-view mirror, as the market will continue to fret what the Bernanke Fed might have to say and whether it lurches into full scale Operation Twist next week (selling at the short end to keep markets orderly and keep the yield positive enough to ensure smooth operation of money markets and short dated treasuries, while buying at the long end to suppress yields and encourage borrowing and refinancing (and the hope is – consumption!).

One wonders if the Fed announces a QE3 with a “Twist”, if the reaction in bond markets would be similar to the start of QE2, when the very bonds that the Fed announced it would be buying began almost immediately to sell-off. If so, this could take some of the pressure off the BoJ and its intervention efforts. From the beginning of QE2, USDJPY rallied from the 80 area to the 84.50 area as yields rose in the weeks following the Nov. 3 QE2 announcement.