Sovereign Debt Default Dominate

The fear of incoming QE2 is making it harder to trade the ‘worse than expected’ economic data. It is difficult to remain bearish in front of the Fed’s involvement. Keynes was correct when he said ‘the market can remain illogical far longer than you or I can remain solvent’. The playing field should return to be rational the moment one is rendered insolvent if one bets too heavily and too early against the irrational. The risk of further downgrade to AIB and talks that Spain could have its credit rating lowered is again hurting the EUR this morning. Risk-on, risk-off, it’s flip a coin time.

The US$ is stronger in the O/N trading session. Currently it is higher against 11 of the 16 most actively traded currencies in a ‘whippy’ trading range.

Forex heatmap

With the lack of US data yesterday, the market is thinking ahead and preparing itself for ISM manufacturing. Traders are already resigned to the fact that the Fed will be revising down their GDP forecast (expectations for a -1% revision) for next year. This morning, the price of insuring Irish Sovereign debt dominates trading activity. The cost of using CDS rose +38bps to +510 (doubling in the last 2-months) as concerns about supporting its own banking system worries the market.

The USD$ is higher against the EUR -0.21% and lower against GBP +0.10%, CHF +0.10% and JPY +0.08%. The commodity currencies are weaker, CAD -0.37% and AUD -0.19%. It was bound to happen, temporarily at least. The loonie fell from its six-week high as global bourses and commodity prices retreated. Weaker retail sales and inflation data from last week has dealers reducing their bets that Governor Carney will be raising rates any time soon. The market is beginning to question the ‘true’ strength of the Canadian Economy after the last few data releases have come in much softer than expected. The loonie has outperformed 9 of its 16 most-traded counterparts this year, rising +2.5% vs. the ‘big dollar’ on speculation the nation’s economy will benefit from global demand for raw materials, which account for half the nation’s export revenue. Currently the currency’s only supporter has been higher commodity prices that are somewhat ‘inflated’ by the weaker dollar sentiment on the back of the Fed’s potential QE2 intentions. With the BOC possibly stepping to the sidelines next month has speculators unwinding some of the CAD long trades in front of the decision. Depending on what commodities are doing, dollar buyers remain on the bid all the way down in the short term.

The AUD has retreated from its two-year high on speculation its recent gains were too rapid and as declining global bourses dampen the demand for higher-yielding assets. In this current environment of negativity, it’s the risk-off trading strategies that dominate. Growth currencies tend to be the first to suffer. Until know the AUD yield advantage has led the currency higher. The spread between 2-year Australian bonds and its US counterpart is near the largest in 24-months (+442bp). There is a strong difference in monetary policy stance between Australia and the US and it should eventually provide stronger support for the Aussie. A large percentage of the market expect Governor Stevens at the RBA to hike rates again next week, further support the currency. Australia is benefiting from its unilateral trade links with the Chinese economy, its largest trade partner. Until recently, the AUD has gained ground against all of its major trading partners as the ‘vix index’ of volatility softened, boosting investor appetite for assets tied to growth. ‘Clearly what happens in the Australian economy is now more dependent upon what happens in China’. Investors are better buyers on deeper pullbacks (0.9609).

Crude is lower in the O/N session ($75.60 -$1.00c). Crude prices have softened again in the European trading session as a stronger intraday ‘greenback’ reduces the appeal of commodities as an alternative investment. The market happened to pare a good chunk of the EUR’s +1.7% gain achieved last Friday. The EUR itself suffered after Moody’s downgraded the not guaranteed debt of AIB. Global bourses rolling over have not helped commodity prices either. Analysts believe that higher weekly inventories, coupled with the lack of any significant weather patterns in the Gulf of Mexico, should be enough to push crude prices lower in the short term. Crude supplies rose +970k barrels to +358.3m last week. The market had been expecting a shortfall of -1.75m barrels. Stocks of gas and distillates (heating oil and diesel) also increased unexpectedly. Gas inventories rose by +1.6m barrels, while distillates rose by +300k barrels. Higher inventory supplies have been the biggest inhibitor for a market advance over the past quarter as stockpiles of oil have recorded the highest levels in 27-years. The market remains wary that the underlying fundamentals have not changed, the overall situation remain weak. Analysts expect speculators to remain better sellers on up-ticks in the short term.

In the short term the market is telling us there is no fear of gold prices retreating too deeply. Day after day it has managed to set new record highs. A concern about a weaker dollar coupled with the sustainable growth issues of the US economy has investors seeking protection in an asset with a ‘store of value’. Any mentioning of projects to keep the currency low will provide stronger support for the commodity. Year-to-date, the yellow metal has appreciated +18.9%, outperforming most of the other asset classes, as global sovereign-debt concerns and an ‘uneven economic recovery roil financial markets’. With the dollar currently trading at or near new lows vs. the EUR is also aiding commodity prices. Metals are heading for their 10th consecutive annual gain. Global ‘fear’ has the momentum, again, to push speculators back into this overcrowded, one-directional commodity trade. With the Fed on the verge of implementing further QE programs ‘tend to be supportive of asset prices and is fueling concerns about the potential longer-term inflationary affect of such measures’. The opportunity costs of holding gold are low due to falling interest rates, by default, the market should expect better buying of the metal on pull backs ($1,289 -$8.80c).

The Nikkei closed at 9,495 down -107. The DAX index in Europe was at 6,219 down -59; the FTSE (UK) currently is 5,515 -58. The early call for the open of key US indices is lower. The US 10-year eased 9bp yesterday (2.51%) and is little changed in the O/N session. It is the same story but a different day amongst the asset classes. Longer-term debt is the winner on the US curve, leading advances, as traders speculate that the Fed will increase their purchases of debt. Bernanke is willing to ease monetary policy to try to boost the US economy and employment. Renewed concerns about further downgrades in Europe will keep the FI market better bid short term and flatten the curve even further (+213bp). Yesterday’s $36b 2-year US auction was so-so received, taken down at +0.441%. Non-dealers took about 50% of product, and the auction had a 3.78 bid-to-cover ratio compared to 3.14 over the last six-auctions. Indirect bidders came away with 39% of the issue vs. an average of 34.5%, while direct bidders took 10.8% (the smallest takedown in seven month). Today we have $35b 5-year product and tomorrow $29b worth of 7-years.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.

Dean Popplewell

Dean Popplewell

Vice-President of Market Analysis at MarketPulse
Dean Popplewell has nearly two decades of experience trading currencies and fixed income instruments. He has a deep understanding of market fundamentals and the impact of global events on capital markets. He is respected among professional traders for his skilled analysis and career history as global head of trading for firms such as Scotia Capital and BMO Nesbitt Burns. Since joining OANDA in 2006, Dean has played an instrumental role in driving awareness of the forex market as an emerging asset class for retail investors, as well as providing expert counsel to a number of internal teams on how to best serve clients and industry stakeholders.
Dean Popplewell