What’s the ECB to do?

Right now it’s not about Greece, it’s about the ability to contain contagion into Italy and other sovereign states. How much help is the region going to get from the ECB this morning? Until now, policy makers have been fulfilling the dual role mandate of stimulating growth and providing enough liquidity to grease the financial wheels by bond repurchasing. The market has priced in a +35% chance of a rate cut later this morning and a +100% chance of a cut next month. With Trichet gone and Draghi now chairing his first meeting, the easier route is to believe that he will focus policy makers commitment to providing liquidity to the banking system and to signal policy easing at next months meeting.

However, weaker Euro PMI last month and a collapse in Italy’s coupled with higher unemployment in Germany and a “contained” regional core inflation certainly provide enough reasons for the ECB to take its foot off the rate peddle. Analysts expect Draghi to argue that the SMP (special markets program-bond buying) will act as necessary to ensure “Euro area monetary transmission mechanisms remain functional”. Will Draghi, like Trichet before him, argue that the responsibility for stabilizing yields rests with governments, not the ECB? Currently, its a losing battle for the ECB, you only have to look at the Italian Government. The ECB, by controlling liquidity is the “only enforcer of fiscal and structural changes in the region”.

If Draghi surprises, and eases or indicates more of an easing bias or an aggressive SMP then investors will see risk appetite and the EUR rally.

Forex heatmap

US data yesterday gave investors the tentative green light to apply some risk. The ADP employment report showed a gain of +110k to private payroll numbers last month. It’s not enough to change forecasts to tomorrows NFP figure (+98k). It was a touch higher than the median forecast of +101k. The revisions to the past two months revealed a net gain of +21k (August-4k, while September was revised higher by +25k). Digging deeper, manufacturing was again a drag on the headline for the third consecutive month, subtracting-8k while service added +114k. Small businesses were the weakest contributors adding just under +50% of the gains. Usually they contribute closer to +60%. Is ADP a good indicator? In relative terms it’s been a whole lot more volatile compared to NFP this fiscal year. Its “absolute” miss has been +/-63k. Last month’s print saw a-46k underestimate.

US policy makers again are buying time. Bernanke’s press briefing yesterday presented downward revision for GDP growth as opposed to their June projections. They also went out of their way to make it clear that they discussed tools to enhance communication but no decisions have been made. The same variables remain a black spot on growth. The labor market is sluggish as the economy is not strong enough to push the unemployment rate down at a faster pace. Risks for the economic outlook are the same as in September, mainly stemming from the global financial crisis. The inflation profile has not changed, with some moderation near term due to lower commodities and stable inflation expectations in the long term.

The dollar is lower against the EUR +0.06%, GBP -0.00%, CHF +0.14% and JPY +0.01%. The commodity currencies are weaker this morning, CAD -0.27% and the AUD -0.64%.

Like a phoenix, the CAD has risen from its lowest level in almost two weeks outright on increased demand for this particular higher-yielding growth currency. The Fed acknowledged that US economic growth “strengthened somewhat” in the third-quarter, giving global equities and commodities a boost. This is always favorable for growth sensitive currencies, especially one that have such a strong trade association with the US. Strong private employment numbers down south suggests that the US may skate a recession. Tomorrow, the market gets the privilege to trade last months NFP and Canadian employment reports. What’s good for the US tends to always be good for its largest trading partner.

The Canadian Finance Minister stated earlier this week that the BoC’s mandate will remain unchanged, allowing Governor Carney to rule the roost the same as before. The CAD, when under duress this week, certainly outperformed other risk sensitive currencies. The BoJ’s intervening actions indirectly dragged the dollar higher and at the same time the loonie was reluctant to fall.

Carney’s comments last week were very transparent. He is concerned about sustainable growth and the market will have to be cautious in trying to push the currency higher at speed. Corporate buyers remain below as dealers focus on the risk reward of owning the loonie at these levels (1.0159)

Growth sensitive currencies are not going to hack it through this trading environment. The AUD fell against the yen and pared its outright advance versus the dollar after the referendum pledge from the Greeks and after the Fed refrained from taking additional steps to ease monetary policy. The chances of a disorderly default has raised the stakes that global growth is unsustainable. Earlier in the week the RBA cut rates (-25bp to +4.50%) and has moved to a more neutral policy stance. In Governor Stevens communiqué, the RBA concluded that a more neutral monetary policy stance would be appropriate to maintain growth now that inflation is likely to stay within its 2-3% target over the next two years. The RBA noted that while financial conditions have eased, overall conditions remain tighter than normal and the AUD is still at historically high levels.

The market is now estimating and pricing a neutral policy rate at around +4.0-4.5% and that the RBA is likely to cut by another-25bp in Q1 of next year. Futures dealers have priced in a market easing of about-88bp in total along the curve throughout this cycle. Currently that looks a tad rich, but hindsight is another matter. These cuts are likely to constrain and cap the Aussie. However, on the flip-side, better than expected data out of the US coupled with resilient growth from the Chinese economy will be supporting antipodean currencies. In this current environment, the market remains a better seller of the currency on rallies (1.0277).

Crude is lower in the O/N session ($91.80 down-0.71c). Oil prices rallied for the first time in four day’s yesterday after the ADP private employment report showed US companies adding more jobs than forecasted (+110k) and as the “mighty buck” found it difficult to maintain this weeks early gains. The job numbers certainly suggest that the US economy may be skating a recession. However, this morning session has pared some of that enthusiasm. The commodity has retreated on the back of Euro leaders threatening to hold back aid to Greece, calling into question sustainable regional growth. Last week’s inventory report is also aiding this morning’s bearish tone.

The EIA report showed that crude inventories rose +1.83m barrels to +339.4m, just above a projected build of +1.1m. Imports of the black stuff fell by-419k barrels per day to +8.92m. Not to be left behind, gas stocks rose by +1.36m to +206.2m barrels, compared to a-600k draw forecasted by the street. The average gas demand in the last four-weeks fell by an aggressive-4% compared with demand this time last year. Distillates (heating oil and diesel) fell by -3.58m to +206.2m barrels, compared with analyst’s forecast for a smaller -1.5m draw. The four-week average demand for distillates (+4.2m) was the highest in two-years. The refinery utilization rose by +0.5% to +85.3%. Analysts had been expected a smaller gain of around +0.1%. Finally, the stockpiles at the Cushing, Oklahoma (NYMEX deliveries), rose by +560k to +32m barrels.

Overall market sentiment near-term remains bearish, given precarious growth sentiment, projected EUR weakness through the fourth quarter of 2011 and slowly improving supply prospects has dealers better technical sellers of the commodity on rallies.

The market is back to wanting to own some of the “shiny metal” as a safe haven investment away from market turmoil. Gold earlier in the week had buckled under pressure from the dollar after Greece blindsided the financial markets by calling a referendum on a supposedly agreed financial plan. There is more of a risk aversion type dynamic developing because of all the complications around Europe. Any political or macro uncertainty is promoting risk aversion trading strategies. Investor’s interest in the yellow metal has continued to pick up all week, as reflected by the inflows of metal into ETF’s according to analysts.

Investors have been using the commodity as a safe-haven alternative to equities or FX. Individuals seem to want to insulate themselves from steeper price falls. The bullion is in its eleventh-year of a bull market and is up +20% this year.

Bigger picture, the commodity has also found support on concern that US monetary policy aimed at shoring up growth will eventually spur inflation. With global sentiment in the fragile category, gold remains the go to “safer-haven” prospect. If we include the demand for ‘physical’ gold from India, then both of these reasons should provide the strongest tangible support to want to own some on these pullbacks ($1,732 up+$3.10).

The Nikkei closed at 8,640 down-195. The DAX index in Europe was at 5,882 down-84; the FTSE (UK) currently is 5,447 down-37. The early call for the open of key US indices is lower. The US 10-year eased-22bp yesterday (+1.98%) and is little changed in the O/N session.

Treasuries again have rallied, extending the longest winning streak in two-years, as renewed concern Greece will default and the European rescue plan will unravel boosted demand for a safer asset class. Aiding prices was the Fed leaving intact its promise to keep its target interest rate in a range of zero to +0.25% until 2013. Policy makers again forewarned investors of impending dangers. “There are significant downside risks to the economic outlook, including strains in global financial markets”. The Fed remains disappointed in the overall economy’s performance and that if anything, “downside risk still permeates the future forecasts on both the inflation and employment mandate”. The Fed it seems is just looking for the right time to pull the QE3 trigger.

Investors are becoming more bearish on the global economy after Europe suspended the next aid tranche to Greece until after next months national referendum. European leaders have warned Greece that it will give up all aid for the region if voters reject a bailout package agreed on last week. The global growth question is now front and center again!

Next week, the US treasury will auction +$72b in 3’s, 10’s and 30-year debt. This market still has a G20 and an NFP to overcome before they can call it a week.

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