Global Economic Engines

Is this the end of the tunnel? Rabobank's team asked in a recent report about the European thing. And after a month in which the ECB and Fed announced radical policy initiatives, this is the question the whole market has in mind. The Euro area continues to be a region where politicians need tons of pressure to get things done and certainly, the next quarter ought to show us some insights about the resolution of the Eurozone saga.

According to market experts and big banks, the 2012 final quarter will be dominated by four themes: the Eurozone drama, the US elections, the fiscal cliff and the growth across the advanced economies.

"Signs of global economic slowdown are visible in all major economies around the world and things will probably get worse before they get better," affirms Ilian Yotov from Allthingsforex.com. "With that said, one can argue that the U.S. economy is doing better than its euro-area counterpart."

Let's see. After ECB's president Mario Dragui put the ball on the politicians court again, all eyes turned back on Spain. On September 27 the Kingdom of Spain's government presented its draft budget for 2013 with a package of spending cuts and tax increases.

Eurozone: The Spanish thing

With public spending to be cut by 58% in 2013 and social spending representing 63.5% of budget, the government maintains that it will meet its budget targets: 6.3% deficit for 2012 and 4.5% for 2013. The black hole is that GDP is projected to decline 1.8% for this year and to contract 0.5% for next year. It seems that the Spanish government is going too optimistic taken the IMF and big banks worst GDP expectations and recent spending overruns.

"The Spanish government seems to be banking on the idea that it can pre-empt conditionality under a precautionary programme (Enhanced Conditions Credit Line)," Rabobank's analyst Elwin de Groot comments. "However, both the domestic and external (Germany) political situation is getting more complex by the day, suggesting that market pressure will still be needed to tip the balance in favour of a formal request." And as Adam Narczewski from XTB well said, "everybody is waiting for Madrid."

The problem with the Eurozone is that with an monetary union that has been built with a Central Bank with not real powers and unwilling to act as a true lender of last resort, and not fiscal and political union. The market is "constantly focused on the weakest link, rather than looking at the average strength across the region," as points Rabobank's team.

Spanish government repeats constantly that the Spain and the Eurozone fundamentals are sound but market doesn't really pay attention on this too much, because they don't have confidence on the euro area, even on the countries itself, institutions. The past October 2nd China Investment Corp Chairman Jin says that "it’s unrealistic to expect China to invest in bonds issued by heavily indebted European countries until fundamental problems are resolved." And it makes sense at all.

And the Spanish policy makers don't help the situation. News reporting Rajoy squandering money and Luis de Guindos providing dark answers to key questions are dampening consumer sentiment. As sample, when asked on Thursday why the taxpayers have made such a big adjustment vs the public sector? De Guindos just said "I prefer to look forward, not back".

The effect? Congress was surrounded past week by people claiming against budget cuts and the politicians squander money at the same time. And Artur Mas, Catalonia president, announced early elections in the region as soon as November 25. A date that will be marked with independence tone following the recent demonstrations early this month. Will be Catalonia a the new euro state? Mass medias across the world are expectant.

At least the bond auction held by the Spanish treasury, the country managed to sell 3.992 worth of 2014, 2015 and 2017 government bonds, at the top end of the targeted demand. 3- and 5-year yields fell in comparison with what the country had to pay at the previous auction.

With this approach, the recent Euro's gains seems to be short live as far as Spain doesn't request bailout as J.Foley, Senior Currency Strategist at Rabobank argues. “Investors will not wait indefinitely and it is very possible that it will take another surge in Spanish bond yields to provide Rajoy with the reason to finally request aid. As a consequence we continue to see scope for pullback in the EUR on a 1 mth view”.

"The European Central Bank’s OMT program provides a backstop to Europe but its activation is contingent upon the request of a nation," comments Kathy Lien from BK. "In other words, the program is obsolete until a country (ahem, Spain) asks for help."

And as the TD securities team remarks in a global research, "political optimism aside, slower growth and looser ECB t o provide fundamental pressure on EUR." In the Eurozone, "the worse off getting better while outperformers mean revert," adds TD.

Four more years for Obama? The fiscal cliff and real growth

Goldman Sachs expects US to grow 2.2% in 2012 and 1.9% in 2013. In the latest FOMC minutes, Fed officials expected the pace of economic growth would remain "moderate over coming quarters but would pick up over the 2013-2015 period." The GS analyst team sees the "unemployment rate to drift down to 8.0% by end-2013 as long-term unemployment continues to depress labour force participation."

In addition, the fiscal cliff is coming as the year is finishing. Expiring tax cuts, Bush tax cuts, payroll tax break, and the planned spending cuts will be undermining business confidence. But negotiations won't start before November 6 elections and probably it won't be addressed until the first months of 2013 . Businesses are more concerned than consumers on this, but as TD securities points, "sheer repetition of the phrase “fiscal cliff” may have dulled its meaning, but it is hard to overstate its significance to the evolution of the recovery in the US and globally."

TD Securities states that the recovery "remains sluggish," but "there are encouraging signs that the economic growth performance in H2 is improving." Said that, TD expects "the USD to be the beneficiary of increased risk aversion in the weeks ahead. Slower growth should weigh on the euro when political optimism fades." USD to outperform EUR.

"Now that we know that the Fed and the European Central Bank are willing to commit to open-ended quantitative easing, things will get back down to economic conditions on both sides of the Atlantic when trying to discover the appropriate levels for the EUR/USD exchange rate," comments Ilian Yotov. "And should the euro-zone register a double-dip recession in Q3, the EUR could emerge as the winner of the weakest currency contest."

Easy money is the world in this age. Marked have already priced Fed easing into USD and it leaves risk for reversal in the current bullish movement. "easy money but difficult returns will probably remain the norm into year-end" as states the JP Morgan team.

Global economy will face US political calendar and after the past October 4th debate, it seems to have an extra point of salt due Romney did exceedingly well and Obama seemed to be playing it safe.

Maybe it is not a "game changer" for Romney taken the recent President Obama's performance but it was new and fresh air for the Republican candidate after its controversial campaign. Polls show 56% of uncommitted voters say their opinion of Romney has changed for the better, while 13% say that about the President, according to Mark Knoller, CBS News White House Correspondent. According to results of CNN-ORC Post-Debate flash poll who won the debate, Romney 67%, Obama 25%.

"President Obama will be very difficult to beat given his consistent lead in the swing states," explains Andrew Busch from BMO Capital Markets. "Last night, Romney was given an opening. To win, the Romney campaign will need to go 3 for 3 in the remaining debates," Busch remarks.

There is three more debates before Tuesday November 6th elections:

  • October 11th Vice presidential debate: Centre College, Danville, KY
  • October 16th Second presidential debate (town meeting): Hofstra University, Hempstead, NY
  • October 22nd Third presidential debate: Lynn University, Boca Raton, FL

Chris Sullivan, chief investment officer at United Nations Federal Credit Union, comments that "the performance of Gov. Romney may be enough to further narrow the polls in certain closely-contested states and may also be supportive of risk markets forward from here."

In an hypothetical case, "Romney victory would be a short-term Risk-On event, US equity positive and US dollar negative. Medium term, a Romney victory is a big US dollar positive due to money flowing back to the country for investment and reduced risk of US debt/deficits," affirms Andrew Busch.

But President Obama is the solid leader in polls and his people base is wider than Romney. Recent September employment report shows a significant improvement in figures. A special gift for Barack Obama as Unemployment rate has fallen to the lowest level since he took office.

The employment report in US was overall positive on Friday. NFP rises 114K in September vs 113K consensus; There was a big revision in August data to 142K from 96K previously reported; Labor force improves; Unemployment down to its lowest level since January 2009.

BBH's Marc Chandler commented in recent employment numbers, "US jobs report was decidedly mixed. There was good and bad news but the bottom line is that the data is still too weak for the Fed to even consider ending its unconventional policy."

The euro extended its recent rally against the dollar toward a fresh 2-week high on Friday, after the U.S. unemployment rate fell to its lowest level in 3 years in September.

While the near-term outlook remains bullish, the pair could lack momentum to regain the 1.3100 mark just yet as indicators are reaching overbought levels in 1- and 4-hour charts. However, should EUR/USD break above 1.3100, the 1.3170 September double top will the next bullish target.

EUR/USD Year-end forecast

Euro finally left the 1.2900 number as the EUR/USD rose 0.86% on Tuesday to close the session at 1.3016 after reaching 2-week highs at 1.3030 thanks to improvement in risk appetite. The Euro has advanced 230 pips this week against the Dollar from October 1st low at 1.2800.

"This time around," comments the Saxo Bank team, "we have EUR already very strong with tail risk already virtually priced out and we have the QE3 launch in the rear view mirror as well, though we know that worse employment means more QE while good data theoretically encourages USD-funded carry trading."

Just as point in context, HSBC Global Research publish in a scheme on how QE could affect currencies across the world:

  • US: QE = USD negative: Resultant “risk on” mood takes us to higher yielding more risky currencies. “Risk off” and the USD’s safe haven status kicks in.
  • Eurozone: QE = EUR positive: Non-conventional easing as lowering the probability of EUR default and disintegration, thereby boosting the EUR.
  • Japan: QE = mild JPY positive: JGB purchases have little JPY effect, but equity market boost encourages foreign capital inflows.
  • UK QE = GBP neutral: Little currency impact as un-conventional monetary easing seen as an appropriate mirror to the ongoing tightening in fiscal policy.

The RBS analyst team has raised its "year-end EUR/USD forecast to reflect the Fed's more aggressive monetary easing stance and the ECB's new policy to support periphery sovereign bond markets." The bank now see a risk that a Spanish request for a bailout should provide additional fuel to EUR/USD during the Q4, "most likely before the October 18/19 EU Leaders Summit" points RBS. RBS EUR/USD forecast is 1.3000 in 1-month view and 1.2500 in December 2012. "An anticipated expansion of the ECB balance sheet as sovereign debt purchases rise is seen highlighting the longer term risks of holding EURs," RBS added.

On the other hand, Ilian Yotov sees EUR/USD to fall into 1.2000 level. "When the euro-zone registers a double-dip recession in Q3 and the European Central Bank has no other choice but to ease policy further, including cutting rates, the EUR should emerge as the winner of the weakest currency contest and could head back towards recent lows around $1.20."

So, as summary, What the market expects for the United States, the Eurozone and its EUR/USD relationship? Players expect the dust to settle down on politics with Spain requesting bailout in October and the United States giving four more years to Barack Obama but no solutions to the so-called fiscal cliff.

The market will even wake up from the sirens sings and will pay attention to fundamental data. At this time, players will recognize "the recoveries in the U.S. and Japan are stalling, while the euro-area is about to confirm my forecast for a double-dip recession," as comments Ilian Yotov and confirms PMIs and weak GDPs across the world.


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