Deeply oversold forex pairs set to undo some of Mario's hard work this week

Macro Outlook

What has the ECB achieved by the easing monetary policy on Thursday? Ostensibly, probably not a great deal other than hammering the euro. A lack of competitiveness in “peripheral” Eurozone countries due to the high valuation of the euro has been a problem for a while, so at every opportunity, Mario Draghi will try and talk the euro lower. Well, this time it is actions that are working. A cut of 10 basis points to the main refinancing rate (from 0.15% to 0.05%) and the deposit rate (from -0.1% to -0.2%) makes little difference to the banks or the man in the street, but is a big symbolic gesture, as a 230 pip euro sell-off is testament to. Draghi also announced that the ECB would begin to purchase asset backed securities and covered bonds in a credit easing attempt to improve liquidity in the banking system. However the ECB is running out of options. This basically just leaves the announcement of full blown QE as Draghi’s final silver bullet. The ECB cannot drag the Eurozone out of the malaise it finds itself in alone. Draghi lamented during his press conference about how “each of us has to do our own jobs” referring to a need for fiscal stimulus and structural reform from individual countries. A lower euro will help, and Super Mario will hope that markets trust him because there is not much left in the locker.

Must watch for: Bank of England Inflation Report hearings

Impact: Another chance for Bank of England Governor Carney to gives his views on the slack in the economy, wage growth and give the market a general steer for when the bank may choose to hike interest rates. The Short Sterling Interest Rate futures have pushed out significantly in the past month and are now pricing a rate hike in Q1 2015, having previously been pricing December. With UK inflation sub 2% throughout 2014, traders will be interested in Carney’s comments as the embattled sterling rate looks for support. Any hawkish hint could crease a significant short squeeze on Cable.

Foreign Exchange

It was an incredibly week on the forex markets as a range of factors helped to drive dollar strength and the G3 major pairs to extreme levels. The headline grabber was the 200 pip sell-off on EUR/USD induced by the ECB easing actions. A series of rate cuts and unconventional measures (purchases of asset backed securities and covered bonds) pushed the euro into a tail spin. However Cable was also around 300 pips lower too as opinion polls increased the prospect of Scottish independence. However the market has now had time to digest these factors and move on. There is a dearth of major US economic announcements this week and this could mean that the market trades on technicals with these pairs. However the technical indicators suggest record deeply oversold positions for both the euro and sterling. This raises the prospect of a technical rally this week on both pairs. Being short on the euro and short on Cable are both very crowded trades and there is certainly room for some near term contrarian money to be made, although not for the feint hearted.

WATCH FOR: Hawkish sterling traders will be hoping for Mark Carney’s inflation report hearing to give them a hint of a rate hike. The RBNZ gives a monetary policy update although will be expected to hold rates after previously suggesting the end of it tightening. US data is limited to Friday’s retail sales and Michigan sentiment.

Indices

With Wall Street spending much of last week in consolidation mode, are we ready for a correction? With earnings season at an end, the bulls will be looking for a catalyst to justify pushing markets back into new high ground. However, there were three key factors last week; a move towards a ceasefire in Ukraine, easing from the ECB and the latest Non-farm Payrolls; which could have been what investors were looking for, but fell flat on Wall Street. This does not bode well for the next few weeks for equity investors. In a month that is traditionally difficult for stock markets, and a lack of earnings news to drive markets, the scope for a near term consolidation or even correction is now quite high. The one exception could be the DAX which has been underperforming badly in the past few weeks due to its economic and geographical proximity to Russia. The DAX could be in line to regain some of its lost performance and is already now outperforming the FTSE 100 again on a relative basis. Traders will once more bemoan the impotence of the FTSE 100 to break out to a new 2014 high. If Wall Street is now in consolidation mode, the FTSE 100 may well have missed its chance again.

WATCH FOR: The lack of US economic drivers this week could result in a consolidation on Wall Street, which could easily filter through to the European indices. The DAX remains at the mercy of news flow from the geopolitical events in eastern Ukraine and any move towards a ceasefire should give it a boost.

Other Assets: Commodities & Bonds

There are two key drivers behind recent weakness commodity prices. Firstly, a “war premium” is being removed as Ukraine and Russia seem to be moving towards a ceasefire. And secondly, the significant strength in the US dollar in which commodities such as gold, silver and oil are denominated. Unless Putin is playing another sleight of hand trick, the geopolitical tensions could see a lasting improvement which would add to downside pressure. However, perhaps the hope this week is with a technically overstretched US dollar which could correct and help to support commodity prices.

Interestingly as the ECB moves ever closer to full blown QE, the yields on French, Italian and Spanish longer dated bonds have sharply dropped in the past few days. However, although the short end of the German bund yield curve remains negative, with the easing actions of the ECB (aimed at helping to generate inflation), the 10 year bund yield has begun to pick up slightly. Furthermore, other “safe haven” debt such as the 10 year yields on UK gilts and US treasuries have also picked up in the past week. It will be interesting to see if this trend lasts.

WATCH FOR: News flow on Ukraine/Russia will continue to drive prices, whilst a lack of US economic announcements could result in at least a dollar consolidation this week.