- Though with pendulum action, the euro will strengthen (entries below 1.25 are must-haves) as liquidity reduces default risk
- The additional liquidity and stability after the fiscal cliff decision will mean current elevated risk will be priced out, putting downward pressure on both the US$ and Yen (QE effect and US economic recovery will dominate over time)
- China hard-landing will be priced out and with it Aud will be beneficiary
- Stable economic growth in the USA (though at low levels) will also mean lower risk premia for the markets
- Overall buying the euro in around the 1.25 region will be profitable and low 1.20's very much so
- Gold will move in inverse to US$ but may take a long while to fully materialise its potential
- Overall expectation must be above stated trends with decent pendulum action around those trends
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We are faced with pendulum action in euroland for a while now, when a crisis situation develops more funds are needed by a periphery country and decision-makers take their sweet time to come to a resolution. The equity markets fall, the german bonds rally, the rate spreads to periphery countries widen and the euro falls as investors flee to safety into the US$ and yen.
And so it is this time around, with spain having a stand-off with Draghi. Spain insists to not ask for funds until they know the preferrential rate they will be getting and the ECB is not willing to disclose this at the moment. Although we expect sooner or later Spain to run under the ESM's umbrella. Really does ESM not stand for Extra Spanish Money?
The important aspect to understand is that liquidity injections in the eurozone work in reverse to the USA. In the eurozone the key issue for weakness of equities and the euro is default risk, which rears its ugly head when politicians or the ECB dither. But any liquidity increase is not to be seen as inflationary nor as a weakener for the euro but instead helps to reduce default risk and strengthen the euro. With more than 1.5tr$ at risk for the whole euro-area if Greece defaults and surely much much more due to the contagion threat (Spain and Portugal will then follow) we have to assume that euroland will muddle through and the pendulum will continue swinging but over time default risk will increasingly be priced out of the market, hence the euro in the low 20's is a good buying opportunity.
Also please note that unlike the USA in the EU access to bank loans are continuing to deteriorate. The sept-oct survey found that 22% reported tighter availability of credit. Enough said.
Also please note that unlike the USA in the EU access to bank loans are continuing to deteriorate. The sept-oct survey found that 22% reported tighter availability of credit. Enough said.
In the USA QE and the expansion of the balance sheet have assured more liquidity into the system and banks are indeed lending more of the assets in their balance sheet, so that the real economy is indeed given an underlying boost. This is the single most important aspect for the longer term sustainability of US growth - ie that the transmission mechanism is working again. Commercial and industrial lending has climbed 23% from a year ago.
QE has helped over time to keep bond yields lower and inject liquidity to such an extent that the transmission mechanism is working again. To achieve this, however, the Fed's balance sheet had to grow substantially and in terms of how much more could be achieved and how - the answer is roughly the same again could be doable, but it would mean intervention into the municiple bond markets rather than mortgages and outright bonds. Realistically, however, each new QE had an increasingly muted effect and looking at multipliers we have to assume that for a long while we have come to a realistic end of QE, with the only possible exception of not letting any of the current programmes roll off (operation twist is scheduled to roll off at the end of this year).
In the USA any liquidity injection is a weakening force to the US$ - the opposite of euroland, as the USA has no default risk and has managed to sustain its reserve currency and bond status.
This means that the market from a future liquidity and growth perspective is dependent on fiscal policy. And the fiscal cliff is the core issue there, which is worth around 600bnUS$ or around 4% of GDP. Base case scenario must be that around 1-2% of GDP will be cut from the US growth rate next year on any compromise solution. This will prevent any US$ weakening until the fiscal cliff issue is resolved.
Interest rate differentials at these low levels are not key drivers of FX rates.
Hence US growth rates will be around 1.5-2% next year, Euroland negative 1% or flat and China steady at 7% - 8%.
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