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The United States: a ‘timid’ rebound

Here's the article by FBS published in the latest issue of FX Trader Magazine.

Almost every day we see US indicators in trader’s economic calendar. Sometimes the reports are good, sometimes they disappoint the markets. The abundance of data can be quite misleading when you want to design a longer-term strategy. What we really need is seeing the whole picture – the real economic trends behind all the fuss.

It’s almost 4 years since the global financial crisis broke out in September 2008. American authorities tried to rehabilitate the national economy and put it back on the sustainable growth track. However, the United States hadn’t managed to overcome its economic problems when new global challenges emerged.

The global economic prospects are now extremely uncertain. This makes us pose questions about US future. How vulnerable is the US to the European debt crisis? Are US debt problems gone for good? Is American economy able to move forward on its own or more rounds of monetary stimulus are needed? These are the issues which we would like to address in this article.

US economic recovery: overview

The period from the Lehman Brothers collapse and up to the second half of 2009 is sometimes referred to as the “Great Recession”. The historical parallel with the Great Depression is not without reason as we have witnessed the biggest shock for US economy in decades which resonated both in advanced and emerging market economies.

According to the data, provided by the Bureau of Economic Analysis, US GDP contracted in Q1 and Q4 2008 quarter-to-quarter by 1.8% and 3.7% respectively and in Q1 and Q2 2009 by 6.7% and 0.7% respectively. The annual growth rates may be seen on the chart below. American economy survived the sharpest contraction since 1960.

In order to support domestic economic growth through lower borrowing costs the Federal Reserve bought $2.3 trillion of bonds in 2 rounds of so-called quantitative easing, or QE, from 2008 through 2011. Then in September 2011 the Fed launched Operation Twist program which had the same purpose. There were intense debates on whether these measures have really helped. As the central bank set no distinct targets set in advance, it is quite difficult to judge about the efficiency of the steps taken by the US central bank. Analysts at Barclays Capital argue that American monetary authorities succeeded in eliminating deflation risk, but failed to generate strong economic recovery.

US real GDP has finally returned above the pre-recession levels in Q3 2011. Never the less, the growth may still not be fast enough to spur a robust recovery and ensure new jobs creation.

High unemployment remains America’s greatest pain. On the back of recession the jobless rate soared from 4.6% in 2007 to the record highs of 9.6% in 2010. It happened as people who lost their jobs in such depressed sectors as finance, housing and construction sectors were forced to change their qualification. According to the Federal Reserve Bank of San Francisco, the natural unemployment rate during the crisis grew from 5% to 7%.

In late 2011 and then in the first half of 2012 the situation at US labor market has also improved. This spring jobless rate subsided to 8.1-8.2% returning to the same levels as when Barack Obama took office in early 2009. Winter gave investors the optimism they have almost forgotten – US economy generated 200K a month encouraging hopes that the recovery will be gaining pace.

However, it turned out that the upturn in non-farm payrolls was caused mainly by unusually warm weather and a decrease in the size of the workforce. As you may see on the chart below, the pace of new jobs creation has slowed down. This may be a sign that American economy still needs monetary stimulus. Remember that one of the main pledges of the Fed’s mandate is “to promote effectively the goals of maximum employment”. If things keep deteriorating or just stagnate at this point, the Federal Reserve may decide that it has no choice but to add more easing – the policymakers are still keeping this door wide open.

Other important US economic indicators aren’t much convincing either. The Conference Board consumer confidence index, one of the main indicators of US consumer optimism, decreased from 112.6 in 2007 to 25.0 in 2009. Since that time the situation has improved, but the full recovery of the consumer confidence still remains a distant prospect: in May 2012 the reading was only 64.9 after one more leg down to 39.8 at the end of 2011.

The Federal Reserve reports that the housing market’s collapse made the median net worth of American families fell by almost 40% between 2007 and 2010, down to levels last seen in 1992. The median family income dropped by 7.7% during the mentioned period.

The ISM manufacturing PMI, the main indicator of the manufacturing sector’s economic health, shows that the industry is expanding for the 34th consecutive month since August 2009. With the help of the QE the index has reached its 7-year maximum in April 2011 at 61.4. However, since the second half of 2011 manufacturing growth has slowed down and the PMI posted 53.5 in May 2012. Such rollback may be another sign that the industry’s rebound is not strong enough to drive the US economy out of the standstill without the central bank’s help.

As for the retail sales, an important gauge of the consumer spending, a remarkable slowdown was recorded after a surge in January and February: the indicator dropped by 0.2% in both April and March. The data clearly demonstrates that the US economic recovery remains sluggish. Many economists have lowered their Q2 GDP growth estimates by almost a half of percentage point to 1.9-2%.

The Organization for Economic Co-operation and Development sees a slow rebound of growth in the United States, driven mostly by private demand. According to the organization, American economy, in contrast, would grow by 2.4% this year and 2.6% in 2013, while the 17-member euro zone economy is expected to shrink by 0.1% this year before posting growth of 0.9% in 2013.

Just from here we are able to make first conclusions. US economy remains fragile: high unemployment and anemic growth are the issues at sight. During the past months the market’s sentiment had its positive moments. These surges of optimism were caused by occasional favorable data. For now US improvement still hasn’t become a trend. In addition, the prospects of the Unites States looked brighter as they were considered against dismal European background. The separate analysis of US economic performance demonstrates that the past post-crisis years haven’t brought an economic breakthrough.

American economy is very open and, consequently, dependant on the global economy, so the lack of the robust recovery may be also explained by the external factors, primarily the ones associated with the faltering Europe. Let’s have a look on the extent to which the euro zone’s debt problem affect the world’s largest economy and then try to outline the main prospects and challenges which lie ahead of America in these uncertain times.

America and the European debt crisis

It goes without saying that nowadays the major risks for the US come from Europe, so we can’t analyze US economic prospects without paying enough attention to this issue. There are 2 principle areas of American economic exposure to the euro zone’s problems: trade and financial effects.

Trade exposure

Have a look at US trade balance. The nation’s exports to the EU account for 19% of total exports and to the euro area – for 13% of the total. That is only 1.3% of US GDP – not much. Nobel Prize winner Paul Krugman points out that even a sharp fall in exports to the EU would be only a small direct hit for the US.

One should not forget, however, about the indirect effects. In 2010 Europe accounted for 25% of world trade. Loss of this market would slow global growth and weight on investors’ risk sentiment and, consequently, financial markets.

Financial exposure

Financial effects of the euro zone debt crisis deserve a more profound analysis. Once again we start with direct impact.

Banks are commonly in the first row to take the blow. European problems did not begin yesterday. Certainly more that 2 years is enough time to hedge preparing for the doomsday. In comparison with 2008, the amount of leverage in the financial system has gone down. Global policy makers were not seating still and tried to encourage this process. Of course a new crisis could reveal that American banks are still undercapitalized, but they are certainly in better shape than they used to be 4 years ago. However, we have to make an important remark here.

In January US Securities and Exchange Commission (SEC) requested American banks to provide reports containing specific descriptions of loans and trading positions relating to Europe. It turned out that the exposure of 5 big American banks’ to Portugal, Ireland, Italy, Greece, and Spain accounts for more than $80 billion. Cumulatively, the banks have hedged their positions by $30 billion, mostly through investing in credit default swaps. The banks analyzed include Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, and J.P. Morgan Chase.

It is necessary to note, however, that the SEC has managed to collect only partial information on the banking sector’s exposure to the European debt as many banks tried to present things in better light than they actually are by concealing some vital details.

For example, American banks revealed the net figures of exposure. That means that US financial institutions diminished the actual size of their European assets by taking into account offsetting items or, in other words, some undisclosed hedges and short positions. The problem is that a bank might not be able to collect all the offsets if the crisis strikes really hard, because many of the US hedges are made in Europe – for instance, through French banks.

This is the main problem of the modern financial sector: no one may be allowed to fail as one failure provokes a chain reaction – the domino effect. Firstly, if European banks get into trouble, they may not be able to honor any payments which they owe on trades American banks have made as a hedge. Secondly, collateral often comes in the form of cash euro or European government bonds and many of the banks’ hedges are credit default swaps which presume prospective payouts to be made in euro . If euro collapses as a currency, that will surely be a disaster.

We admit that the European Central Bank’s decision to inject about 1 trillion euro into European banking sector will help to save the banks from running out of liquidity and, consequently, reduce the risk of the credit crunch. Never the less, the Fed’s Chairman Ben Bernanke has pointed out that although US banks are now less exposed to the sovereign debt issues in Europe, there will be a great number of different channels through which euro zone’s crisis may affect US financial system.

Apart from the banking sector, the US is also vulnerable because households and governments are still in the midst of deleveraging from the last financial crisis and policy makers are running out of ammunition to stimulate economic activity. In addition, US and European markets are closely correlated. Of course, American equities outperformed the European ones during the last few years which were marked by severe tensions in the euro area. At the same time, though the Euro Stoxx 500 and the S&P 500 move in different magnitudes, they are quite rarely entirely out of step with each other.

Let’s look back to the notorious 2008. The fault in the global financial system made economies all over the world suffer in unison, no matter how intense was their trade with America. There are no doubts that if Greece or another struggling European nation defaults on its debts and quits the euro zone, the future of monetary union will be in question. That will certainly trigger turmoil in markets. Business investment would stall, while banks would pull back on credit, equity prices fall and consumer spending contract. Commodity prices would plunge, helping importers but hurting growth in export economies. The extent of the damage would depend upon how quickly global policymakers could calm the markets.

Economists propose different scenarios of further developments in the euro zone. Hence, the impact on US will differ from weakening growth to severe recession. Even if all goes relatively well – political situation in Greece stabilizes and the nation stays in the monetary union, Spain recapitalizes its banks and EU integration gradually advances – the ongoing volatility in financial markets and slow-to-mildly negative euro zone growth would continue weighting on US growth prospects. All in all, we come to the conclusion that the risks associated with Europe can be contained, but not isolated.

US economy: challenges and prospects

As we have uncovered above, American economy will suffer from the negative influence of the European debt crisis and euro zone’s poor economic performance. However, the hurdles for US economic rebound do not end here.

Debt crisis is not a unique European issue. Analysts at Deloitte claim that US debt problems are “bigger than you think”. Last summer after fierce debates between Democrats and Republicans the nation’s policymakers have increased the debt ceiling by $2.1 trillion to $16.4 trillion. Note that at the end of Q1 2012 the nation’s GDP was equal to $15.5 trillion. Anyway, this was only a temporary solution and the critical debt level may be reached already around the end of the year.

Mounting debt represents a great burden for US economic growth. According to Deloitte, American government will need to spend at least $4.2 trillion in interest payments during the next 10 years. These are immense amounts of money that could be otherwise invested in increasing US competitiveness. Moreover, spending cuts touch the areas which are most connected to competitiveness, such as education and R&D.

Automatic spending reductions of more than $1 trillion are taking effect in January, while bush-era tax cuts expire at the end of 2012. No doubts that this will increase the negative pressure on the economic agents the next year. On the other hand, the Congressional Budget Office said that an extension of these cuts and current Medicare spending without monetary policy change would make the federal debt climb in 25 years to twice the size of US GDP.

At some point the Fed will probably have to introduce additional monetary stimulus whether extending Operation Twist or purchasing more government debt. There is scope for such action: US consumer prices increased by 1.7% in the 12 months ended in May showing the smallest 12-month gain since January 2011. The Fed’s mandate is to target 2% inflation. Inflationary pressure decreased due to the decline in gasoline prices.

At the same time, the more the Federal Reserve loosens its policy, the less room for maneuver it has: the interest rates are already extremely low, so their further decline probably won’t be efficient enough. As you may see on the chart below, the central bank’s balance sheet has more than doubled since 2008.

It’s also necessary to note that opinions in the Fed are divided. Although the FOMC has turned more dovish this year, there are those who think injecting more money into the economy is risky. Some officials claim that US economic outlook hasn’t significantly darkened yet. The annual Federal Reserve’s August meeting in Jackson Hole will be likely marked by the key monetary decisions as it was in the last couple of years.

In conclusion we would like to underline that without the European threat American economy would continue recovering with the press of huge debt looming over the US in the longer-term. However, the United States isn’t isolated from the uncertainty and risks of contagion which have been constantly emanating from Europe during the recent years.

US Treasuries still represent the largest and the most liquid sovereign debt market: the yields went down even after the nation has been downgraded by the Standard & Poor’s as US debt securities and the greenback remain the market’s final refuge in the absence of worthy alternative elsewhere. Yields on US 10-year government debt touched the record minimum of 1.44% in June. The Dollar Index added 10% since last summer.

Risk aversion will keep supporting US currency against its counterparts. However, the door for more monetary easing in America is still open. Both QE1 and QE2 led to the decline of the DXY by approximately 16% in 2009 and 7% in 2010-2011.

In the near future US policymakers are not as limited in their choices of further actions as the European ones – it’s even harder for more numerous and more divergent euro zone’s governments to reach consensus than for US parties. America’s manufacturing industry is in better shape and US markets seem more stable. Rating agencies confirmed American credit ratings for now, though with negative outlook. The tensions between Republicans and Democrats will keep on: the first will continue insisting that any increase in the nation’s debt limit should be matched by spending cuts of the same magnitude, while the latter will keep supporting the idea of economic stimulus. For now we do not see a way out of this stalemate. With the presidential elections at the end of 2012 there is a political battle coming, so the words “recovery”, “debt” and “Europe” will stay in the center of the polemics.

Elizaveta Belugina

Kira Iuchtenko

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Commerzbank: comments on USD/JPY

Analysts at Commerzbank expect USD/JPY to slide to 78.99 (200-day MA) as in an uncertain environment yen gains momentum as a safe haven. The pair is likely to remain above 78.61 (June 15 minimum) in a short term.

However, if USD/JPY manages to break below 78.61, a decline towards 77.65 (June minimum) will become possible. Strong resistance for the pair lies at 80.07/10 (July 5 maximum and 38.2% Fibonacci retracement) and 80.61 (June high and a 100-day MA).

Chart. Daily USD/JPY

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July 11: economy and currencies

On Wednesday EUR/USD remains choppy ahead of FOMC meeting minutes: will the release reveal some discussions on QE3 or Fed funds rate? FOMC minutes (18:00 GMT) are probably most important risk event of the day. US will also publish a May trade balance (forecast: 48.5B trade deficit) and hold a 10-year bond auction today.

EUR remains weak today even as European finance ministers at a meeting in Brussels worked out a way for euro bailout funds to intervene in bond markets and said the first 30 billion euros of 100 billion euros in rescue loans will start flowing to Spanish banks this month. Spain was given an additional year (until 2014) to meet a 3% budget deficit target. On Wednesday Germany sells 10-year bunds. Yesterday Spanish and Italian 10-year bond yields were below the critical 7% level, giving some relief to the markets.

USD/JPY weakens for a fourth consecutive day on expectations the BoJ won’t add stimulus on a next meeting on Thursday. EUR/JPY reached a new one-month low on demand for the yen as a refuge. AUD, NZD and CAD are strong against their US counterpart. Australia consumer sentiment improved by 3.7% in July as households became more optimistic about the economic outlook . Canada releases a trade balance (forecast: 0.5B trade deficit).

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Westpac: trading AUD/JPY

Westpac analysts recommend going short on AUD/JPY at current levels, setting a stop at 82.35 and a target of 78.50.

In their view, this week the Aussie will get under pressure because of the negative data releases. Firstly, Australia employment report is to disappoint the investors on Thursday after the unexpectedly strong previous print: economists forecast the number of employed to increase only by 0.3K in June after a 38.9K growth in May. Secondly, China’s GDP is likely to come out below expectations (around 7.3% vs. a 7.9% forecast), what will also influence the Australian currency.

Chart. Daily AUD/JPY

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BoJ expected to leave the policy unchanged

On Wednesday the Japanese yen strengthens against the greenback for a fourth consecutive day. The Bank of Japan starts its 2-day meeting today and is widely expected to leave rates unchanged and not announce any new easing measures.

It seems that lately the regulator has become slightly more optimistic: the country's economy is headed for a moderate recovery as improvement in domestic demand eases the pain from slowing global growth. According to a Regional Economic Report released July 5 by the BoJ, in Q2 business conditions improved in all nine regions of Japan. Tankan manufacturing and non-manufacturing indices showed improvement in Q2 (-1 and 8 respectively).

Some analysts, however, expect the regulator to follow the central banks of Europe, Britain and China with its own monetary measures in a united effort to fight the global slowdown. Moreover, weaker national currency would be beneficial for the Japanese economy. Bank of The BoJ Governor Masaaki Shirakawa said on Tuesday that the bank is ready to undertake all the necessary measures to bring the nation out of its deflationary state. According to him, the BoJ has already accumulated 54 trillion yen of asset purchases, but is aiming for 70 trillion.

UBS: We continue to expect the BoJ to add more stimulus on a meeting and by this to weaken the yen. A deterioration of machinery orders and another drop in the current account confirmed the bad sentiment of economy watchers. Moreover, Japan is still struggling to recover after Fukushima.

Bank of Japan Governor Masaaki Shirakawa

Photo: Reuters

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Credit Suisse: trading EUR/USD

Analysts at Credit Suisse recommend going short on EUR/USD at current levels with a stop at $1.2340 and an initial target of $1.2160.

In their view, the fact that yesterday EUR/USD didn’t manage to overcome the $1.2340 resistance creates potential for a further decline. The next support for the pair lies at $1.2150 and $1.1985. Only a break through $1.2401/$1.2408 will let the pair reach $1.2693.

Chart. Daily EUR/USD

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FOMC: easing options remain open

The US dollar strengthens against the euro after the minutes of the FOMC June 19-20 meeting, in which Fed officials decided to extend the Operation Twist, revealed some members said additional stimulus may be needed to support the weak labor market. However, the greenback depreciates against the high-yielding currencies.

While several policymakers were in favor of the policy easing, the others believed that would only make sense if the economic rebound loses momentum or inflation drops. The Fed underlined that rates are likely to remain at "exceptionally low levels" at least through the end of 2014. Several Fed members said in an intriguing manner that it is necessary to develop "new tools" to ease financial conditions.

Photo: Bloomberg

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BofA: USD to rise regardless of FOMC

Specialists at Bank of America expect the greenback to remain strong regardless of the speculation the Fed will ease the monetary policy. They point that the overall trend for the US currency remains bullish.

According to their technical forecast, the Dollar index will increase to 85.32 (78.6% Fibonacci retracement from a 2010-2011 decline) if it manages to break above 83.54. A downward movement will become likely if the index falls below 83.00 and 80.73 support levels.

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Chart. US Dollar Index (DXY)

Source: marketwatch.com

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Commerzbank: bearish on NZD/USD

NZD/USD remains strong after a FOMC meeting minutes didn’t give any clear hint on the additional policy easing in the nearest future. Analysts at Commerzbank, however, remain bearsh on NZD/USD and expect the pair to decline to 0.7844 (38.2% Fib of 2012 downtrend) and 0.7825 (55-day MA) after a 2-month upward movement.

In their view, a break below 0.7825 would pave ground for a drop to a 0.7469/0.7371 support zone. According to specialists, the New Zealand currency will remain under pressure while it trades below 0.8319 (April maximum). However, resistance at 0.8085 and 0.8255 (78.6% Fib) looks too strong for the pair to overcome it, so NZD/USD is likely to move on a downside.

Chart. Daily NZD/USD

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Bank of Japan: no easing, only technical changes

REUTERS/Issei Kato (JAPAN)

The Bank of Japan has made a technical change to its asset purchase and lending program. The total size of the program was maintained at 70 trillion yen ($879 billion). The BOJ expanded its asset-purchase program by 5 trillion yen to 45 trillion yen ($564 billion) cutting the loan facility by the same amount to 25 trillion yen. As a result, the total amount of the asset purchase and lending program remained unchanged at 70 trillion yen.

The BOJ pledged to increase its purchases of short-term public debt – previous extensions of the program had been mostly for long-term government bonds. As for the benchmark rate, the central bank left it in the 0-0.1% area.

Japanese Finance Minister Jun Azumi called for more support from the central bank for growth and inflation to meet a 1% price goal. Azumi expects BOJ policy effect to emerge gradually.

The market weren’t much impressed by the move which is not regarded as monetary easing. USD/JPY has briefly spiked to 79.96 before sliding to the levels below today’s opening around 79.50 yen. Investors bought yen as a refuge ahead of the release of the euro zone’s industrial production later today and important Chinese data tomorrow.

The pair remains supported above 200-day MA at 79 yen. Some market players say that Japanese exporters will sell the currency above 80 yen.

Chart. Daily USD/JPY

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Key options expiring today

Market prices tend to move towards the strike price at the time large vanilla options (ordinary put and call options) expire. It happens (all things equal) as each side of the deal seeks to hedge its risk exposure. This action is most noticeable ahead of 10 a.m. New York time when the majority of options expire (2 p.m. GMT).

Here are the key options expiring today:

EUR/USD: $1.2200, $1.2215, $1.2225, $1.2230 (large), $1.2400, $1.2550;

USD/JPY: 78.75, 79.00, 79.85, 80.00;

AUD/USD: $1.0200, $1.0350;

EUR/AUD: 1.2065;

EUR/GBP: 0.8020, 0.8030, 0.8070;

NZD/USD: $0.8000.

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Aussie hit by poor jobs data

Australian dollar dropped versus the greenback from the pivot point (200-day MA) breaching uptrend support line from the beginning of June.

Aussie got hurt due to the discouraging Australian labor market data: the number of jobs contracted by 27K last month (vs. + 0.2K expected). Australian currency is also affected by the expectation of Chinese growth slowdown. China’s GDP is released tomorrow and its growth rate is forecasted to decline from 8.1% in the first 3 months of the year to 7.9% in Q2.

Analysts at Westpac claim that Australian jobs report is “pretty horrible”. The specialists underlined that all jobs that were added were part-time and that’s a bad sign. Strategists at NAB, on the other hand, think that things as not as gloomy as they seem. In their view, the unemployment rate of 5.2% remains low by historical standards. The odds of another RBA rate cut increased, but such move in August still seems unlikely as Australia’s monetary authorities will like to watch for the effects of their recent rate cuts. The central bank cut rates in May and June to 3.5% and stayed on hold in July.

AUD/USD set the daily minimum at $1.0135 and then recoiled up to $1.0150. Support lies at $1.0125 (June 28 maximum), $1.0090 and $1.0055. Resistance lies at $1.0200, $1.0225 and $1.0240.

Chart. H4 AUD/USD

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Commerzbank: forecast for GBP/USD

Technical analysts at Commerzbank note that GBP/USD has recently completed consolidation.

In their view, British currency will return to $1.5600 and then slide from this point firstly to $1.5403 (June 8 minimum) and eventually to $1.5268/33 (June 1 minimum and 2012 minimum) and then possibly to $1.5000/1.4990.

According to the bank, resistance lies at $1.5593/1.5600 (June 25 maximum, June 7 peak) and $1.5750/85 (200-day, 200-week MAs, 50% Fibo retracement of the decline in May).

Chart. Daily GBP/USD

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Barclays Capital: bearish on USD/JPY

Analysts at Barclays Capital are bearish on USD/JPY and recommend going short on the pair at 79.6, setting a stop at 80.0 and targeting at 78.0. In their view, slowed global growth and European woes are likely to push the Japanese currency up, while the BoJ is unlikely to extend the asset purchase program.

However, improving risk sentiment and more aggressive BoJ easing could threaten the yen’s strength. Japan’s monetary authorities claim they are ready to loosen policy in order to reduce the deflationary pressure on the economy. Core consumer prices contracted for the first time in 4 months sliding by 0.1% y/y in May, while Tokyo core CPI fell by 0.6% in June – the BOJ’s 1%-inflation target seems like very hard to attain.

Chart. Daily USD/JPY

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NAB: AUD/USD to fall below parity

Analysts at NAB expect AUD/USD to drop below parity by the end of 2012 on the back of the slowed global growth and lower prices on raw materials.

Specialists devote considerable attention to weak economic releases coming from China lately. China’s slowed economic growth could pull AUD/USD to $0.97.

According to CFTC report, traders remain in net short positions on AUD for six consecutive weeks (the longest stretch since 2009) as falling export prices raise concerns the RBA will cut rates further.

Chart. Daily AUD/USD

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EUR/USD: fundamental & technical

Fundamental

- Spanish Prime Minister Mariano Rajoy announced yesterday 65 billion euro ($80 billion) of new austerity measures in a renewed effort to meet EU budget targets after the nation was granted another year to reduce the budget deficit. Now Spain has until 2014 to bring its deficit within the EU’s 3%. This is Spain’s fourth austerity package in 7 months and the new flashpoint for supports and the opposition.

- Finland is in discussions to get shares in Spanish banks as collateral in exchange for its contribution to the bailout.

- Euro zone May industrial output +0.6% m/m, -2.8% y/y, better than consensus forecast.

- ECB monthly bulletin: heightened uncertainty, some downside risks to growth outlook have materialized.

Spanish 10 year yields are up by 3 bps on day at 6.61%.

Technical

Strategists at RBS recommend selling EUR/USD up to $1.2290 (June minimum) targeting $1.1875 (2010 minimum) stopping above $1.2350 (the recent cluster of daily maximums).

Analysts at UBS claim that key support for EUR/USD lies at $1.2152. If euro breaches this level, it will slide to $1.2000. Resistance lies at $1.2336 and $1.2402.

Chart. H4 EUR/USD

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China's GDP is to disappoint markets

China’s GPD release on Friday attracts investors’ attention as will define the risk sentiment and influence the commodity currencies. Most analysts expect the second largest economy in the world to grow below the expectations in Q2 (consensus: 7.9%; previous print: 8.1%).

Experts at Development Research Centre expect China’s economy to grow by 7.5% in Q2. In the second half of 2012, however, the economy is likely to recover modestly as the monetary policy measures will bear fruit. China’s economy could grow around 8% in 2012. Specialists believe the world's second-largest economy is entering a phase of more modest expansion in comparison to the 10% annual average rate in the past three decades, but it could still maintain a 7-8% annual rate in the next 10 years. Still, any reading below 8% tomorrow will hit the market's risk sentiment.

According to Barclays Capital forecasts, China’s June industrial production may exceed the 9.8% forecast, but this small positive result will be offset by the negative GPD surprise. In their view, the weaker-than expected GDP will hurt the Aussie.

Chart. China's GDP (2003-2012)

Source: forexfactory.com

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FBS Quarterly Report

Q2 Review

Every quarter of the year is a small lifetime. In the first 3 months of the year the main topic of the headlines was US economic data. In Q2 everyone’s attention was focused on Europe. We have lived through a half of the year and now it’s time to pause and asses the past events and the market’s developments.

Europe

Political mess

European woes frayed investors’ nerves pretty much this spring and early summer: it’s the third year of the euro zone’s debt crisis, yet both political and economic situations have been extremely strained.

Once again Greece got in the highlight scaring the hell out of the markets with its huge debt, incapacity to form a parliamentary coalition and unwillingness to meet the EU conditions. The nation’s exit from the currency block seemed as possible as never before. It took the Greek 2 attempts to finally form the workable government.

The French presidential vote was another spot of the market’s increased attention. Francois Hollande won on the back of his anti-austerity program. Meanwhile, German Chancellor Angela Merkel kept losing support at home: the German don’t want to pay for their debt-stricken neighbors. Even earlier, when Merkel-Sarcozy duet was navigating the course for its neighbors, the region’s policymakers didn’t manage to run the things smoothly. As the euro zone’s ruling couple broke up, European leaders faced a lot more troubles reaching consensus as diverging interests prevent them from conducting a coordinated policy.

One could think that after the Greek tensions somewhat eased, the region would be on the mend. Never the less, it’s not that simple. Market’s attention has instantly switched to larger Spain and its troublesome banking sector. On June 25 Spain officially requested bailout for its credit institutions.

Euphoria - EUROphoria

The June 28-29 summit went well and was presented by the policymakers as a breakthrough. The EU authorities promised fresh capital for Spanish struggling banks. The European Union also pledged to allow the 500 billion-euro European Stability Mechanism (ESM) to aid euro zone banks directly. This, however, will become possible only after a joint bank supervisor for the euro zone replaces the existing network of national regulators – this to be done by the end of the year.

However, the relief was, as usual, short-lived. Even though euro zone leaders may have found political will to solve the crisis, it’s clear that there are no quick solutions. The agreement announced at the summit excluded any longer-term policies to address the underlying European issues. Germany remains in stubborn opposition to the idea of common Eurobonds regarded by many economists as the only way to save the currency union. This stalemate looks very hard to resolve.

There are important decisions ahead. Greece has to renegotiate its bailout with the Troika – the new round of talks will begin on July 24. Until the revised bailout agreement is signed, there will be no further disbursements from the ESM to Greece beyond 1 billion euro withheld from the May tranche. Greece has to pay bonds maturing on August 20 and it won’t be able to do that without external help.

Photo from dailymail.co.uk

Discouraging economic prospects

Signs of economic weakening may be witnessed all over the world – in Europe, Asia and the United States. The European crisis is surely weighting on global demand and will keep doing so in the coming months taking into account the uncertainty about the region’s regulatory and fiscal policy outlook.

For now we don’t think that European economy may start rebounding. If the currency union’s, US and Asian economic performance is really better than expected, the likelihood of further monetary stimulus will surely decline. The equities won’t take it well, so the risk sentiment will get hurt. The worse data releases are, the more aggressive the monetary policy response from the central banks will be and stock markets will likely run up on the easing news spurring investors’ risk appetite.

Many economists have correctly pointed out a very important thing: the situation isn’t the same as 4 or even 1-2 years ago. The main thing which has changed is monetary conditions. The central banks have already done much to prop up the stumbling advanced economies, so the efficiency of new steps in this direction is questionable.

Here are the world’s major central banks’ rates:

All in all, the biggest global risks are:

- Escalation of European crisis;

- Stalling recovery in the United States;

- Slowing growth in Asia;

- Geopolitical instability in the Middle East.

Take a look at this snapshot of the key latest data for the world’s leading economies.

Euro area

According to Fitch Ratings, the European crisis worsened in Q2 amid the deterioration in global economic prospects, capital flight from the peripheral countries, bond yields rise and anti-austerity sentiments. Euro zone’s unemployment rate rose in May to the record maximum of 11.1%. The poor labor-market conditions and the negative effects of fiscal consolidation will continue dampening household disposable income. Specialists at the Ifo institute claim that the 17-nation currency area’s GDP may have shrunk by 0.2% during the months from April to June and will contract by 0.1% in the next 3 months before growing by 0.1% in Q4. The European Commission projects that the region’s economy will contract by 0.3% this year.

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FBS Quarterly Report part 2

The United States

The ISM manufacturing PMI, a good indicator of the economic health of the manufacturing sector, shows that in June the industry switched to contraction after 34 months of expansion. The situation at the labor market – the key area of the Fed’s concerns – isn’t bright either. Investors had to forget that American economy generated 200K of new jobs a month in winter with 70-115K monthly gains in Q2.

Now, as the expectations are low, data in the coming months may surprise to the upside. We may see some improvement in the second half of 2012 as it was last year. However, one thing is clear – the recovery surely won’t be robust and self-sustaining. Even if Q3 turns out to be better than expected, there will be no reason to get deluded with vain hopes. Also note that November presidential election will bring back concerns about US fiscal health. The more detailed report on US economic prospects prepared by FBS analysts may be found here.

Unconventional US Federal Reserve’s monetary policy remains the largest risk to the greenback’s safe-haven status. Will there be the third round of QE? As the Fed refrained from such action in Q2, it would likely take a substantial worsening in economic and financial conditions to US central bank to announce additional bond purchases.

China

China’s latest economic data point to a deepening slowdown making domestic social and political situation more and more tense. The world’s fastest growing economy is experiencing the deepest slump in growth rates since the 2008 global crisis. This could hurt Chinese demand for imported oil, iron ore and industrial components.

The People’s Bank of China is also riding the monetary stimulus wave: the central bank has cut interest rates for the second time in 2 months in the latest attempt to bolster slowing growth. Experts say more easing may follow.

All in all, the hopes that the Asian nation will drive global sales in the foreseeable future amid anemic demand in the United States and debt-crippled Europe are fading.

Currency majors in Q2 2012

Japanese yen was the best performer versus the greenback among G10 currencies in Q2 unlike Q1 when it lost 7% against its US counterpart. Apart from yen, American currency gained versus all its major counterparts.

Q3 prospects

EUR/USD

The single currency is entering Q3 in a clear downtrend after forming a flag in May-June. Although euro finished last month with a sharp advance, it ended 5% down due to the sell-off in April.

As we’ve said earlier, there have been some positive shifts in the euro area, but it takes the implementation of fundamental changes to solve the crisis – the development which can be hardly seen at the horizon these days.

Spain represents the greatest risk for the currency market. The nation’s 10-year yields remain close to the dangerous 7% level. Even though Spanish banks have been granted support, the nation’s government itself may ask for help to mend finance amid recession and unemployment of nearly 25%.

It’s also necessary to note that as the market players remain extremely bearish on euro, there should be a substantial shift in positioning and sentiment to signal that the European currency has a sustainable chance to reverse upwards.

GBP/USD

At the end of April GBP/USD reached $1.6300, the maximal level since August 2011, before slumping by more than 900 pips in May. In June the pair managed to correct upwards, but then it resumed downward movement.

British economy fell back into recession around the turn of the year and a string of weak economic data has pointed to another quarter of contraction between April and June. The Bank of England remains concerned with the state of the country’s economy: the central bank began Q3 with the 50-billion-pound increase of its asset purchases leaving open the door for further monetary stimulus.

There’s a reason to turn down the gloomy views on sterling, at least for the month ahead. We’re speaking about the Olympic Games which start in London on July 27. Thousands of visitors arriving to the UK will be buying pounds this summer. So, pound has chance to strengthen, especially against the single currency.

Things may dramatically change, though, once the Olympics are over on August 12 and British are left alone with their shaky economy – home currencies tend to fall by around 3% in the year following the Games. One should, of course, remember that Britain remains extremely vulnerable to the events in the euro zone through trade and banking links. Sterling’s attractiveness as safe haven from European crisis may be outweighed by the negative impact of euro zone’s problems on the UK economy. After all, there are other refuges.

USD/JPY

The USD/JPY trade will likely remain quite choppy. Although the bears were more successful in Q2, the pair is still above 77 yen – the level at which it started 2012. The greenback is pressed between support and resistance – both levels used to be strong. At the same time, the consolidation within a triangle is coming to an end and we are to brace for the breakthrough to either side.

The key factor here is the same – the Bank of Japan – yen’s future depends on how aggressive its actions will be. On the one hand, the BoJ raised its fundamental assessment of all the nine regions for the first time since October 2009. At the same time, the central bank still has to fight 2 main enemies of the nation’s economy – deflation and strong yen.

Japan's core consumer prices contracted for the first time in 4 months sliding by 0.1% y/y in May, while Tokyo core CPI fell by 0.6% in June – the BOJ’s 1%-inflation target seems like very hard to attain. We believe deflation will be the policymakers’ primary concern and this battle will require additional monetary stimulus.

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July 13: economy and currencies

The markets were apathetic to China’s GDP release: everyone has already submitted to the fact that the growth pace of world’s fastest growing economy is slowing down. Even the consensus was dragged lower before the release from 7.9% to 7.7%. The data released today showed that Chinese GDP increased by 7.6% in Q2 after extending by 8.1% in the first 3 months of the year. Chinese industrial production and retail sales grew a bit less last month than in May, while the advance in fixed asset investment was slightly bigger.

Investors are now much more preoccupied with what’s happening in Europe, particularly in Italy. The nation holds a 10-year bond auction. Overnight Moody's ratings agency downgraded Italy's government bond rating by two notches to Baa2 from A3. According to experts, Italy’s near-term economic outlook has worsened: weaker growth and higher unemployment creates risk of failure to meet fiscal consolidation targets. On Thursday, however, Italy raised 7.5 billion at a lower rate than previously, indicating improved investor confidence.

US is to release PPI (forecast: a 0.5% decline in June), core PPI (forecast: a 0.3% growth in June) and preliminary UoM consumer sentiment index (expected to increase to 73.5 in July).

Risky currencies are trading on the upside today, though they are set for the weekly declines due to the general pessimism. The MSCI Asia Pacific Index of shares added 0.6% after falling by 0.2%. Analysts at Westpac underline that the growth momentum is still slowing down, though there may be more of a short squeeze in the currencies like Aussie in the near term.

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Analysts: trading EUR/USD

Analysts at Commerzbank expect EUR/USD to decline to $1.2053 (200-month MA) after having reached $1.2187. According to specialists, the descending triangle figure paves the ground for a decline to $1.1934 and to $1.1876 (2010 minimum). Resistance for the pair lies at $1.2287 (June 1 minimum), $1.2367 (200-day MA) and $1.2475 (triangle support line).

Strategists at Aspen Trading Group are also bearish on EUR/USD and recommend going short at $1.2150 with a stop at $1.2300 and a target of $1.1850. In their view, this level is close to fair value of the pair.The specialists claim that being bearish on euro is the best risk-off trade these days.

Chart. Daily EUR/USD

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Key options expiring today

Market prices tend to move towards the strike price at the time large vanilla options (ordinary put and call options) expire. It happens (all things equal) as each side of the deal seeks to hedge its risk exposure. This action is most noticeable ahead of 10 a.m. New York time when the majority of options expire (2 p.m. GMT).

Here are the key options expiring today:

EUR/USD: $1.2135, $1.2170, $1.2175, $1.2200 (large), $1.2235, $1.2300, $1.2350, $1.2375;

USD/JPY: 79.00, 79.25, 79.75, 80.00;

AUD/USD: $1.0000, $1.0100, $1.0195, $1.0200, $1.0220;

AUD/JPY: 83.00;

GBP/USD: $1.5500, $1.5650;

EUR/GBP: 0.7900;

USD/CAD: 1.0150.

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GBP/USD: technical comments

GBP/USD touched a new 5-week minimum in Thursday due to a risk-off market mode ($1.5392), but then started an upward correction to the $1.5440/50 area. Most technical indicators show the descending trend is likely to continue. Yesterday the pair broke through a flagpole of a bear flag pattern. All in all, GBP/USD trades in a downward channel since June 20.

It makes sense to sell GBP/USD on a pullback higher, targeting $1.5267 (June 1 minimum). The next support for the pair lies at $1.5233 (2012 minimum), while resistance – at $1.5450, $1.5510 (23.6% Fib. retracement of a May decline) and 1.5662/45 (38.2% Fib. retracement and a resistance of a downward channel).

Chart. H4 GBP/USD

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BoA Merrill Lynch: delusions about euro area

Analysts at Bank of America Merrill Lynch looked at the euro zone’s problems from the point of view of the game theory. The specialists analyzed the economic situation in each of the 11 largest euro zone countries and assessed the likely impact of their exit from the currency bloc.

Delusion #1: Strong countries like Germany and Austria could leave the euro zone without too much pain, while the weaker peripheral countries need the stability of the euro.

BoA has found out that “Italy and Ireland have the highest relative incentive to voluntarily exit the euro, while Germany has the lowest incentive of any country to leave.”

Conclusion: Italy has a stronger incentive to leave the euro zone than Greece and, consequently, will be less likely to accept tough conditions to stay.

Delusion #2: The euro zone will hang together because it's to the member countries’ collective advantage.

BoA recalls the famous prisoner’s dilemma (the game theory problem, in which individuals’ own incentives outweigh their joint interests) in the context of Germany and Greece and austerity-Eurobonds debate. It would be in both countries' interests to cooperate – for Greece to adopt austerity and Germany to agree to Eurobonds – but each country will ultimately try to maximize its own benefit: Greece would be better off with Eurobonds but no austerity, while Germany would benefit more from the opposite.

Conclusion: countries have not so many incentives not to cooperate on resolving the crisis, so euro’s future is really under threat.

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July 16: events to watch

Japan: Bank holiday

Euro area: CPI growth is to remain at 2.4% in June, while core CPI – at 1.6%. According to the ECB report, inflation rate will fall below the regulator’s 2% ceiling next year.

US: Core retail sales are expected increase by 0.1% in June, what is much better than a 0.4% drop in May, but still points at the weakness of the US economy. Retail sales demonstrate the similar dynamics: 0.2% growth in June vs. a 0.2% decline in May. Weak figures will add to investor’s concerns about a new QE.

Cartoon: jeffreyhill.typepad.com

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