The main theme of today is the ratings downgrade of Ireland, but markets still performed reasonably well on the day, with Asian and European boursesup, while U.S. markets demonstrate a lack of momentum. The main spots of weakness were India and China, with market mood dampened in the latter by concerns about rising interest rates, and in the former by the recent bout of corruption scandals that have shaken the government of PM Manmohan Singh. Against this background, the EURUSD barely moved, while the USD was little changed against its major peers. The USDJPY pair is testing its 100-day MA, with little followup so far. Among commodities, after failling to make much downward progress during this week, gold started the day in the red, but seems likely to end it in the black.
Today Fitch cut Ireland`s sovereign credit rating by three notches to BBB+, to two levels above speculative grade, in a move that was widely anticipated by the markets. We think that BBB+ is too high for the country, given the uncertainties that surround its financial independence, but Fitch is still the most realistic among the three major credit rating agencies.
The CDS market is reported to be pricing in losses of about 20% for senior holders of Irish debt due for the next 3-5 years, and Fitch`s move has not had a perceptible impact on the bond or CDS markets, as it does not go much beyond the certification of the obvious. Still, West European sovereign CDS generally ended the day with a higher yield today.
3-month Euribor was unchanged today at 1.029%. USD Libors show little movement. In other Eurozone news, German HICP inflation has continued to trend higher, with the latest number coming at 1.5% y-y vs. the previous 1.3%. It is unlikely that the Eurozone inflation will become a serious problem next year, but if the trend continues, as it is possible it will do with the Euro depreciating, the ECB will find it even harder to engage in further easing while maintaining any remaining degree of credibility.
The Bank of Korea is reported to have left interest rates unchanged after moving to increase them last month in response to rising inflation. Nonetheless, the pressure to keep the won weak is strong, and the bank is not likely to change the current stance for some time to come. Korea`s recovery has not been very robust, and low rates make sense from more than one angle.
In the rest of Asia, we have yet more evidence that Asians are committed to reining in speculative inflows in a decision by China`s SAFE to the effect that the interbank FX market will close at 4:30 pm (8:30 GMT) from next Monday, revising the existing regulations that ends operations at 5:30 pm. In a similar move, they are reported to have advised HK not to drop the peg, since, we think, that would accelerate the fall of the USD and greatly complicate their management of the yuan.The Chinese are obviously unnerved by the massive amount of speculative cash flooding the country, and hope to be able to limit the impact on the domestic market through cosmetic measures such as this latest announcement, but as long as appreciation expectations remain, there is very little that they can do to reverse the trend, especially because there are few alternatives in today`s world against the safe bets provided by the USDCNY pair.
We conclude by noting the announcement by Goldman Sachs today that it is revising downward its previous EURUSD forecasts for the next year, in acknowledgement that they have been over-optimistic in assessing the performance of the Eurozone, and the troubles of the periphery. The bank is still bullish, however, with a 6-month target of 1.45 vs. previous 1.50, and a 12-month target of 1.50 vs. a previous 1.55.
Gold, and oil are higher today, while the Euro is weakened against the dollar, and the yen holds its ground the against the American unit. Bourses are mixed, with European equities generally doing better than the rest, as American markets demonstrate a very indifferent performance.
Today is mostly a quiet day, but there is some talk about some major European nations, including France, losing their triple A ratings unless strong measures are taken to address the Eurozones problems. The nations on the watch list nowadays are Ireland, Greece, Spain, Portugal, Belgium, Italy. But oddly enough, even France is having a fair share of speculation and gossip depressing its CDS and bonds as bondholders look anxiously at the future, and the few remaining speculators sell to benefit from sentiment. Nonetheless, action is weak as we approach the end of the year, and it looks like this trend will stretch out until the cold days of December are over.
Moody`s, of course, has been slashing ratings and issuing warning about downgrades for quite some time. It is just three days ago on Friday that the agency cut Ireland`s sovereign credit rating by five notches, after warning on Wednesday that it would move against Spain as it sees "substantial funding requirements" weakening the country`s prospects. By contrast, in August Moody`s had stated that France, in addition to U.K. And U.S. would maintain their ratings as they move aggressively to cut deficits, but it seems like the events between then and now have compelled them to change their outlook on anything that is West of Germany. France`s CDS yields have been rising on the back of these developments, reaching an all-time high of 105.5 bps which is almost triple the yield at the beginning of this year. It is now costlier to buy protection on France than on Czech Republic or Chile, which are both rated lower by ratings agencies.
So what is the interpretation of all this? We think that the European CDS market is even more illiquid these days as everyone moves to vacation, but beyond this trivial fact, there is also the somewhat scarier fact of rising correlation across the board in Europe, as markets begin to throw all these nations, as long as they are to the West of Germany, in to the same bag, partly due to worries about contagion, partly because of the recent rapid reversals in markets, and of course, because they want to bring down someone before the game is over in Europe. Some analysts and even academics regard a default in the Eurozone an inevitable event nowadays, and there is a lot of doubt as to whether the Euro itself will survive such a severe test. And once markets begin to question the future of the Euro, there is very little that is immune to suspicion and doubt, which is why we are seeing convergence in the market`s assessment of the regions. It does indeed seem that the market`s general pooling of all these widely disparate economies into a single basket is a little irrational. But at the same time, isn`t it true that there is hardly a signle economy in the world that would be immune to adverse results and crises if creditors and speculators begin to doubt the will and credibility of authorities and governments? This, then, above anything related to markets, CDS, or bonds, is what is driving the rapid convergence that we have been observing in Western Europe these past months. Just like a few years ago it looked like nobody could default, it now looks like just about everyone is on the road to a default. Market sentiment and action is only in part based on rational arguments, but that is something most of us know very well already.
What, then, is in store for sovereign debt in Europe next year? And what about the rest of the world? The rest of the world will probably remain immune to these pressures because traders are focusing on Europe, and there are a lot of target candidates in the area. For at least the six months we`ll keep hearing about potential defaults, austerity, and ever stricter budget plans. At least for the first six months, it seems very unlikely that anyone will default, because most of the nations in dire straights have been funded amply for quite some time into the future. This also coincides with seasonal market patterns, since the first half of the year is generally more bullish than the latter, and as such, we suspect that much of the real action and sweating for the Eurozone will be kept in store for the second half.
Will there be a default in 2011? With Merkel and Sarkozy still in office, we find it hard to believe that any particular nation will be allowed to default. After all, if the E.U. has already spent close to $1 trillion in bailing out nations in order to protect the currency, what is the point of refusing a couple hundred billion more(!) and keeping the edifice intact at least until the next elections? The Euro will of course keep weakening on a year-on-year basis, with its descent being prevented from being a plunge only because of the Fed`s QE2-3-4 series.
In short, then, we don`t expect a default in 2010, and believe that one would only come in consequence of a big public relations disaster or a severe breakup among leaders of the union at a personal and international level. That, of course, is impossible predict accurately, at least as far as we are concerned.
The fireworks, so to speak, will only begin once the current frustration of voters transforms to real wrath at the ballot boxes, as oceans of cash evaporate into thin air even as the promised improvement in growth fails to revive the region`s economies. This is true for not only the periphery, but also for the core, because next year is likely to see weaker growth after this year`s fairly strong performance. In the meantime, all we need to do is to wait and see. It is difficult to purchase the USD with Bernanke standing on our path, and it is nearly impossible to purchase the Euro confidently with all the troubles standing in between. Some would go and gamble into emerging market currencies as a "safe haven" gamble, but we find it difficult to find confidence in anything other than gold as long as the cash channels remain open into world markets.
