EURO Losing Policy Divergence Support

In truth, concerns about the risk of restructuring Greek debt is more immediate than the current US fiscal difficulties. The reality is that peripheral sovereign restructuring would be harmful for most Euro-zone bank balance sheets. Despite Germany being so strong, the last thing that the periphery requires is higher interest rates. Markets have cut ECB hikes for the next year by 60bp in the past week, reducing ‘policy divergence support’ for the EUR.

The US$ is weaker in the O/N trading session. Currently, it is lower against 11 of the 16 most actively traded currencies in a ‘subdued’ session.

With the US debt situation getting a reality check from S&P yesterday, technically there is a lack of a major currency reserve asset. Due to the week that is in it, and because of the immediate risk appetite, JPY and CHF are expected to continue to trade rich to interest rate spreads for the time being.

The USD is lower against the EUR +0.20%, CHF +0.00% and JPY +0.24% and higher against GBP -0.02%. The commodity currencies are weaker this morning, CAD -0.02% and AUD -0.32%.

Yesterday, the CAD decided to break out of its current mundane range, albeit temporarily. The loonies’ demise was due to its guilt by association to its largest trading partner the US. One can throw all the fundamentals out when North American currencies trade as ‘one’ entity.

The CAD fell to its lowest level in almost two weeks outright, as yields on Greek and Portuguese bonds rose to new records, damping demand for riskier assets. The currency underperformed on fears that Europe’s most indebted nations may be forced to reorganize debt payments to bondholders, damping demand for currencies linked to growth.

Last week, Governor Carney kept rates on hold at +1%. The BoC is less concerned about global and US risk as it focuses on the strong dollar. Governor Carney has been trying to talk the CAD down and should be pleased with the recent currency movement. However, once the dusts settles, expect investors to covet the loonie as an alternative to the EUR and the dollar (0.9652).

The AUD has weakened for a second day versus the greenback as a slide in global equities and debt concerns in both Europe and the US is dampening the demand for higher-yielding assets. Risk aversion trading strategies continue to weigh on growth currencies.

The RBA seem comfortable with interest rates at the moment, as highlighted in the released minutes last night. The RBA viewed its policy setting as appropriate, saying it will ‘look through’ higher inflation and slower growth stemming from natural disasters. ‘Headline inflation was likely to be quite high in the March quarter, while GDP would be held down, to a greater extent than earlier assumed’. It’s expected that the RBA will want to see more data that’s not so distorted by weather, which may take some time to come through, before moving on rates again.

The market weakness in commodities and emerging market equities certainly is not supporting growth sensitive currencies. Depending on how risk appetite pans out, these pull backs may end up being a good buying opportunity. Australian yields are still the highest in the G10 and do look attractive. The expected mix of trade surpluses and rising capital inflows should provide support for the currency on these pullbacks (1.0485).

Crude is lower in the O/N session ($105.95 -$1.15c). Oil prices plummeted after S&P’s cut the US’s credit outlook to negative and Saudi Arabia, at the weekend, stating that because of weak demand had forced it to reduce crude output. Saudi’s Oil Minister al-Naimi said that the global ‘market is oversupplied’ with crude, forcing them to cut output last month by more than +800k barrels a day.

Last week the IEA said it maintains its 2011 global oil demand growth forecast but noted that the high oil prices are beginning to dent demand growth based on its preliminary data for January and February. Both the IEA and IMF have said that prices above the $100 watermark are beginning to hurt the global economy. Even Goldman is recommending to investors to take profit on the one directional commodity trades. Averting to risk aversion trading strategies is also pressurizing this liquid commodity. Market remains a better seller on rallies.

Gold has raced to another record on speculation that the sovereign-debt crisis in Europe will worsen and after S&P revised its US credit outlook to negative. Investors are looking to gold as the ultimate currency. Fundamentally, prices are supported on speculation that record-low interest rates will encourage demand for an inflation hedge amid expectations that the Fed will maintain its accommodative monetary policy in the medium term. Gold, as a non-yielding asset, has a higher opportunity cost when interest rates rise.

The precious metal has become the currency of choice despite Goldman recommending last week that if one owned commodities, the risks outweigh any further potential gain. The metal has jumped +29% in the past year.

The metals bull-run is far from over with investors continuing to look to buy the commodity on dips. Any price pullbacks are viewed as favorable opportunities for investors to continue to diversify into safe-haven assets, especially metal being used as a store-of-value ($1,494 +$1.20c).

The Nikkei closed at 9,441 down-115. The DAX index in Europe was at 7,053 up+27; the FTSE (UK) currently is 5,902 up+33. The early call for the open of key US indices is lower. The US 10-year backed up 2bp yesterday (3.39%) and is little changed in the O/N session.

The long end of the US curve rallied, pushing treasury prices temporarily lower after S&P cut the US credit outlook to negative. Big picture, if funding costs were to rise significantly for the US government, then we can expect it to weigh on economic growth and not be positive for US companies.

It’s worth noting that the cost to protect US corporate bonds from default rose to their highest level this month. Treasuries have managed to pare some of their initial losses as speculation rises that Europe’s debt crisis is worsening. Together, this is forcing a loss of risk appetite in this shortened trading week and making it more expensive for the Fed to buy as much as $11.5b of treasuries to keep rates low and spur growth as part of their QE2 program this week.

The 10-year benchmark has a good chance of retracing all the way back to its recent highs of 3.58%.

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