November 20th 2011: Weekly preview - Hope and fear will continue to trade blows
A lack of liquidity is likely to be a key feature over the forthcoming week and this will amplify the threat of volatile trading conditions, especially if there is a further tightening of margin requirements across the exchanges. The US Thanksgiving Holiday on Thursday will severely undermine trading volumes and there will be lower than normal liquidity on Wednesday and Friday as well. The balance of hope and fear will have a critical role to play over the next few days as policy-makers battle to respond to the escalating financial crisis. Given the underlying deadlock there looks to be a strong case for selling any improvement in risk as conditions overall are liable to deteriorate further with fear holding the upper-hand.
In this context, the measures of financial-sector stress will certainly be watched extremely closely over the week. On Friday, there was a fresh increase in Libor rates with the 3-month dollar rate rising to near 0.49% from 0.48% the previous day, maintaining the run of increases seen since July, and there will certainly be concerns that the rate of increase appeared to be accelerating which suggest that underlying tensions were getting worse.
Other indicators of financial-market stress are also flashing red warning lights with a rise in Euribor-OIS spreads while swap spreads are close to the highest levels seen during the peak of the 2008 financial crisis. Yield spreads will also be extremely important for the Euro.
Its an old cliché that markets don’t like uncertainty, but there has certainly been a big increase in unknowns in the banking sector as markets try to assess the scope of liabilities and losses within the European sector. This is having an extremely negative impact on confidence as trust is disappearing at an alarming rate with a cut in credit lines. If these indicators continue to deteriorate, risk appetite overall will not improve and institutional funds will be under strong pressure to cut-back positions.
An important strategy of the Euro-zone governments has been to try and stave of any debt restructuring and credit defaults until the banking sector was more secure. This tactic has back-fired spectacularly as fears over the sovereign debt crisis has undermined the banking sector which has also triggered increased recession fears and put even more stress on sovereign debts as yield spreads widen across the Euro-zone. Growth prospects have deteriorated further and the European banks are, therefore, trapped within a negative feedback cycle.
The Euro-zone PMI data will be important for market sentiment during the week with the November flash indices due for release on Wednesday. There has been a consistent slide in the indices over the past six months with the major components all at their lowest level since 2009. The overall Euro PMI index has dropped from a February 2011 peak of 59.0 to a two-year low of 46.6 for October. A further slide in the readings would increase recession fears which would further undermine confidence in the Euro-zone’s ability to avoid recession.
Euro-zone policies will also be watched extremely closely over the week. There will be continuing pressure on the ECB to buy more peripheral bonds and there will also be further attempts at financial alchemy, illustrated by reports of the latest plan to circumvent the ECB charter by letting it lend to peripherals indirectly through the IMF. Internal ECB tensions will need to be watched very closely and the potential for major splits within the bank would severely limit the effectiveness of any fresh policy announcements.
There is likely to be further bad news out of Asia and increased fears over the Chinese outlook as the discovery of hidden losses will increase fears over a hard landing.
The US outlook will, therefore, be extremely important in the short term with increased pressure on US demand to underpin the global economy. There has been some slightly more optimistic US data, but this is likely to be too high a burden for the US to bear for long given the weak fundamentals. The existing home sales data will be released on Monday with revised GDP data on Tuesday. Wednesday will see a cluster of releases ahead of Thanksgiving with durable goods orders and unemployment claims as well as the latest FOMC minutes.
Evidence of improvement in the US outlook will inevitably have a mixed impact on the dollar as the prospect of increased yield support for the dollar would be offset by a net improvement in risk appetite which would also dampen defensive demand for the US currency at least to some extent.
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