Dollar Advances But Not With The Conviction Of Risk Aversion

You would expect with the US Presidential (and Congressional) election passed, the markets would find their sense of uncertainty moderated. That isn’t what the markets were saying however with the Dow Jones Industrial Average plunging to a three-month low and EUR/USD taking a dive back below 1.2800.

Though there are longer-term business and economic implications of incumbent President Barack Obama winning a reelection, the real concern comes from the divide between the Executive and Legislative branches. With a Democrat President and Senate majority paired against a Republican House of Representatives, the threat of an impasse on the US Fiscal Cliff is far greater.

The risk of a substantial risk aversion and deleveraging move by the global financial markets has been a serious danger for months – made all the worse by the "moral hazard" related to stimulus efforts. In the advance for US equity indexes (excellent proxies for investor sentiment) these past years, we have seen confidence outrun economic performance.

Growth both in the US and abroad has struggled at best and more recently earnings growth has faded. This unfavorable backdrop was tolerated, however, because investors believed that the Fed and other central banks would step in to curb at the first sign of trouble. That said, market participants have ignored growing risks and used greater leverage to chase increasingly smaller levels of return. Such a level of exposure is highly unstable.

Making it a far more volatile situation, the rise in capital market exposure has occurred under severely reduced levels of participation. ICI mutual fund figures (good proxies for the general market) have shown consistent outflow of capital from assets from 2009 despite the advance in the market.

This creates an extremely dangerous mix where risk trends are fully dependent on the hope for more stimulus should markets grow unstable (where the Fed has essentially hit the ceiling with an open-ended QE3) and limited relatively liquidity that can exacerbate the influence of a selloff. All the components are there for a rapid risk aversion move, but those invested have not yet folded. Yet, with the Fiscal Cliff, eurozone crisis, China government uncertainty, Japan budget countdown, downgrade in growth and fading investor confidence; that may only be a matter of time. Last minute saves could come in with a large stimulus program or a miraculous resolution to the Fiscal Cliff, but both are low probability.

Euro Drops Back Below 1.2800 on Growth Downgrades
There were two, headline events for euro traders to respond to today: the European Union Autumn Economic forecasts and Greece’s austerity vote. As it happened, the first drew a reaction from the market and the later was largely ignored. This alone suggests the market is paying more attention to tangible economic issues and affording less faith in means for temporarily holding the region’s crisis at bay. In the later Austerity vote for Greece, Prime Minister Samaras found support for the €13.5 billion in cuts (from pensions and wages, among other places) by a reasonable margin.

Yet, euro traders saw this as an outcome to merely keep the situation status quo. The national head himself noted that the country needed more than the €31 billion tranche of aid this vote would help unlock. More capital, more time and debt forgiveness are extremely difficult to encourage as the region’s economy slows and the floor on capital needs has yet to be found. In contrast, the EU’s downgrade of the region’s 2013 GDP outlook from 1.0 percent to 0.1 percent growth paints a desolate picture. The EUR/USD is looking increasingly heavy.

New Zealand Dollar Plunges after Unemployment Rate Soars
Risk aversion was a prominent fundamental factor this past trading session, but there was an additional weight exacted on the high yield New Zealand dollar. The region’s third quarter employment delivered a considerable surprise to traders. The 0.4 percent drop in the number of employed kiwis through the quarter was far greater than expected and matches the worst pace since 3Q 2009.

Furthermore, the unemployment rate unexpectedly jumped (0.5 percentage points) to a 13-year high 7.3 percent. The hawkish view from RBNZ Governor Wheeler (established just last week) suddenly looks far more suspect. If rate expectations drop, the kiwi could suffer the same fate as the aussie in 2Q.

British Pound Traders Prepared for BoE Meet, EU Budget Debate
The market has a tendency of ignoring the Bank of England’s monetary policy meetings. Under most circumstances, the central bank keeps its policy unchanged. And, even when the MPC does decide to boost its stimulus, the comparatively small level of the central bank’s moves do little to compete in devaluing the currency (versus the Fed and ECB)…and perhaps to also offset the economic slowdown.

However, desperation has increased globally and other central banks have amplified their efforts. We should look for changes to the unusual Funds for Lending program. Beyond this rate decision, we should look to Friday’s EU budget discussion. The UK has taken a strong stance against its mainland counterparts for an increase in spending. In turn, the EU downgraded the UK growth outlook from 1.7 to 0.9 percent.

Australian Dollar Rally on Jobs Data Will Fail Against Risk Trends
Fundamentals always run in order of importance. This morning we were met with a better-than-expected October employment reading. Yet the modest 10,700 jobs added and hold in the unemployment rate doesn’t really fend off serious risk aversion. Be cautious of non-risk advance.

Swiss Franc: Slight Reduction in SNB Reserves Contrasts EU Risk
For the first time in eight months, the Swiss National Bank’s reserves have actually contracted. However, the reduction was modest and the net holding of foreign currency is still extreme. If the euro-area crisis continues to build steam, expect EUR/CHF to return to 1.2000.