For a day with limited data, there are plenty of leftovers to chew on: the Federal Reserve’s meeting last Wednesday, the European Central Bank’s unimpressive TLTRO and now the Scottish vote. This was supposed to be a “mega-week” of important events and trading opportunities. Expectations of important news weeks rarely turn out that way, as markets mostly discount results beforehand, or take plenty of time to digest important developments.
My taste of the week now drawing to a close is that Europe remains very troubled economically and politically and the markets overestimate the resolve of the European Central Bank, and the efficacy of the tools that it has on hand.
The Fed remains as pragmatic and fluid as before, and the US economic surprise index is at relatively high levels and could be expected to begin to fall, if only to revert to the mean, in response to weakness in China and Europe. Weaker US and weak ECB could suggest the EURUSD does not have much downside left and is vulnerable to a correction higher.
Relief at Scotland vote
The results of the Scottish vote for independence will be known by the time you are reading this, or soon afterwards. The last-minute polls, voter turnout and initial results suggested that “no” would win. While markets were worried that “yes” might triumph, such fears had dissipated during the week. The GBP has been gaining in value. UK shares will almost certainly gap higher following the “no” result.
Longer term, what kind of political mess this creates is unknown. While the marriage of the UK and Scotland will stay, the relationship could become more strained, as Scotland has courted something else on the world stage. This implies that Cameron’s government could sustain some sort of political damage, although in the short term, the outcome will be seen as a victory. The effect on separatist campaigns elsewhere are also unknown.
The weekly and daily charts show that this week belonged to the JPY and GBP,. The EURUSD failed to provide much excitement, even though it broke to new lows and the event calendar was supposed to make it “the pair of the week”. Note that the EURGBP is nearing possible target areas, while the GBPUSD is back to where it was before the Scottish scare begun. The weekly EURUSD candlesticks show two “hammers”: both the current and the previous week have opened and closed toward the high end of the week’s range, suggesting that the market is not comfortable to probe to new lows as yet.
German weakness
Germany August producer price index (06:00 GMT) is expected to show a fall of 0.1% from the previous month and a fall of 0.8% from year ago, both unchanged from July. Excluding energy, the price index is expected to be almost flat, with 0.1% increase both for the month and from a year ago. Germany’s low inflation and lower inflation outlook are the result of lower energy prices and worsening economic outlook, as this week’s ZEW sentiment index continued to indicate (see also James Picerno’s note for more).
The German weakness is partly explained by the pain from economic sanctions against Russia, but the longer the current situation persists, the more accommodative Germany might become toward ECB quantitative easing. Next week brings us Markit’s purchasing manager indexes and the Ifo index, which are not expected to suggest a near-term turnaround. At the moment, German bad news could actually be good for the rest of Europe.
LTRO repayment (11:00 GMT)
The low take-up of the Targeted Longer-Term Refinancing Operations (TLTRO) yesterday ignited some fears that measures already announced by the ECB will be inadequate and incapable of fulfilling the ECB's stated goals, making the case for quantitative easing in government bonds stronger. See my article published yesterday for a deeper discussion.
The trend in the EURUSD has been somewhat confused lately. Traditionally, monetary easing has weakened the euro. Meanwhile large Long-Term Refinancing Operation (LTRO) repayments have strengthened it, as have small take-up of new loans from the ECB. Now smaller-than-expected monetary easing is acting the other way around, as the more the ECB misses its goals, the more likely an eventual massive attempt at monetary easing through the QE becomes.
This partially explains yesterday’s market reaction in the EURUSD. At first, the small TLTRO take-up led to a fall to new lows, but the markets quickly turned around. I am not sure if the markets are beginning to doubt the probability of QE yet. A good starting point would be to look for today’s LTRO repayment, and if the euro reacts negatively to a large repayment, then QE believers are still in the lead.