Part of this article was originally published to C3X clients on 28 Nov 2011 early Asia trading time and discussed in the C3X live trading room, on Nov 18 2011 when the S&P was at 1160 and AUD/USD below 0.9688, EURUSD at 1.3230 and USDCAD at 1.0480. Markets have already moved in the direction of trends and trading calls that we have published since then.
ES Daily charts
Stochastic have rebounded indicating a rebound while the vortex continues to bearish. We expect ES to pull back to 1230 levels which is a developing *confluence* zone.
EU volatility charts leading us
The EUR volatility has been falling over the last few days even while EURUSD has been tracking Italian Yields. We expect in between the EU auctions, EURUSD will find enough reasons to rally given the falling stress in inter bank lending. The stochastics on volatility are falling to a relatively calm lending market.
AUDUSD Daily charts
AUDUSD is a key barometer for risk. We expect AUDUSD to bounce of key FIB levels .9650 to 1.02 levels in December tracking risk trades.
USD/CAD Daily charts
USD/CAD is leverage play on crude but even then USD/CAD supersede crude over a longer duration. We expect USD/CAD to play ball with risk as USDCAD falls back to 50 MA at 1.0220 levels before Dec is done.
On fundamental side, we believe that the world is about to crash to a crisis that we may not have seen in our life times. Two of the world largest importers of world trade, China and India are now nearly 200 bps of their peak growth rates with both countries slowing sinking into a political quagmire.
In the euro zone, to everyone utter surprise, Germany is becoming the crux of the problem. Macro economic slowdown and credit markets starting to question the very ability of Germany to be the corner stone of EU bailout. The CDS flew of the handle to 120 from under 100 levels though since then have calmed. But it was a stark reminder to Berlin that “Do not take the bond markets for granted”.
As the crisis has spread over the last six months into the larger peripherals, the need for fiscal consolidation from large euro area member states has increased. Austerity in these larger member states such, as Italy and France, clearly weighs more on euro area economic prospects than does the austerity in smaller countries. Six months ago, we were already predicting a significant tightening of the euro area fiscal stance in 2012.
The failure of the EU authorities to find a solution to the sovereign debt crisis means the downside risks are materializing. The ECB will step in as a temporary buyer of Italian and Spanish bonds but treaty changes and fiscal union are coming our way in 2012. But without the compensating moves on the political front, markets will fear this as politically unsustainable.
The trouble is, we fear the impact of fiscal tightening on broader economic activity is itself increasing, that is, the fiscal multiplier is growing. We think this for two reasons. First, the crisis is having a materially greater impact on the bank credit channel. Second, the austerity has been insufficient to inject confidence back into markets, with the danger that it loops back into the economy with no tangible benefits seen in which case a greater level of austerity will be demanded which will then shrink growth even further.
Consumer and Industrial Confidence
The consumer and Industrial confidence in Germany are being dragged down by EU debt crisis. It is a matter of time before the Debt crisis will fully engulf the German economy, something the EUR founders need to happen if their dream for EU fiscal union needs to be realized.
German Debt holding
Significant portion of German debt is held by foreigners and hence making the Germany economy extremely susceptible to volatility.
EU Debt redemption in 2012
In other part of the world, both India and China are struggling with rising Yield and FX issues over and above a slowing consumer growth .
Expected auctions by Italy and Spain are upwards of 500 bn euros. With bond markets nearly calling a strike on Italy and Spain, we expect to be catastrophic defaults across EU zone with crisis dragging right to the German doorsteps. We expect the auctions will drag EUR/USD to parity in 2012.
Spreads are pointing to imminent Inversion
Spreads between 2y and 30 y are falling below key levels which are indicating to severe liquidity crunch which will now boil into the larger economy.
German CDS springing
Italian Yields refusing to calm
Italy, the third largest bond market in the world, is now defining the EURUSD moves. It is no more Germany which leads EURUSD moves, but in a strange sense, Italy defines the EU zone destiny.
On the other side of the coin, US economy has maintained a certain sense of calm but we believe this is temporary.
US home sales
The US home sales while have held up till now are now weakening again. The case shiller index has been stable after a 35% correction but is now ready to begin the decline as financial markets pay scale takes a drop and speculation starts to ebb away given the rising 2Y yields on US treasury (key schemes through which banks and speculators borrowed for speculation).
The Indian economy today has more depth and breadth than a decade ago but it is also more vulnerable to global cycles and high expectations from investors and its own population. A year ago, India boasted the best performing stock market in Asia, surging foreign investment flows, and confidence among observers and policymakers about growth exceeding 9 percent for years to come. In a striking turnaround, a year of persistently high inflation, an anaemic investment cycle, repeated governance scandals, and little movement in market friendly reforms have soured the underlying economic dynamic and market sentiments. Coupled with
substantial headwind from the debt crisis in industrialized economies, much of the exuberance associated with India has dissipated, and India’s perennial Achilles’ Heel, a pernicious combination of trade and fiscal deficits, has come back under scrutiny. We believe that India is on a structural slowdown for the next half a decade thus affecting world growth as a whole of till the time a second reform revolution brings about change.
China’s October trade surplus amounted to USD17bn and inward FDI amounted to USD8bn, the size of outflow of capital (which includes authorized outward FDI, portfolio outflow, private sector purchase of forex, as well as hot money outflows, among others) was substantial. It obviously reflected the expectation of RMB depreciation by some market participants. The negative net forex purchase by the PBOC leads to a contraction of RMB liquidity in the banking system, initially by the amount PBOC forex sales, and over a period of time this contractionary effect will be multiplied by the money multiplier (3.7x time). This exacerbates the downward pressure on the deposit base in the banking system and makes it more difficult
for banks to fund their lending activities. This will have severe consequences for Chinese credit markets as we already see wild volatile movement in China CDS spreads. China may no longer be the net importer of world trade and hence pushing the ball back into US and EU courts.
We believe, far from solving any crisis, the world has sunk deeper into a crisis whose depth and breadth will surprise everyone. Bond markets are ready to come calling as they take no prisoners once they decide to call the bluff. But we also believe that 2012 will see EU fiscal union being enacted post which we expect EURUSD to spring back to 1.5 and then continue the rise given the coming holocaust of US Municipal Bond run starting Oct 2012.
The immediate short term, we expect markets to well bid in Dec till the summit on 9th . We expect EURUSD to recover smartly and risk assets to post gains. The sante rally, however suppressed it maybe, is now upon us. Santa may just be a bit pale this time around.
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