Risk assets bounce back on short covering and mildly encouraging US economic news and rumours of Euro bank rescue

admin10/Oct/2011Currency Updates

Equities and commodities overcame a dismal start last week, and put on a fairly decent bounce from Tuesday’s lows to end the week solidly up amid very high volatility. Fears from the previous week (a double dip recession in the advanced economies, the solvency of European banks in the event of one or more peripheral sovereign defaults) carried over into this week, and stocks worldwide dropped sharply on Monday and early Tuesday. Starting then, a steady drip of better-than-expected US economic news went some way to dispel fears that the US is about to enter recession. Coupled with persistent rumours of extensive public injections of capital into European banks, they brought about a sharp rally in all risk assets; position squaring among fast money that had been extensively short also helped equities. The dollar came off somewhat against emerging market currencies, but still managed to end the week up against the Euro, in spite of the risk rally – a significant development, in our view.


The main news of the week was the meeting of the MPC committee of the Bank of England. As we expected, but somewhat against consensus, it decided to expand Quantitative Easing through the purchase of another 75billion GBP in gilts. The details on the meeting will not be published for another three weeks, but it is clear that the BoE is increasingly worried about the weakness of domestic demand brought about by fiscal austerity. This view received further confirmation with the publication of the 2Q GDP breakdown. While the overall level was revised only marginally down , the details displayed a worse than expected QoQ decline in household demand: down nearly 3.5% saar. This is the fourth consecutive negative number. Had it not been for GBP depreciation, the UK would be in a double dip recession. Sterling dropped sharply after the release of the BoE decision, but it rallied back together with risk assets later in the week to end up unchanged against both the Euro and the USD – a result the belies the high volatility of GBP trading all week.


The ECB meeting was also the highlight of the trading week in Europe. The ECB did not cut rates, but it did increase more than expected the liquidity facilities available to European banks. There will be another two one-year unlimited refinancing tenders, and it unexpectedly announced another 40billion EUR worth of purchases of covered bonds. This funding avenue had been closed to European banks for months, as investors spooked by the European banking crisis had been on a buyers strike through the summer. It also sounded relatively dovish about inflation dangers, which it now sees as balanced, and economic growth, where it sees “intensified downward risks”. In view of all this, it is quite puzzling that the ECB did not also decide to cut rates, and we now expect that rates will be back at 1% before the end of the year. In response, the common currency fell moderately against the dollar.


The US September employment report provided some news that, if not quite good, were at least not disastrous. The number of jobs created surprised to the upside, and previous months data was revised upwards somewhat. One does not want to get carried away: the number of jobs being created is still barely sufficient to keep up with the growth on the labour force, let alone beginning to make a dent in the millions of long term unemployed workers. However, this positive surprise, combined with the better-than-expected PMI data, seem to push off for now the spectre of a double dip recession in the US. We remain moderately bullish on the greenback, and the fact that it managed to rise against the Euro on a week when stocks rose sharply appears to us highly significant.


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