FYI | Jul 13 2012
– Europe to moderate over the quarter
– China softening expected to slow
– Long-term versus short-term bond yield spread a key risk indicator
– European stocks to outperform US peers near-term
By Andrew Nelson
Investors are now living in a time with more questions than answers. What will happen in Europe? Will the US recover and if so, when? How much will a flagging China drag down the Australian market and economy? With no answers at hand, this quarter is shaping up to be one of the more fascinating in recent times.
In an attempt to plot the path ahead over the next few months, analysts at Forex.com have taken a look at both the fundamental and technical pictures for financial markets. The company’s latest report, “Is there a light at the end of the tunnel?” tries to answer some of these nagging questions and a few more.
Let’s start with Europe where market sentiment is still cautious post the latest summit meeting. Global markets are holding surprisingly steady, accompanied by a slight decline in risk aversion. For the most part, markets are remaining calm and while the end of the EU story is still a long way off, it seems the steps taken at the June summit may have been a step in the right direction.
The report recommends keeping an eye on the Italian and Spanish bond yields in the weeks and months ahead. This is especially so for the spread between 10-year and 2-year Spanish bond yields, which is noted as a useful indicator to show extreme stress in Europe’s bond markets.
Look for short-term yields rising at a faster pace than long-term bond yields, says Forex.com, as this indicates sovereign concerns are extreme. Since the summit, 10-year yields have already started to increase at a quicker pace than short-term yields. A closing in this gap is seen as a good indicator that risk aversion could grip the wider market.
There are other looming risks in Europe that are political in nature. The upcoming election in the Netherlands has turned itself into a vote on eurozone membership. This is not great news given Holland is one of the few AAA-rated countries on the continent.
Finland, along with the Netherlands, also wants European preferential treatment if a member state defaults, putting private bond holder at the end of the line. The report notes this both makes building functional union more difficult and could also lead to bouts of risk aversion in the markets.
This lead Forex.com to think the euro won’t be staging any big comebacks any time soon. However, they do believe the downside is limited given short euro positions are already at extended levels and because the prospect of an economic re-slowdown in the US could see the Fed move on to QE3, a definite greenback negative. A range between 1.20-1.27 is expected this quarter. Unless Greece, Spain, Italy or whoever falls over.
The report predicts a little more excitement in the euro-commodity currency crosses, thinking the EUR/AUD to plumb to new record lows over the coming months. The first big barrier is the 1.22 support zone from February this year. A significant break below this opens the way to 1.20.
Indicators from China have been growing increasing weaker, but Beijing has acted just as quickly to provide support to the economy. None the less, investors, especially those in Australia, are warily watching the situation. Forex.com expects the People’s Bank of China will likely continue to ease monetary policy in the months ahead. Yet while the report acknowledges this will have a beneficial effect, it will be more about slowing the fall than reversing the trend.
With economic activity likely to slow further in China, closing in on the Government’s 2012 GDP target of 7.5%, and with the eurozone at the gates of recession, economic uncertainty is prompting a flight to safety. Bond yields in the US, UK, and Germany have reached record lows and Forex.com expects the uncertainty to remain high, which makes investors risk averse and unwilling to invest in businesses and spending.
More of the same if not a little worse is predicted for the UK in the months ahead. QE isn’t working and is less likely to for the time being, while growth levels are expected to remain flat for the rest of the year. While have the upcoming Olympics have been heralded as an economic boon, the report sees little positive impact on growth or help for the pound in the coming quarter.
Forex.com has the GBP/USD trading between 1.5350-1.5800 over the quarter, although there is some downside risk if a bout of risk aversion sparked by another eurozone panic occurs. Ultimately, any weakness in the pound is expected to be limited given weakening signs from the US could drag on the dollar.
In Australia, Forex.com expect things to stay trudging along, seeing the possible chance of maybe one 25bp rate cut during Q3. Demand for resources is not expected to pick up significantly during the quarter given China is still a-ways from turning the ship around. An Australian GDP growth rate of around 1.6% is expected.
High interest rates, a solid economy when compared with Europe and North America and numerous other factors have helped keep the Aussie at or above parity for the last year and a half. However, given the prospects of further monetary policy loosening and severe amounts of global uncertainty, it the report deems it unlikely for the AUD/USD to remain where it is.
On the technical side, the report notes the AUD/USD has pushed past a major resistance level around 1.0225, leaving the past clear for a push towards 1.0500. Were the Aussie to break past 1.0260-1.0270, then a push towards 1.0500 is likely. If there isn’t a clear break, then the pair could head back towards parity, with a drop below 0.9970 suggesting more possible downside, possibly towards 0.9580.
The report goes on to demonstrate how the Gold/Silver ratio provides a very good read on risk appetite in the market. Both metals are regarded as traditional safe havens and hedges against inflation, but silver accounts for a much larger share of industrial demand than gold. That means silver will tend to outperform gold when the global economy expands and underperform when it slows. Thus, a lower XAU/XAG ratio promotes risk seeking and a higher ratio suggests risk aversion.
Gold’s recent outperformance relative to silver is has Forex.com thinking we are in another period of risk aversion, especially given the growth prospects on offer in the US, Europe and China.
Further on gold, the report predicts another sharp pullback may be in store. Were the price to drop below the $1520 level over the coming weeks, then a move towards $1445/50 would likely find the next major level of support. Forex.com wouldn’t be surprised at all if this were to occur in September, as this is when the company’s model typically advocates a stronger bullish bias for the yellow metal.
On the energy front, the report predicts further weakness in crude oil – both Brent and WTI – as global growth concerns remain a driving factor. Crude is expected to encounter resistance into US$89-US$92 and for Brent to see gains capped around US$102-US$105. They are both expected to remain under pressure throughout much of July and August, likely seeing them test US$75 and US$85, settling around US$78 and US$89 respectively by the end of Q3.
As far as share markets go, the report sees a good chance of European stocks outperforming US equities. A US slowdown, ironically brought on in part by problems in Europe, combined with the uncertainty of looming elections, could well start to weigh on US stocks.
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