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FX Update
Market wants to take a holiday, but will it be allowed to?
John J Hardy, 15 hours ago20 December 2011
Markets are normally very thin during the last two weeks of the year, as many investors and hedge funds have more or less closed up shop for the year and a many are away from their desks on holiday. This year is no exception. And yet, while the majority of market participants might prefer to stay on the side-lines until the New Year, pressing questions remain on the agenda for this week and next, and could yet introduce considerable volatility into year end.
The ECB’s LTRO – a back door QE?
The first of these is the ECB’s first 3-year Long Term Refinancing Operation (LTRO) today and tomorrow, in which the ECB will offer unlimited funds for 3-year loans to banks, which in turn can now employ a wider range of collateral for their borrowings. The hope for some is that the 3-year LTRO will serve as a kind of “back door QE” that sees banks enjoying the cheap borrowing from the ECB to fund purchases of EU sovereign debt (i.e., borrowing from the ECB to lend to EU governments), where yields have soared of late due to default worries. In anticipation of this week’s LTRO, EU sovereign yields have dropped sharply of late. But will the enthusiasm for this week’s LTRO prove justified? After all, a dramatic expansion of investment in sovereign debt by EU banks would represent a leveraging up of bank balance sheets. And EU banks are already the most leveraged in the world and political pressure of late from the various summits is clearly for banks to deleverage. What to look for then from the LTRO? If banks show modest enthusiasm or worse at the LTRO, it would generally be seen as risk- and Euro-negative as it suggests that banks are unwilling to overindulge in the carrots the ECB is extending with this facility. If banks borrow hand over fist, on the other hand, this larger than expected enthusiasm could be seen as helping to feed a further stabilization of the EU sovereign debt market in the near term and thus prove to be Euro- and risk-positive for a time, even if it hardly serves to alter the longer term challenge of the EU sovereign debt picture.
US Politics and the face of the tax cuts
US lawmakers are debating whether and how to renew a number of important US policies that will otherwise expire in two weeks’ time with the end of the 2011 calendar year, policies that were instrumental in keeping the US economy out of recession danger in 2011. The most critical of these policies in focus at the moment are the 2% payroll tax cut and extended unemployment benefits. On the former, the two houses of Congress are divided in their approach, as the Democratic majority in the Senate has led to an agreement on a mere two-month extension of existing policies because no deal could be struck at this time. The Republican-led House, on the other hand, made it clear yesterday that it didn’t like the temporary Senate deal and instead wants to reduce the unemployment benefits from 99 to 59 weeks even if it does agree to the extension of the payroll tax cut. Obama would inevitably veto any such deal. This is yet another in a series of political showdowns, one that could drag on as we enter the critical part of the two- and four-year election cycles in the US next year. If a deal isn’t reached here in the next week or two, the uncertainty could negatively affect markets and generally benefit the USD (which seems to always do well in times of uncertainty, almost regardless of its source.) Fewer hand-outs to the unemployed and an across the board reduction in consumers’ income from higher payroll taxes would directly hit the bottom line of US GDP in Q1 and ensure a whiplash-inducing turnaround in growth after a very robust Q4. Still, odds are that some deal will be reached, even if the drawn out process does not inspire confidence in the near term.
Either of these two issues could easily drive the USD out of the very tight range it has established over the last week.
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