EUR, EZ Sovereign Yields Under Pressure, JPY Strengthens

Snowball effect on ECB’s QE extends beyond the Eurozone borders

EUR/USD trends lower as the market remains determinedly short before Wednesday’s ECB meeting and Mario Draghi’s press conference. We are curious to hear what Draghi has to say on the drastic impact of ECB’s sovereign purchases on Eurozone’s money and bond markets. The impact of ECB’s sovereign bond purchases has been so drastic that the market has already started questioning whether it is possible or no to follow through the program until September 2016, the official deadline.

Regarding the matter, we remind that the ECB has committed to purchase 60 billion euro worth sovereign debt every month until September 2016 (or longer if needed). The snowball effect that has followed the launch of the QE program is purely speculative as investors rushed into the sovereign debt markets to compete with the ECB, especially in purchasing the low risk core debt. No matter how low the yields are, as long as the bond prices are set to trend higher, there is a good reason to keep investing. Consequently, the entire sovereign yield curve of the core shifts lower, but also flattens in anticipation that the liquidity in short-term EZ core papers will soon be drained and the ECB will have no choice but to move toward longer maturity debt. The German 10-year sovereign yields hit a fresh low today (0.137%). The distortion introduced by the QE program is multi-dimensional: across the Eurozone countries and along the individual yield curves. First, the core-periphery spreads do no longer reflect the risk-reward ratio within the Eurozone. Even if the ECB applies a two speed program on core and peripheral yields, the core/periphery spreads are set to narrow, whereas the underlying country risks stay unchanged. Second, the demand for longer-maturity core debt is being amplified by the wrong reasons, that hold-off the market from fundamental realities. All in all, the stress on sovereign yields continues to weigh on the EUR.

This shift toward longer maturity Eurozone core debt has started to visibly influence the asset prices even beyond the Euro area borders, with Switzerland in the first line of influence. As the risks of a spill-over to the alternative Swiss markets materialize, the euroswiss futures trade 100.950 as the EUR/CHF tests 1.03 support. The likelihood of an SNB policy intervention is constant yet is not getting aggressively priced in just yet. After all, the ECB meeting has the potential to trigger a relief rally, even though the upside EUR attempts are not expected to be sustainable. EUR/CHF should continue fading toward parity, while levels below the parity could ring the alarm bell for lower SNB rates.

Is this a step back in Abenomics ?

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The USD/JPY weakens as Japanese officials’ pre-election comments have now started to favour a slightly stronger Yen. The fact that Abe’s adviser Hamada pointed at 105 and said there is “no need” to force for BoJ’s 2% inflation target was indeed very interesting, given that the inflation target has been doubled by Abe himself. In desperation, the PM Abe and the BoJ seem to have already started looking for fresh strategy to boost economic recovery. The probability of a policy action at BoJ’s second meeting scheduled for the end of this month is now clearly set to fade and should place USDJPY and JPY crosses under pressure. A break below 118.50/118.94 (technical support / daily Ichimoku cloud base) should pave the way to 115.75/86 (technical support / Jan 16th low).

US focus on earnings

The US session will be driven by major companies’ earnings reports for the rest of the week. Johnson & Johnson (NYSE:JNJ), JPMorgan (NYSE:JPM), Wells Fargo (NYSE:WFC) and Intel (NASDAQ:INTC) announce results before the US open today. The US earnings are expected to have weakened over the past quarter, both on unfavourable weather conditions and the slowdown in economic recovery. Even if this is the case, there is little chance for the Fed to step back from its plans to start normalizing sometime in the second half of the year; June or September stay the most popular bets. Therefore, the potentially weak earnings announcements might revive short-run hope for a later Fed rate hike; however the conviction should stay firmly limited on further dovish shift in Fed scenarios.

Written By: Ipek Ozkardeskaya