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Thursday, 24 November 2011 11:36

EU Contagion Spreading to Germany; French and Italian Debt Auctions Next Week

The Week Ahead


  • EU contagion spreading to Germany; French and Italian debt auctions next week
  • Global growth outlook deteriorates
  • Risk assets in full retreat

EU contagion spreading to Germany; French and Italian debt auctions next week

On Wednesday, Germany was only able to sell about 2/3 of the EUR 6 bio in 10-year government bonds on offer, making it the sixth of the last eight bund auctions that went undersubscribed. But the amount left on hold was the highest proportion of unsold 10-year debt since 1995. While the German finance ministry downplayed the shortfall as ‘technical' in nature, it strongly suggests that investor fears are now engulfing the bulwark of the Eurozone. The failed auction comes on the back of continued insistence by the German government that Eurozone common bonds are not an option, not that such bonds would necessarily find takers anymore.

Investors were earlier unnerved by reports that the French/Belgian bailout of Dexia was unraveling, potentially requiring further capital guarantees by both governments, which many fear could lead to credit rating downgrades for the two sovereigns. The Dexia reports may have simply hit a raw nerve in already stressed Eurozone debt markets, leading to a spasm of fear that undercut the German auction. We are cautious that this may be only a one-off ‘buyers strike' for German debt, as the solvency of Germany is beyond question. But we are also acutely aware that further erosion in Eurozone debt markets highlights the potential burden on Germany and other core members to the rest of the Eurozone. We will be closely watching the results of debt auctions next week by key core-Euro members Belgium, Italy and France as a key gauge of near-term investor sentiment.

Global growth outlook deteriorates

Risk assets and global markets were further roiled by China's advance November manufacturing PMI which fell from 51.0 to 48.0, below the critical expansion/contraction threshold of 50. Preliminary November Eurozone manufacturing PMI's also fell further into contraction territory (47.1 to 46.4), highlighting the ripple effect of Eurozone slowing on the global economy. US durable goods orders for October also disappointed to the downside, but US manufacturing is expected to remain resilient as firms rebuild inventories and seek to take advantage of an expiring government tax credit on investment. Still, heading into the final month of the year, all indications are that 2012 is likely to get off to an anemic start in global terms. Thursday will see German November IFO economic outlook gauges followed next week by Nov. EC Eurozone confidence gauges, which are likely to mirror declines seen in today's PMI's.

While we have been expecting incoming Eurozone data to depict a likely 4Q negative-GDP reading, declines in Chinese data and the fiscal deadlock in the US, potentially leading to expiring tax breaks at the end of the year, increase the risks of a more severe global downturn ahead. We think this will keep investors risk averse and support the USD into year-end. The most recent FOMC minutes suggest to us that investors' last best hope (QE3) remains a distant mirage, with Atlanta Fed Pres. Lockhart (non-voter but well-known dove) in separate remarks indicating that QE3 should be reserved for recessionary conditions. As such, we would not expect any presents from the Fed's next meeting on Dec. 13. There is some hope that US legislators will move shortly to extend expiring payroll tax cuts, but that represents maintaining the status quo as opposed to fresh stimulus, so we continue to anticipate overall weakening global growth conditions.

Risk assets in full retreat

Given the negative news flows in recent days and weeks, risk sentiment has experienced an abrupt set back, which we highlighted in last Friday's outlook. The damage done this week, so far at least, has been significant on many assets price charts. But we are always leery of moves occurring in holiday-thinned conditions and around month ends. As such, our preference is not to chase the current decline in many risk assets, but instead to actively protect short-risk positions in case of a squeeze higher if it turns out to be only a temporary liquidity-driven slump. Below we highlight near-term resistance levels for key risk assets, where we would exit shorts on rebounds. Longer-term, we remain alert for bounces on which to re-enter short-risk positions at more advantageous levels.

EUR/USD: downside potential remains while below 1.3400/20 on a daily closing basis. The drop below that level exposes potential to the early Oct. lows at 1.3140/50 as an initial target, followed by the 1.2860/90 lows from January.

GBP/USD: we expect further downside while below 1.5650/5700, with a daily close below 1.5500 targeting further weakness to the Sept./Oct. lows in the 1.5280/5370 area initially.

AUD/USD: downside potential while below the most recent breakdown level of 0.9800/20, with scope to Oct. lows in the 0.9400/9500 area.

S&P 500: we look for further weakness while below 1190/1195, where the top of the daily cloud rises to next week (price last inside the cloud). A daily close below the bottom of the daily cloud (currently 1153/54), which rises to 1165/66 next week, will open up scope down to 1100 initially with potential for a fuller retracement to the 1075 Oct. lows.

WTI crude oil: further weakness is expected while below the 99/100 daily Tenkan line and a drop below the psychologically significant 95 level (Kijun line last at 93.75) potentially triggering sharper declines to 84/87 area, where the top of the daily cloud is set to span over the next week.

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