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Risks To Our Eur Views - Goldman Sachs

Fuseworks Media
Fuseworks Media

The China data for August was better than expected.

In particular IP shows a strong sequential improvement.

The big increase in fiscal spending suggests some signs of stimulus.

The data is positive for our paying AUD rate trade, short EUR/AUD and long HSCEI recommendations.

The US releases a batch of important data this week, we are above consensus, particularly retail sales.

Political issues and slowing sequential Euroland activity, point to EUR/USD lower in the near term.

However as protest momentum slows and the market realises that Euroland growth will only slow to trend, EUR/USD may rally sooner than we think.

Indeed given the relative growth differences between Euroland and the US and the latter's imbalances, EUR/USD could trade higher than we currently envisage.

We recommend clients to be short INR/KRW.

1. Overview - Better China Data

The weekend brought a raft of Chinese data for August which was notably better than expected. In particular, IP rose by 13.9%yoy against consensus expectations of a 13% rise. Monthly momentum picked up from 5.7%mom annualised to 14.2%, which suggests activity is climbing back up the cliff it fell off in March. The pick-up in August IP was underpinned by the easing in financial conditions in July and August. Loan growth was also a little better than expected. The other aspect of the data which caught our attention this time around was the 35%yoy increase in fiscal spending in August, which is a fairly substantial rise. This data suggests that the Chinese administration have facilitated some fiscal loosening by stealth which appears to have helped boost activity. In late July, we asked the question in a Global Markets Daily, What if China eases? and it looks like they did indeed ease through August, which is also in line with the observations made by Yu Song and Helen Qiao in their Asia Economics Flash in August. The strength of the China data supports our paying Aussie rates recommendation and short EUR/AUD FX trade. The data is also favourable for our long HSCEI top 10 trade, which has faced notably headwinds in recent months.

In addition to the Chinese data, the CNY fix has been drawing attention. Today the CNY fixed at a new all time low of 6.7509 and the currency has now appreciated by close to 1% since the beginning of September. In the September FX Monthly, we argued that pressure would step up to stem the degree of intervention in Asian currencies as the US mid-term elections and the G20 meeting in November approached. Indeed, this could be the motivation behind the notable appreciation of the CNY since the beginning of the month (the strength of the activity data could also be a factor). So far, the rest of the Asian currencies appear to have shrugged off the magnitude of the move in the CNY. However the TWD, MYR and THB continue to strengthen notably.

In anticipation of broader pressure to stem appreciation pressure we recommended clients to consider being short INR/KRW on the basis that the Korean authorities will be persuaded to tolerate more currency strength and the size of Korea's BBoP will help propel the currency stronger. The choice of India as the short leg reflects India's much more balanced BBoP and negative real rates. In addition, we preferred to express this in only a moderately risk-on way, which is what this cross embeds, rather than through $/KRW, which is much more correlated with risk.

Away from the China data, the US will deliver a slew of important data including August retail sales, IP, inflation, TIC data, the Balance of payments data for Q2 and the usual weekly claims data. We are above consensus on the hard activity data for August - notably so on retail sales where the consensus expects a 0.3%mom rise on both headline and core while we expect 0.6% and 0.7% respectively. On inflation we are in line with consensus on the core measure at 0.1%mom, but below consensus on headline, looking for a 0.17%mom rise vs. 0.3%. If the US data pans out as we expect, it is likely to continue the sell-off in US rates and support the US and equity markets more broadly. As usual, we will continue to scrutinise the BoP and TIC data for the extent of foreign appetite for US assets, which has been weak of late and underpins our Dollar bearish view.

Otherwise, Australian business and consumer confidence data will be key for our trades in AUD and Aussie rates, we expect the RBNZ to keep rates on hold and sound cautious about the outlook, the RBI is likely to hike policy rates by 25bps and finally the outcome of the DPJ presidential race is likely to be key for Japanese assets. If Ozawa wins this is widely expected to be bearish for the Yen given his more concrete comments about intervention, as well as bearish for Japanese rates given his fiscal stimulus plans. At this point, the election outcome is too close to call.

Following last week's release of our latest FX Monthly, we look in a bit more detail at the risks around our EUR/$ baseline forecasts.

2. More Front-Loaded EUR Weakness in the Near-term?

We are currently projecting a decline in EUR/$ to 1.22 over a 3 month horizon. The main reasons for this move are two-fold. First we have been highlighting for a few months that the return from the summer holiday period will likely see the re-emergence of fiscal/political concerns. Moreover, there is also anticipation of a sequential slowdown in the Euro-zone as growth slows to levels more consistent with trend demand growth.

On the first point, the post-summer period is important as many reform and consolidation programs enter the implementation stage which may bring home to the population what fiscal consolidation actually implies. A number of European countries have held strikes mainly in the public or related sectors. France saw a large-scale protest against pension reforms last week, widely seen as a success for the local trade unions. There is a strike planned for September 23rd and unions in a number of countries, including the UK, are calling for a Europe-wide strike on September 29th. In addition, government popularity in key Euro-zone countries continues to decline or stay at very low levels, including France, Spain and Germany.

At least at a Europe-wide level significant progress has been made on the policy front, notably via the creation of the EFSF and the involvement of the IMF. It should also be noted that many polls point to solid underlying support for reforms (a majority of the public supports - or at least recognises the necessity for - both pension reform in France and fiscal consolidation in the UK). But that doesn't rule out a more negative reaction in the meantime. Amid public protests and declining poll ratings markets could well start to question governments' resolve to push necessary macro and fiscal reforms through - a factor that could weigh on the EUR. .

Our growth forecasts are also consistent with only softening in the Euro exchange rate but only as a temporary phase. As we discussed in some detail in the FX Monthly, the chances are quite high that the macro data in Europe will continue to slow for a few months from extremely high sequential rates in the spring and summer. But we think the decline will be relatively limited and, relative to the market, we are more pessimistic about activity in the US than that in Europe.

Overall it appears quite possible that EUR/$ troughs notably earlier than the 3 month horizon. But given that this reflects our shortest regular forecasting horizon, we have decided to keep the numbers unchanged for now until we see indeed more evidence of stabilising momentum and reduced political tensions.

3. More USD Weakness Than Projected?

The second main risk to our current forecast path, i.e. even more USD weakness, needs less explanation, given we set out the case out in some detail in the FX Monthly. Bottom line is that we see bigger macroeconomic imbalances in the US, which are difficult to correct without involving notable USD weakness. This week brings the US balance of payments data for Q2 and the July TIC data, both of which are likely to highlight the fragility of the US external balance.

Markets may soon start to refocus on the "twin-deficits", or faltering domestic demand and the need to reclaim manufacturing jobs lost to the rest of world in recent years. Even the reserve currency issue may become a talking point once again. And when combining our relative transatlantic views on monetary policy with comparisons of domestic and internal imbalances, upside risks to our longer dated EUR/$ forecasts in the high 1.30s emerge.

In order to embed such risks in our forecast path we first need to see evidence that the very latest moderate improvement in US data really is only temporary. The upcoming business surveys, in particular the ISM will be particularly important in that respect.

4. Current Trading Views

The following trading ideas from the Global Markets Group reflect shorter-term views, which may differ from the longer-term "structural" positions included in our "Top Trades" list further below.

In FX:

1. Stay short $/CNY via 1-yr NDFs, opened at 6.7550 on 10 June 2010, with a target of 6.50, and a 1-day stop of 6.83, now at 6.6761.

2. Stay short MXN/CLP, opened at 41.19 on 05 August 2010, with a target of 38 and a stop on a close above 38.50 (tightened from 43), now at 38.6456.

3. Stay short EUR/AUD, opened at 1.3750 on 9 September 2010, with a target of 1.30 and a one-day stop on a close above 1.4150, currently at 1.3757.

4. Go short INR/KRW, opened at 25.11 on 13 September 2010, with a target of 23 and a stop on a close above 26, now at 25.0599.

On Rates:

1. Stay short an equally weighted basket of 5-yr CDS spreads in Poland, Korea, China and Czech, opened at an average spread of 115 bp on 17 June 2010, with an initial target of 75 bp and a stop-loss of 140 bp, now at 105.6 bp.

2. Stay short UK inflation vs. long Euro-zone inflation through 5-yr zero coupon swaps, opened on 09 July 2010 at 1.63%, for a target of 1.2% and a close set at 1.85%, now at 1.42%.

3. Stay short 5-yr AUD swaps vs. 6-month rates, opened at 5.09 on 03 September 2010, for a target of 5.60 and a stop on a close below 4.80, now at 5.35.

4. Hold steepeners in EUR 10s-30s vs. flatteners in GBP 10s-30s, opened at -35bp on 03 September 2010, for a target of 0 bp and a stop on a close below -50 bp, now at -34.3 bp.

5. Go long 10-yr Italy vs. France, opened at 112 bp on 03 September 2010, for a target of 70 bp and a stop on a close above 130 bp, now at 106 bp.

6. Go long 30-yr Greek GGBs, opened at 54c (ask) on 03 September 2010, for a target of 60c and a stop on a close below 50c, now at 55.00c (bid).

Equity Trading Strategies:

Stay square.

5. Recommended Top Trades for 2010 (opened on 02 December 2009 unless otherwise stated)

1. Stay short S&P 500 Dec10/Dec11 Forward Starting Variance Swap, opened at 28.20, with a target of 21, now at 30.74.

2. Stay long Russian Equities (RDXUSD), opened at 1645.9 for a target of 2050, now at 1647.65.

3. Stay long GBP/NZD, opened at 2.29, with a target of 2.60, now at 2.1151.

4. Close short 2-yr GBP swap rates vs. long 2-yr AUD swap rates on a 1-yr forward basis, opened at -268.5 bp, for a potential loss of 24 bp (inclusive of carry).

5. Close short 2-yr TRY rates through cross-currency swaps, opened at 8.77%, with a target of 12.0%, for a potential loss of 168 bp (inclusive of carry).

6. Close long 5yr credit protection in Spain vs. short 5yr credit protection in Ireland at 13 bp, opened at 70 bp, with a target of 20 bp, for a potential profit of 2.9% (inclusive of carry).

7. Stay long the GS FX Growth Current, opened at 103.5, with a target of 111.8, now at 105.4.

8. Stay long PLN/JPY, opened at 32.1, with a target of 37.5, now at 27.3945.

9. Stay long Chinese Equities (HSCEI), opened at 12616.01 on 01 April 2010, with a target of 15000, now at 12113.03.

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