Expect short-term tumble, but no long-term USD collapse

What a weekend.

I sense that many have been reluctant to get involved in the necessary task of trying to work out what the two almost seismic bits of financial news over the weekend mean.

However many did get involved. I’m trying to distil  – in the simplest, essential way possible – the main themes – these are what are likely to have a large influence on what European markets look like in a few hours.

I will concentrate on the potential impacts of the downgrade of US’s long-term credit rating from AAA to AA+, mostly because inception of the ECB news is less solid and corroborated and looks to be still developing.

Sensibly, views about the downgrade appear to be organising into two main strands – short term impacts and long-term impact.

Short term impacts

The first thing to note is that the downgrade event is not a surprise.

S&P did a good job of warning over the risk of a downgrade and the market’s behaviour since showed it explicitly took the threat seriously.

Even so, the raw impact of the change in circumstances and the enormity of that change, even if it was very widely taken as a quite probable risk, are expected to dent risk appetite somewhat on a short-term basis.

There could be some forced liquidation from some money market funds but the sizes involved will not be that significant and provided there are no major distortions in funding markets due to collateral shifts, one may well find that the effects are transient.

No doubt spreads will be wider in the short term and the loss of a risk free ‘core’  could create some number of unintended consequences.

At this stage, The Fed is not expected, at its meeting this week, to make any signals about the possibility of QE3. Teasing out the factors on that issue are perhaps beyond the scope of what I am trying to do here, and rather quickly, so I’ll leave it at that.

On the other hand, as we know, news suggests Europe’s central bank has decided to act in response to the downgrade although it has chosen to fire artillery it kept in reserve last week.

The news is that the ECB is moving closer to purchasing Italian and Spanish sovereign debt, in an effort to stem the spiralling yields of the two.

The daily run rate of bond buying is estimated to be on average around EUR2.5 billion, equivalent to an annualised rate  of EUR600 billion if maintained over time. In the short term, the ECB intervention is seen as likely to be a fillip to business and consumer confidence, but long term more fiscal austerity and weaker growth are seen a price that has to be paid in a deleveraging cycle.

Also, it’s feared that any attempt to stop the bond purchase programme will lead to renewed dislocation and the ECB will be forced back in as buyer of last resort.

In terms of Treasuries Investors: On Monday, cash-flush and not yet long investors [the majority] are expected to act accordingly.

Even after the 125bp rally in 10-year paper since early April. Dips will be bought. Monday’s close rather than the open is seen as more important to assess the near-term path of rates. Key support and resistance levels to watch in 10yrs today are: 2.33% and 2.865%.

As for forex.

Both AUD/USD and USD/CAD are singled out as likely to retrace further back to parity next week. Both commodity currencies were already under pressure this week.

As for ‘our’ EUR zone

So far, the euro might even be bid! It’s certainly up on the European close. This might not signify anything material however, participation would be on the marginal side at this time of day in any case: throw in holiday effects and just plain old common sense and of course volume is likely to be thin, right now.

EUR is trading close to 1.4375 following Friday’s close at 1.4282, while AUD commenced about 50 pips lower. The CHF move is, as one might expect given the recent trend, the most pronounced with USD/CHF dropping almost 200 pips soon after commencement.

USD/JPY, is having just another day at the office and is well within the recent range – towards the top of it in fact.

Back to the US, the USD and the Long Term Impacts

There has been a consistent trend towards lowering USD holdings by reserve managers for a number of years and while there is no substitute globally at this point in time, the process of diversification is sure to accelerate and could particularly help currencies like the AUD or GBP.

However no major [if any]  forced selling of Treasuries, GSEs, or other fixed income instruments is expected.

Good luck.

ThSM

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