On to Draghi/Bernanke Duet

<p>As the ECB heads into today’s meeting, markets are aware of Draghi’s desire for further centralized supervision & unified banking, but most of all aware […]</p>

As the ECB heads into today’s meeting, markets are aware of Draghi’s desire for further centralized supervision & unified banking, but most of all aware of the central bank’s remaining bullets, which include:

i) Slashing the refinancing rate to 0.5% from 1.0%– could be used for a new round of LTRO at lower rate & but not necessarily 3-year period (seen as among last remaining solutions & unlikely at this time unless liquidity deteriorated further);
ii) Renew its bond purchases, which have been inactive since late January (could begin gradually before more LTRO);
iii) Extend Emergency Loan Assistance to Spanish banks (highly unlikely without formal IMF assistance).

We expect the combination of Draghi’s willingness to lower interest rates (indirectly signaled by downgrading CPI) and Bernanke’s hinting at “further action” in tomorrow’s speech is seen boosting EUR/USD towards the $1.2630s, at which point we could see an extended consolidation ahead of this month’s FOMC & Greece elections. Any further bounce is seen limited at $1.28 before the current downcycle resumes and attains our projected target of $1.18 for end of Q3.

Despite the broadening dynamics of a risk-off environment (dismal US jobs report and financing deadlock in Spain), the current rebound in EUR/USD, stabilization in gold and pullback in the USD is a reflection of 3 factors:

1. Escalating expectations that QE3 is inevitable. But such reflexive moves (rising gold and falling USD) disregard the possibility that any quantitative easing from the Fed will be sterilized by sales on the shorter-maturity notes, regardless of whether MBS or US treasuries are purchased on the long end. The round of asset purchases proved that Operation Twist (sterilized purchases) was not sufficient in countering market selloff by itself.
2. Increasing expectations of coordinated intervention from G7, Troika(IMF, EU & ECB) aimed at: i) weakening the yen; ii) using EFSF funds to partially recapitalize Spanish banks; and iii) coordinated FX swaps led by the Federal Reserve.
3. Bernanke shall re-assert his dovishness this Thursday as has been hinted at by other FOMC members that Fed is willing to turn-on QE3 to help tackle market dislocation resulting from European factors.

Announcement effect may work but unsustainable. Any renewed USD decline is likely to remain a corrective move (temporary), which could last into the end of summer, before fresh flight-to-safety re-emerges on the realization that:

i) Spain will require at least EUR 250 bln in fresh capital;
ii) Policy uncertainty in Greek austerity;
iii) Fundamental erosion in previous risk-on currencies (Further easing by Reserve Bank of Australia, reversal in Bank of Canada’s path towards tightening, Cyclical shift in Kiwi).
iv) Cooling off in US consumption as signaled in slowing retail jobs;
v) Deepening BRICs weakness (shown in Brazil rate cuts & Indian GDP slump);

Aussie GDP Rebounds, but so does Deficit
Australia’s latest GDP figures showed a 1.3% increase q/q, the highest since Q2 2011, confusing some traders about the RBA’s decision to slash rates by 25-bps earlier this week. But beware of the ongoing deterioration in Australian’s trade figures, which could begin weighing on growth. Tuesday’s release of Q2 current account balance showed the deficit shooting up to 4.10% of GDP, the highest since Q1 2010. Meanwhile, all of Australia’s three PMI indices (services, manufacturing and construction) are in the 40s territory.

Although the RBA made its fourth interest rate cut in less than 12 months, dragging the overnight rate to 3.50%, Aussie banks continue to resist calls to trim lending margins. Banking sources say dragging rates to the 2009 levels would hinder lending margins and “place the banking system at risk”.

AUD/USD technicals suggest the current bounce could garner further ground towards parity before encountering resistance at 1.0140s.

Ashraf’s CNBC interview earlier today(view here) commenting on latest Aussie GDP, Bank of Canada policy decision, previewing ECB announcement, Bernanke & the EUR/USD outlook as well as risk currencies. Also, distinguishing between mudding policies & real solutions.

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