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The dark storm clouds that engulfed financial markets on Monday dissipated somewhat yesterday, with North American equities managing to claw back a portion of those losses as investors out bargain shopping bid the S&P up 0.76% (a retracement of roughly 38.2% from Monday’s drop.)   Investment flow out of bonds and into equities yesterday saw yields on 10 year US debt climb higher, closing above the 2.6% handle, while the VIX dropped to 19% as protective hedges were unwound.

The optimistic mood quickly soured as the overnight session began, with S&P futures dumping quickly after the cash close when the S&P rating agency downgraded the Commonwealth of Puerto Rico to junk status.   Citing limited liquidity, an increase in debt service burden as near-term maturities are rolled at higher interest rates, and continued economic weakness, the S&P rating agency warned there is little margin of error in the short-term, with increased difficulty in financing any larger than anticipated future deficits.   The crux of the matter, and what investors will now surely be focused on, is if there will be an contagion effects from the Puerto Rico ratings cut, especially since S&P has noted that the government might face a collateral call on its short-term debt obligations in the neighborhood of $1bn.

Despite the fresh round of emerging market worries seeping through markets after the North American close, the Nikkei managed to finish higher by 1.23% and gain back some of the lost ground from earlier in the week; however, USDJPY has failed to follow suit, and is banging around the 101 handle as we move throughout the European session.

Turning our attention towards Europe, Retail Sales and PMI data in the Eurozone were released overnight, with both printing on the soft side of expectations.   Retail Sales for the month of December dropped by 1.6% on a m/o/m basis, well lower than the anticipated decrease of 0.7% and the downwardly revised November reading of a 0.9% increase.   Service sector activity also disappointed compared to what economists had forecast, with weakness in the German survey dragging the zone down to 51.6 vs. expectations of 51.9 print.

This comes ahead of the European Central Bank rate decision  tomorrow  morning, where it is anticipated that the central bank will leave rates on hold at 0.25%.   While there have been many ideas floated as what the ECB can do to grease the monetary policy transmission mechanism to stoke inflation and boost economic growth (a further cut in the benchmark lending rate, negative deposit rates, ending the sterilization of SMP bond purchases), the strategy that would seem most likely to us is one that involves the ECB purchasing ABS and other securitized product from bank’s balance sheets.   This would appear to be one way to try and free up access to credit in the SME space, and likely have the most success in achieving credit generation for private business.

Keeping the focus on the ECB, there has been chatter from sources that members of the governing council have mixed views on the disinflation currently being experienced in the zone, but that unanimity of the governing council is no longer required for approval of policy changes.   This leads us to believe that Draghi’s position will be key heading into tomorrow’s meeting, and puts more weight on the corresponding press conference after the decision on rates has been made.

While we don’t think the ECB will announce anythingtomorrow, there is a strong likelihood Draghi will elaborate further in regards to the monetary policy tools available to the ECB should inflation deteriorate further, with the dovish slant making us cautious in regards to oversized long EUR positions heading into tomorrow’s announcement.   Corporates that are buyers of EUR and looking to cover off some of their near term exposure might want to utilize a trailing stop, allowing you to participate in any weakness in the EUR should Draghi’s press conference convey a dovish slant, while still protecting against the possibility of a sharp spike in the EUR if the meeting doesn’t play out as expected and short-covering pushes the EUR higher.   The EUR is marginally higher against the USD this morning, making its way into the mid-1.35s as we enter the North American cross.

As we get ready for the North American open, a few key data points from both sides of the 49th  parallel just hit the wires.   The ADP Non-Farm Employment Change was just released, and showed that the American economy created 175k private jobs over the month of January, slightly less than the 180k that had been forecast heading into the release.   The report showed that the majority of gains were in the construction sector, with weakness in manufacturing and finance, but the real question is how this report flows through to Friday’s number from the Bureau of Labour Statistics.   Obviously there is a little skepticism surrounding the correlation after last month, but investors are not exactly happy with the slight miss in ADP, as futures begin to deteriorate on the back of the softer jobs number.

On the Canadian side of the border, building permits for the month of December fell by 4.1% compared to November, a wide miss of the 2.0% increase that had been anticipated, and the second consecutive month of decline showing stark weakness heading into the end of 2013.   The Loonie has retraced the majority of the early morning gains it registered on the back of the weak US ADP report, with USDCAD back trading in the high-1.10s after the soft housing data has taken some of the wind from the CAD’s sails.   Loonie traders will want to keep their eyes on Canadian trade balance figures  tomorrow, as the level of export growth for the month of December will have a large bearing on price action in USDCAD considering the importance the Bank of Canada has put on the level of exports.  

Looking ahead to the remainder of the session, US ISM Non-Manufacturing PMI for January is due out at  10:00am EST, with expectations we see a slight uptick in activity from the December report.   The median analyst estimate is to see a print of 53.7, however the Manufacturing PMI from  Mondaysaw a dramatic miss to the downside, so we would caution there is a possibility the service sector also follows suit with a weak reading.   With the market still walking on eggshells after the trying start to February, a print close to, or below, 50 would spark a further bought of risk aversion, causing stocks to head lower and drag high-yielding asset classes with it.

With two central bank meetings and Canadian trade balance figures on tap for  tomorrow, make sure to speak with your dealing teams ahead of the announcements, as limit orders and trailing stops can be used to leg into either hedging contracts or spot orders, and are efficient at utilizing currency volatility to your advantage.

Furhter reading:

ADP NFP: 175K – It could have been worse – USD slightly stronger and then drops

Returning to hype