The question of whether FX traders will continue to ignore yearend risks is a question about whether the recent recovery in currencies and equities is a bottom or a pause before further losses. The sentiment in the financial markets improved dramatically in last week’s shortened holiday trading week. Having fallen nearly 8% between October 19th and November 15th, the S&P 500 is now close to 5% off its lows. The EUR/USD also rallied 2% last week and while this may not seem to be a lot, it is significant when considering that the EUR/USD only lost 3.45% of its value during the same period. We never want to complain about a rally in the financial markets, especially after such a deep sell-off in risk but investors are blatantly ignoring the elephant in the room, which is the U.S. Fiscal Cliff. This raises the question of whether the fiscal cliff risks are overblown or another correction is near.

While the Fiscal Cliff poses the biggest risk to the financial markets, euro area policymakers have yet to make a decision to release Greek aid. Even if an announcement is made after today’s meeting, economic adjustment in Europe is a long process that will affect growth for years to come. The recent focus has been on Greece but Spain has not fallen off the radar. Early elections were held in Catalonia last night and it is widely believed that the Prime Minister Rajoy has been waiting for elections in Catalonia to pass before actively considering a bailout. The Prime Minister has also made it clear that he would not consider one without knowing the terms of the bailout. Yet with Spanish 10 year bond yields below 6%, the urgency has receded. The ECB’s OMT program has not been tapped but the mere offer to buy Spanish bonds has been enough to stabilize borrowing costs and Spain will want to ride this train for as long as possible. Unfortunately the longer Spain waits, the greater risk it poses to their credit rating. France just lost their AAA rating from Moody’s and further downgrades could be in store for Europe.

Last Minute Deal for Greece and the U.S.?

Yet currencies and equities rallied last week because investors hope that lawmakers will reach a last minute deal on Greece and the Fiscal Cliff – time is running out and they need to deliver. While it is still possible that aid may not be disbursed to Greece in time to avoid a default, which would be disastrous for euro, the decision by Euro area Finance Ministers to resume their talks on Monday suggests that they are committed to announcing aid disbursement and soft debt restructuring measures as soon as possible. It is clear from the rally in the euro that investors are hopeful. We also believe that a deal will be sealed, eliminating a major source of near term risk for the financial markets. If and when an announcement on Greek aid disbursement is made, we expect a relief rally in euro.

Congress is back from their Thanksgiving recess this week, which means negotiations on the fiscal cliff need to get under way quickly. With only 5 more weeks to go before the end of the year, if we include the holidays in December, Congress has even less time to reach an agreement on debt reduction measures that would spare Americans from the harsh economic consequences of falling off the cliff. Indications out of Washington suggest that a last minute deal will help the U.S. avoid the fiscal cliff. On Sunday, lawmakers from both the House and Senate said all options need to be considered and while we do not believe that a full blown grand sweeping deal will be reached in the next few weeks, we anticipate a partial deal that would give lawmakers breathing room to discuss broader reforms in the New Year. There are some areas of agreement such as closing loopholes, limiting tax deductions and extending tax cuts for middle and lower income earnings.

Aside from expectations for a last minute deal on Greece and the U.S. fiscal cliff, better than expected economic data from China is also easing the pain and helping to fuel the recovery in risk appetite. A positive resolution to the 2 biggest risks to the financial markets at the end of the year could help to sustain the rally in currencies but when it comes to politics, we have seen talks break down quickly and so we can’t rule out the possibility of no deal before the end of the year. If lawmakers let the U.S. economy fall off the fiscal cliff, it could set off a sharp sell-off currencies and equities.

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