'Equities to trade sideways with negative bias till Sept'

Q: Do you see this resistance to buying bonds also continuing from the Germans, even if Spanish and Italian yields go up sharply as they started to yesterday?

A: Eventually, probably yes. But as of today, there still seems to be German Bundesbank resistance to the ECB acting aggressively in the purchase of Spanish and Italian bonds. On the ECB governing council meeting, Mario Draghi reported that there was a unanimous vote in support of the intervention with one exception. He obviously did not say who that one exception was, but one can assume that it was the representative from the German Bundesbank.

So the message that at least the markets have received today is that there is still Bundesbank resistance to the ECB purchase of sovereign bonds.

Q: The market reaction to yesterday’s statement has not been great, but do you expect this current phase of risk-on to meet with serious challenges going forward?

A: My view is that this concept of 'risk-on' and ‘risk-off' is actually in the process of changing. Clearly, equity markets have rallied since the third week of June, but this week we have had a negative market reaction. Today, I actually think investor flows would be driven by number of other factors rather than these short-term risk-off and risk-on trades.

Having said that, over the next few weeks, probably going into late-August, I am assuming that the markets will probably trade sideways with a downward bias. But as we go into late-August, early September, there is a high probability that global equity markets actually build on the rally that started in late June.

Q: What are your expectations from the US Fed? At the Jackson Hole meeting or the September 13 meeting, are you expecting any firm commitment or of QE3?

A: I think there is a very high probability that the Fed will initiate QE3 that could be USD 600 billion, both in the US treasury market and the mortgage backed securities market. That would take its balance sheet to USD 3.5 trillion.

They may also take action on interest rates that they pay when banks deposit money with the Federal Reserve. That would be the logical thing to do because it would discourage banks from leaving idle funds with the Fed and encourage banks to lend into the real economy.

Obviously Ben Bernanke at the end-August Jackson Hole meeting will give an important policy statement. In that policy statement, I think he is going to continue to air his concerns that the recovery in US economy is troublesome.

Q: Where does all this leave the euro? We have seen it yo-yo in a band of 1.20-1.24 to the dollar.Where do you see it headed from here now?

A: Let us first give some historical perspective. The euro started life at an exchange rate against the US dollar of 1.17. Since the euro has been in existence, its range against the US dollar has been a low of 0.82 and a high of 1.6. Today, we are in a range between 1.2 to probably 1.23-1.25. Recently there has been a historically high short market position on the euro and that actually gives support for the euro around current levels.

In comparing the euro against the dollar, we have the age old problem of comparing one weak currency against another weak currency. Interest rate differentials are marginally supportive for the euro. If we go into QE3 from the Fed, that should support the euro. My view, for at least the next three months, is that we are in a trading range around current levels on the euro, probably a low of 1.17-1.18 and a high of 1.25-1.26.

At these levels of the euro, Northern Europe led by Germany is super competitive. Going back to Mario Draghi’s comments, he makes the observation that Southern Europe still has a competitiveness problem. He didn’t, however, make the statement that with the euro close to 1.20, German industry and most of the northern European industry is super competitive. So we have a situation where the exchange rate is great for one part of the euro zone but it is still troublesome for the southern part of the euro zone.