The FINANCIAL — Two major themes look to influence the currency markets over the month ahead.
Done Deals
August began on a positive note, as policymakers on both sides of the Atlantic managed to reach consensus and avert short-term disaster in the sovereign debt markets. However, for many, these hard-fought victories were bittersweet.
In Greece, a rescue package delivered much-needed liquidity, but managed to effectively add to an already insurmountable national debt burden. This served to weaken confidence in the common currency zone's willingness to take the harsh measures required to fend off disaster in the larger peripheral economies.
In a similar sense, American politicians succeeded in closing the Treasury funding gap, while leaving longer-term issues largely unaddressed. The debt bill will cut expenditures by an estimated $2 trillion over the next decade, but also postpone difficult taxation and entitlement reforms for negotiations later this year.
Partly as a result, downgrades remain on rating agency menus in the United States and Europe. Several countries are expected to see their ratings fall several notches, and investors are responding accordingly.
However, a wide disparity exists between the United States and Europe. Throughout the debt ceiling crisis, Treasury yields remained extremely low, evidencing strong global demand for the world's most liquid debt market.
In stark contrast, yields are soaring across Europe as investors flee indebted Southern countries. This is creating a self-fulfilling cycle, as rising interest rates increase borrowing costs and make further defaults more likely. As such, it appears that the European debt crisis is not over, and has simply transitioned into a new state.
Global Cooling
Markets went into risk aversion mode in the first week of August as the odds of a US recession rose sharply. Activity began to slow across many of the most important areas of the economy. Consumer spending measures stalled in late July and several sentiment indexes turned negative. With orders dropping, manufacturers cut production and the pace of hiring slowed. At the same time, fiscal stimulus continued to be withdrawn at the national, state, and municipal levels.
Making the situation more worrisome, central bankers are finding that their options are limited. Interest rates are already well below historical norms, inflation is on the rise, and political pressure is building against the use of quantitative easing programmes that can push money into the financial system.
If the US economy does cool further, and the Federal Reserve proves unable to provide new stimulus, the repercussions for global growth could be severe.
Whether a 'double-dip' becomes a reality or Europe's debt crisis worsens, markets are clearly nervous. Investors seeking safe havens have bid up precious metals and the Swiss franc to unprecedented levels. Counter-intuitively, this may be leading to a worsened risk environment, in which the safe havens move into overbought territory–thereby becoming more dangerous than the assets they are meant to supplant.
Potential volatility catalysts abound, meaning that corporations will want to maintain a disciplined approach to hedging risks over the month ahead.
EUR
Despite its region’s seemingly never-ending debt concerns, the euro held a strong position against the dollar from mid- to late-July, surging past the 1.45 level. Though the Eurozone and US economies were the cause of much risk aversion across markets, prior to August 2nd it was mainly concerns directed towards the US that had investors pushing gold to record highs over $1,600. It was only due to the fragile US budget negotiations, the debt limit circus, and the increasing threat of a downgrade to the treasury market's AAA credit status that the euro was able to stay afloat. However, the European debt crisis is very far from being over. Risks related with the growing evidence of a slowdown, the implementation of the new bailout plan, and the announcements of credit events still remain.
Now that the US has lifted its debt ceiling to $2.4 trillion for another year, the heat is temporarily off the Greenback as the focus of the media and investors over the next month is likely to be on Italian and Spanish debt woes. Unlike Greece, both are too big to be bailed out, and with Moody’s downgrade threats coupled with the announcement of early elections in Spain, any negative news could cause a short-term run on the euro. In fact, given July’s rate hike and softening inflation in countries like Italy, another hike from the ECB in August would be too optimistic. This leaves very little in the way of possible upbeat fundamental data to give hope during the next few weeks. With moving averages trending to the downside early on in the month, it looks likely that the multination currency could gravitate down towards the 1.40-1.41 region with support around 1.4010, unless there are further troubles over the Atlantic that provide respite.
Lee Yoong, FX Trader and Cash Manager – London
USD
July saw the US dollar sell off against almost every major pairing as investors took cover from a looming debt ceiling deadline. A default would have sent a shockwave through global capital markets that would certainly have been felt by the currency world. US lawmakers, however, managed to come to an agreement just one day before the deadline on August 2nd, passing a bill into law that allowed the government to avoid a default on any debt obligations. This brought calm to the storm although the USD continues to be outperformed on an annual basis.
But August kicked things off in nothing short of a sea of red. Equity markets shed trillions in market capitalization globally as nervous investors exited positions long in–everything–amidst fear that the US economy seems headed for another recession. This biggest one-day rout since March 2009 not surprisingly saw a knee-jerk surge in the USD as other majors sold off amidst the panic. This brought about the question, “What about QE3?” Although growth in the US has been anaemic, the Fed has made it clear that only a risk of deflation would be grounds for such action to be taken. After mass amounts of liquidity were pumped into the system for QE1 and QE2, Fed Chairman Bernanke will continue to be cautious about putting their balance sheet back to work.
On a domestic data front, numbers continue to be weak with GDP, job figures, and payrolls measuring-in at anything but inspiring. Early August non-farm payrolls for the US posted better-than-expected figures (much to the market’s surprise), allowing for a modest 0.01% decline in the unemployment rate.
Markets will be fixed on both the sovereign debt loads of the Eurozone and the condition of the US economy. Any sign of a potential slide back into recession should spell positive performance for the USD. There is certainly no lack of fear in the marketplace: the VIX index, which measures the cost of using options as insurance against declines in the Standard & Poor’s 500 Index, surged at the start of August the most since February 2007 to 31.66. Although the Greenback has been sluggish for 2011, watch for any shift in economic outlooks to have a major influence on its performance through the choppy summer months.
Adam Smith, Corporate FX Dealer – Vancouver
Discussion about this post