The FINANCIAL — To know the future, sometimes we must look to the past.
In February and March, there was a great deal of optimism over the euro zone debt crisis. The European Central Bank (ECB) had just wrapped up its second Long-Term Refinancing Operation (LTRO), pumping billions into the banking system to help bring down government borrowing costs. The European Union Summit was convening, and expectations were high that a fiscal consolidation of sorts would be hammered out between EU nations. The euro moved to 1.35 against the US dollar, buoyed by hope.
But following the Summit, disappointment set in as problems persisted, ultimately unresolved, and the unit dropped a shocking 12%.
Today there is the same feel-good mentality in markets that we witnessed earlier this year. The uptrend in the euro is based on expectations that the ECB will come to the rescue with some form of bond-buying programme, which will cap government borrowing costs relative to Germany’s yields. Further, Greek Prime Minister Samaras has met with EU leaders to try to sell his government’s austerity plan, which will require more time than was initially agreed-to. Preliminary comments from Germany’s Chancellor Merkel are hardly positive—understandably, as she is under increased pressure from her coalition government to hold Greece to their existing commitments. Nevertheless, investors are hopeful that the lifeline to Greece will not be broken, and that some compromise will be achieved.
Threatening to crush all of this optimism are Greece, Spain, and potential disappointment following the upcoming September EU Summit and October ECB meeting.
The ECB is likely to ease its monetary policy further in coming months. At the September meeting, the central bank could lower interest rates by 25 basis points to help ease growing tensions in markets. Euro gains could be limited at this time, but investors have also been pricing-in the possibility of the central bank’s stepping into the bond market by placing caps on short-term borrowing costs. Such a policy is unlikely to take place until the October meeting, however; the ECB has said that EU governments will first have to fulfil their commitments to the European Stability Mechanism, which still requires Constitutional Court approval in Germany before it goes into effect. The possibility of an unexpected (and for many, disappointing) ruling on this matter on September 12th poses some downside risk.
Nevertheless, the ECB has not denied that it is working on a bond-purchasing programme, though it has suggested that intervention will come only after the country in need has asked for an official bailout. Currently investors appear to be getting ahead of themselves with the view that the ECB will cap yields willy-nilly. And there is, of course, the question of actual effectiveness if such a programme were to be implemented—as well as the fact that bond purchases buy time, but don’t actually help growth. Investors could end up being disappointed, which would spell weakness for the euro in the medium term. If the past gives any indication of how markets will trade in the future, the euro could be in for trouble by the start of the fourth quarter.
GBP: United Kingdom — David Starkey, Senior FX Trader, Denver. The Sterling was among the better-performing currencies in the month of August, making solid gains against the AUD, JPY, and USD, though its performance against the CAD, CHF, and EUR was less spectacular. When it comes to the value of the pound in August, however, domestic activity seemed to take a back seat to events outside its borders; despite the London Olympics, GBP- related trading took its lead from speculation on QE3 in the United States and the ongoing debt saga in Europe, which led to much of the unit’s recent strength.
On the domestic front, the London Olympics seem unlikely to provide much in the way of a meaningful long-term boost. Historically, the games have had a short-term, one-off positive impact, but limited extended benefits. Furthermore, with London’s already-cemented status as a tourist destination, the games are unlikely to attract new tourists in the future, which would be the primary long-term benefit of hosting the Olympics. Otherwise, the domestic landscape is less than encouraging: the British economy remains weak as GDP figures regularly print in negative territory, and the outlook for the future is cloudy at best.
Manufacturing is holding at contractionary levels, the labour market continues to languish, and consumer spending is still depressed.
That said, despite the UK’s obvious domestic problems, when compared to Europe, and considering the potential impact of additional American quantitative easing, the Sterling isn’t such a bad bet. In the near term, the GBP looks likely to remain supported at or near current levels by external factors. As long as Europe and US quantitative easing concerns dominate the headlines, prolonged weakness in the UK economy will remain in the back seat.
USD: United States — Joe Manimbo, Senior Market Analyst, Washington. September may be a grueling month for the US currency. The dollar entered the home stretch of the third quarter near multi-month lows on a trade-weighted basis as expectations mounted that the Federal Reserve would soon embark on more monetary easing.
The dollar had spent most of the summer enjoying solid support from safety flows on worries about European debt and slowing growth in China. But demand for defensive assets has been in decline recently on signals from the European Central Bank that it may soon craft a plan to put a lid on elevated borrowing rates for indebted countries. At the same time, American unemployment continues to hold stubbornly above 8%, showing that US central bankers are failing to achieve at least one of their goals (maximizing employment). Meanwhile, US growth hit the brakes from April to June, slowing to an annual rate of 1.5% from 2% in the first three months of the year.
Against this backdrop, investors are bracing for a Fed policy meeting on September 12-13, at which officials may decide to launch a new wave of monetary easing, such as a third round of bond buying, to nudge long-term borrowing rates further south with the aim of encouraging consumers and businesses to spend. A bold move by the Fed to boost the economy would tend to come at the price of a weaker dollar.
But as daunting as September may prove to be for the dollar, there is also scope for appreciation, and recent indicators suggest the economy is gaining strength. The continuation of recent improvements in hiring and consumer spending could play favourably into the hands of so-called Fed “hawks,” who tend to oppose more action to boost growth, worrying instead about inflation. Fed “doves” have long lobbied for new pro-growth measures such as QE3 to help lower the nation’s high jobless rate.
Europe’s far-from-resolved debt crisis could also flare anew, leading to renewed buying of safer investments. Pressure has built on European policymakers to come up with a convincing plan to stem the debt crisis. And European officials don’t have the best track record when it comes to meeting market expectations.
At the very least, September should be a more exciting time for currency traders, who saw volatility abate markedly during the latter part of the summer, when many Northern Hemisphere traders were on vacation.
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