Credit Strains Begin to Ease; Risk Appetites Improve

10/21/2008 12:01 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

Over the last few weeks, we have been calling for an eventual improvement in financial market conditions as a series of aggressive, government-led steps are set to come into effect. If you were only looking at stock prices, however, it might be difficult to discern any sense of stabilization. But if you look at credit market conditions, the signs of a thaw are becoming apparent. The measures of credit market stress that we monitor are all showing signs of improvement, though all still remain at stressed-out levels. (Many of the following indicators are spreads between two interest rates. The larger the spread, the worse are credit conditions. The smaller, or narrower, the spread, the better are credit conditions.) The TED Spread, which measures the difference between borrowing costs for banks relative to governments, is down over 100 bps from its peak at 4.63% seen last Friday. The two-year swap spread, which measures the difference between two-year treasuries and the floating swap rate, is down about 40 bps from its high of 164.75 bps seen on Oct 2. By these two measures alone, credit market strains have eased by about 25% over the last week. Three-month LIBOR rates, which measure the cost of lending between banks, a proxy for counterparty risk (the higher LIBOR is, the greater the fear of lending), have also fallen, but relatively less so, dropping from 4.82% to 4.42%. Again, all of these credit market stress gauges are still abnormally high, but are clearly showing improvement.

Another gauge of market fear and risk aversion can be found in the price of gold. During times of panic and dislocation, gold prices soar. This was the case following the bankruptcy of Lehman Bros., when spot gold prices leapt from about $780/oz to a high over $925/oz just last Friday. Gold prices have since collapsed and are closing out this week just $5 above pre-Lehman levels. Contrarian indicators also abound, with inflows into money markets (investors fleeing stocks and seeking the security of cash) hitting a one-week record of $44.5 bio. The VIX index of stock option volatility, popularly known as the "Fear Index," also hit a new all-time high despite stocks actually gaining ground on the week. The fog of fear is lifting and the pace of normalization is likely to accelerate in coming weeks as more of the government initiatives are put into place, and this is likely to see risk appetites improve further.

In currencies, the main measure of risk aversion is weakness in JPY crosses, like EUR/JPY, AUD/JPY, and GBP/JPY, also called carry trades. When fear reigns, JPY crosses get hit hard; as fear subsides, JPY-crosses are likely to rally. Those pairs hit their nadirs on Thursday/Friday of last week and have since recovered and stabilized. We look for the JPY crosses to continue to move higher in coming weeks as credit markets normalize further and investor fears diminish. We stay with our preferred strategy of buying JPY crosses on dips, which may be substantial as stocks attempt to stabilize. But we are also beginning to see more concrete signs that a bottom has formed in many JPY crosses and that a surge to the upside may be in store. On the Ichimoku charts, GBP/JPY is set to close above the Tenkan line (174.00), the fastest moving line in the system, signaling a potential change in direction higher and initially targeting the Kijun line at 181.72. AUD/JPY has similarly closed above the daily Tenkan line (69.43), opening potential up to the Kijun line at 76.67. NZD/JPY has also made a close above the daily Tenkan line at 61.77, targeting a possible move to 65.72. USD/JPY has also closed above its Tenkan line at 100.60, opening up potential to 102.97 initially. Only EUR/JPY and CAD/ JPY have failed to close above their respective Tenkan lines at 136.99 and 88.13, perhaps representing an opportunity should they play catch-up next week. Keep in mind that the Ichimoku levels cited above will change slightly next week, but the overall impression is that a significant base is forming.

USD Likely to Weaken Against all Others but JPY

One of the major impacts of credit markets freezing up was a surge in the USD, as excess demand from money markets spilled into outright buying of spot USD in forex markets. This flow was augmented by safe haven plays that saw funds move into US treasuries, which also created USD demand. As credit conditions ease further, so too should demand for USD, and this is likely to see the greenback move down to the lows of recent ranges. But USD weakness is likely to be most pronounced against all but the JPY, given our expectations of higher JPY crosses. We would then look for EUR/USD, GBP/USD, AUD/USD and NZD/USD to all move higher, while USD/JPY is expected to gain relatively less ground, but still resulting in higher JPY crosses.

Certainly the fundamental outlook does not bode well for the USD, and the main reason the USD has managed to hold firm stems from market stresses rather than fundamental outlooks. Expectations for a follow-up Fed rate cut at the Oct. 29 meeting are likely to begin to hurt the USD in coming days, as a minimum 50 bps reduction gets priced in. We look for EUR/USD to move to the 1.3750/3800 area initially, with corresponding levels in GBP/USD at 1.78/79 and in AUD/USD 0.76/77. In USD/JPY, the Kijun line at 102.97 may contain the upside again, but a daily close above there sees potential gains back to the 105/106 area.

Bank of Canada and RBNZ Rate Decisions

The Bank of Canada and Reserve Bank of New Zealand will decide on interest rates next week in what could be pivotal events for the direction of NZD and CAD. Here is our assessment of what to expect.

The Bank of Canada is up first on Tuesday at 0900ET/1300GMT. The market expects the bank to cut rates by -50 bps to 2.00%. There are a few forecasters, however, that are looking for a more modest -25 bps cut and even some who expect no change. While Canada's economic prospects have not deteriorated at the same rate as those of the US and Europe, the US slowdown is expected to have a discernable impact on Canadian exports. This coupled with the recent declines in oil to just around $70/bbl is putting the Canadian economy at risk of slowing down in a big way. We would view a -50 bps cut in the target rate as a proactive and necessary measure to nip the likely slowdown in the bud. The risk remains that the BOC does less, however. In terms of what this means for the currency, the initial reaction to a lower than expected rate cut would likely elicit a knee-jerk reaction to buy CAD. This would likely dissipate as a modest cut would put the economy at risk of potentially going into a recession. Thus, the initial reaction to buy CAD on a lower than expected rate cut would be a good opportunity to sell the currency, in our view.

The Reserve Bank of New Zealand rate decision is scheduled for Wednesday at 1600ET/2000GMT. The consensus is that the bank will slash rates by -100 bps to 6.50%. Similar to the BOC rate forecast, this one is also very contentious. There are numerous economists looking for the bank to cut just -75 bps and even some are looking for a more modest -50 bps reduction. The economy contracted in 2Q but recent reports such as retail sales and business confidence have improved. That said, the recent leg down in commodity prices-which have fallen more than -40% from their July peak-has the potential to throw the economy into a more prolonged slowdown. The central bank clearly has lots of room to maneuver, with rates currently at very high levels, and as such a cut of -100 bps is very probable. The reaction in NZD from a more modest rate cut will also likely be similar to that of CAD-with the currency initially bid only to reverse course as the economic realities sink in.

Key Data and Events to Watch Next Week

The US economic calendar is on the light side next week, and kicks things off with the index of leading economic indicators on Monday. The next piece of major data will not be out until Thursday in the form of initial jobless claims. Friday rounds out the week with existing home sales. Next week also has a couple of Fed speakers on tap. Bernanke, Lockhart, and Kroszner are all due to speak on Monday, while Stern is scheduled for Tuesday.

In the euro zone, we have a modestly busy week coming up with some top-tier data to boot. Monday starts it off with German producer prices, while Wednesday has the euro zone budget deficit on tap. Thursday is a busy one with French business confidence, French consumer spending, euro zone current account, and euro zone industrial new orders. Friday rounds out the week with German import prices and euro zone services and manufacturing PMIs.

The UK has a very light week, and kicks off on Sunday with home price data. Wednesday has the minutes from the recent Bank of England meeting, and these should highlight the fresh weakness in the UK economy. Thursday sees retail sales and Friday closes out the week with the GDP report.

Japan's calendar is characteristically light as well. Monday has the leading index and the cabinet office monthly economic report due up. Tuesday sees the all industry activity index while Wednesday rounds out the week with the trade balance.

Canada is relatively busy and has some important data on tap. International securities transactions and wholesale sales get things started on Monday. Tuesday has the main event for the week in the Bank of Canada rate decision (see full analysis above). Leading indicators and retail sales are on deck for Wednesday. Thursday has the Bank of Canada monetary policy report while Friday closes it out with consumer prices.

It is pretty quiet down under next week. Monday will kick things off with Australian producer prices and New Zealand consumer prices. Tuesday sees New Zealand credit card expenditures. Wednesday rounds out the week with the RBNZ rate decision and Australian consumer prices.

By Brian Dolan of

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