Extraordinary Volatility Obscures the Near-Term Outlook
12/22/2008 10:07 am EST
In perhaps a fitting end to one of the most volatile trading years I have ever seen, torrential USD selling suddenly gave way to an onslaught against the EUR. Year-end illiquidity certainly exacerbated the currency market's abrupt gyrations, and it may even have been the root cause, but it has clouded the near-term outlook considerably. The USD selling took on a frenzied pace following the Fed's aggressive rate cut to a range of between 0.0% and 0.25% and the explicit adoption of quantitative easing by the US central bank. (Quantitative easing (QE), a term coined by Japan at the start of the decade, refers to a central bank policy that seeks to inundate an economy with liquidity (cash) to spur domestic demand and fend off deflation. The central bank does this by buying debt securities (balance sheet expansion) and driving yields lower to drive down consumer interest rates.) Many analysts refer to QE as “printing money” and frequently leap to the conclusion that QE leads to a weaker domestic currency on the simplistic basis that more supply leads to a lower price. But that view neglects the relative value argument that drives currency relationships, meaning a currency is only weak relative to another currency's strength.
USD Demand Ebbed, EUR Demand Increased
What has changed significantly is a drop in demand for USD funding from foreign markets, as the Fed extended nearly unlimited supply of dollars through central bank swap lines back in early November. Those moves ended the USD uptrend beginning in November, during which the USD made a plateau. Similarly, US investor repatriation flows (selling foreign assets and buying USD) crested in September and October, and slowed significantly by the end of November. On the flip side, European investors appear to still be deleveraging and repatriating funds at home, leading to increased demand for EUR. At the same time, year-end credit market funding has increased demand for EUR, for which the ECB has provided relatively less liquidity than the Fed did for USD liquidity. The result was a drop in demand for USD and a relative surge in demand for the EUR. Note that the moves this month were most heavily concentrated in EUR/USD, with other currencies largely being dragged along. Also, concern over USD weakness stemming from QE is belied by surging US Treasury securities, suggesting global investors are not especially concerned with USD devaluation.
ECB Announces Key Changes to Market Operations
At the end of the past week, the ECB announced it was widening the so-called interest rate corridor, lowering the rate it pays on deposits and raising the rate it charges on loans. The move is designed to push banks to stop parking funds at the central bank and start lending again, not an interest rate cut. On Friday, the ECB announced it will discontinue USD-liquidity operations at the end of January, but added it could re-start the operation again at any time. That raised the prospect of heightened USD-funding demand again, adding further pressure to the EUR/USD reversal. Perhaps more significant were comments from ECB President Trichet this week suggesting that the ECB may not cut rates further at their next meeting on January 15. While it seems more likely that Trichet will eventually moderate his views in light of deteriorating reality, a lack of easing is seen to doom the euro zone to a longer and deeper recession, and that adds to pressure on the EUR. On top of those developments, the US government finally announced a package of loans to prevent the imminent failure of key US automakers, removing a near-term negative for the US outlook. Taken together, the EUR/USD retreat should continue next week, with a drop under 1.3800 setting the stage for further weakness toward 1.3500.
Key Data and Events to Watch This Week
Traders please note: Trading conditions this week will be even thinner, and thus, volatility is likely to intensify even further.
US data next week is heavy and packed into only two days. On Tuesday, we'll see final 3Q GDP, final December University of Michigan consumer sentiment, November new and existing home sales, and the December Richmond Fed Manufacturing Index. Wednesday sees November personal income and spending, PCE inflation, durable goods orders, and weekly jobless claims. There are no Fed speakers scheduled next week.
Euro zone (EZ) data begins on Monday with November German import prices, January German GfK consumer sentiment, October EZ industrial new orders, and December Belgian Business confidence, which is actually very important to EZ sentiment. Tuesday sees French November consumer spending, October Italian retail sales, October EZ current account balance, and December Dutch and Italian consumer sentiment. Friday sees only Spanish November retail sales.
UK has data only on Wednesday, when we'll see final 3Q GDP, 3Q current account, and November mortgage lending statistics.
Japanese data is heaviest next week, with the BOJ's monthly report due out on Monday afternoon in Tokyo. Wednesday morning sees the 4Q BSI large industry sentiment gauge and the November trade balance. Thursday morning sees the release of the BOJ MPC minutes from the November meeting and the November corporate service price index, followed by housing starts and construction orders in the afternoon. Friday morning sees November employment data, November household spending, November CPI, industrial production, and retail trade, followed by small business confidence in the afternoon.
Canada sees only October monthly GDP on Wednesday morning.
Down under, Australia has only the October Conference Board leading index on Tuesday morning, Sydney time. NZ sees 3Q current account data on Monday morning in Wellington, followed by 4Q Westpac NZ consumer sentiment in the afternoon. Tuesday sees final 3Q GDP.
By Brian Dolan of Forex.com