Why the Euro Remains Resilient

08/22/2011 9:52 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

European banking sector concerns, safe havens like gold at new all-time highs, and actions by several of the world’s central banks are among the important themes in the currency markets this week.

Risk assets (stocks, commodities, JPY and CHF crosses, and commodity currencies) stabilized further to start this past week but suffered what seems likely to be the first in a series of periodic relapses, as market conviction remains extremely low. We remain cautiously optimistic that the selloff in the first half of August marked the low point in the current risk retrenchment, but we are keenly aware that risks remain skewed to the downside.

In support of the view that a medium-term bottom may have been reached, we would note that last week’s lows in most risk assets were not tested, much less breached. But to argue the bearish side, the charts do look quite damaged, with all major currency risk pairs and stocks trading below their daily Ichimoku clouds.

In particular, we would also point out that the rebounds from late last week/early this past week, all reversed at or just below the Daily Kijun lines (take a look at any AUD/JPY or EUR/JPY Ichimoku charts as examples), a textbook example of a bounce within a larger downward trend.

Lastly, on the S&P 500, we would note what may be the beginning of a bear flag consolidation channel, where a break below the 1120/1125 flag base might signal declines are resuming. Gains above the 1215/1220 flag top would be needed to invalidate the pattern. If we are in fact entering into a consolidation phase, we would expect to see continued short-term volatility into the end of the month, but would then expect a resolution at the start of September.

To be sure, there is no shortage of negative news. While the ECB has managed to stabilize European sovereign bond markets, there is a creeping sense of stress in the European banking sector. Overnight, interbank lending rates have been moving higher and there is growing talk of another potential USD funding shortage. European bank shares have been pummeled in the recent shakeout, and we think banking sector stress is the most likely catalyst for a renewed bout of risk aversion. We will keep a close eye on interbank borrowing rates in coming weeks.

Waiting for Jackson Hole

Markets are waiting for next Friday’s speech by Fed chairman Ben Bernanke at the annual Fed symposium in Jackson Hole, Wyoming. A year ago, Bernanke used the venue to announce the Fed was considering a second round of asset purchases, which then came to fruition when QE2 started in November. From the August 26, 2010 Jackson Hole speech, the S&P 500 bottomed and turned higher, rising nearly 300 points by spring 2011.

NEXT: Two Key Questions for This Week's Fed Symposium

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So the questions this time around are 1) Will Bernanke signal QE3, and 2) Will markets respond as enthusiastically if he does? We think the answer is "no" in both cases.

A year ago, deflation loomed as a threat, while today, inflation is temporarily elevated. A year ago, the recovery was struggling, and today it remains eerily sluggish. But there is little evidence that QE2 generated any sort of economic stimulus, apart from a stock and commodity rally. Besides, market interest rates are currently below levels seen before QE2 was announced, meaning markets have done the work of QE3 on their own.

Bernanke will surely repeat his prior indications that additional asset purchases remain an option, but we think the Fed is too far from consensus to expect more decisive signals. On the market reaction, the current gloomy outlook is predicated on reduced growth prospects, and the best that can be said is that maybe most of that negativity is already priced in. Perhaps Bernanke will pull a rabbit from the hat and strike a more confident tone, but we think markets in search of a savior will end up disappointed.

However, in the run-up to Bernanke (ECB pres. Trichet will also be speaking there Friday), we think markets are still likely to anticipate some magic balm from him, and we would not be surprised to see risk assets attempt to rally/safe havens decline early in the week (see below). We would then expect disappointment following Bernanke to see another risk selloff as markets conclude there’s no one riding to the rescue, and even if they are, they’re out of bullets. Such a rebound and failure fits nicely with the potential S&P 500 bear flag consolidation channel highlighted above.

Are "Safe Havens" Due for a Short-Term Pullback?

Over the past week, many of the traditional safe havens have made new all-time highs (gold, ten-year Treasuries, Japanese yen and Swiss franc) due to fears over a potential European banking crisis and slowing global growth concerns.

In efforts to fight this risk aversion, a few central banks have taken action over the past two weeks. The Bank of Japan (BOJ) intervened aggressively on August 4 by selling an estimated ¥4.6 trillion, which is the largest single-day intervention since 2004. The Fed announced that they will keep rates “exceptionally low…at least through mid-2013” at their August FOMC rate decision. The Swiss National Bank (SNB) initially expanded bank sight deposits from CHF30 billion to CHF80 billion and narrowed the Libor target range 0-0.75% to 0-0.25% on August 3, and then once again expanded banks’ sight deposits a few days later to CHF120 billion.

On top of all of this, even the Chicago Mercantile Exchange (CME) joined in when they raised gold margin requirements by 22%. Unfortunately, all of these measures failed to stem further risk aversion.

It wasn’t until rumors circulated that the SNB may peg the franc to the euro (we’ve heard 1.15) that the CHF began to weaken. On top of this, the SNB once again took further measures this week in an attempt to further weaken the swissie by increasing sight deposits to CHF200 billion and restated their intention to use FX swaps to inject further CHF liquidity. This saw the franc fall relative to the USD and EUR by over 13% and 14%, respectively, at one point this past week.

With that said, other safe havens continued to strengthen. US ten-year Treasury yields reached a low of 1.97%, USD/JPY broke below the 76 handle to touch 75.95, and gold soared to a high of $1877 (each of them new all-time records).

So where do they go from here? The torrent appreciation of these assets is currently unsustainable, and we believe a short-term pullback may be warranted. It appears that safe-haven momentum is weakening, as underlying indicators are failing to confirm these recent highs/lows, thus creating a divergence.

NEXT: Drastic Actions from the Swiss National Bank (SNB)

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Furthermore, using Elliot Wave analysis, we have identified five-wave sequences in both Treasuries and gold, which suggests a reversal is in order towards the prior wave four and/or 38.2% retracements. Therefore, we would not be surprised to see gold trade lower towards $1700/$1725 and ten-year yields to rise to around 2.40%/2.45%.

Additionally, USD/JPY may catch a bid towards 79/80.00 and USD/CHF could test 0.82/.8300 over the coming days/weeks. However, in the end, this is most likely just a relief rally rather than a longer-term bottom. Consequently, such a rally could be used as an opportunity to re-enter "risk-off" positions in these otherwise turbulent markets.

SNB Intervention Risk Is Here to Stay

Last weekend, reports suggested that the Swiss National Bank (SNB) would consider taking drastic action to limit franc strength, including a currency floor or peg to the euro. In the middle of last week, the SNB did intervene, although it did not use such extreme measures. The Bank announced FX swaps and more quantitative easing to try and reduce the franc's value. After initially strengthening, the franc eventually reversed course and EUR/CHF rose 2.6% last week.

It seems like investors are taking the SNB seriously. However, we believe that it is unlikely that the SNB will use more extreme measures to weaken the franc for a few reasons. Firstly, a floor on EUR/CHF or a euro peg are nuclear options that would require a hefty financial commitment from the SNB. It would also mean that the SNB would have to lock in the swissie at the current rate, which is already extremely strong. This could further damage the Swiss economy.

Secondly, If EUR/CHF looks like it is going to hurtle to parity once again, we think the SNB will come out and announce a peg or a currency floor. But right now, the cross is above 1.10. At this level, we believe that “intervention-lite” measures like FX swaps, more QE, and possibly a further reduction in interest rates are more likely means of intervention in the near term.

However, rumors have been circulating that the Bank may choose to introduce capital controls, a tax on foreigners/speculators holding CHF. We think the tax would apply to future Swiss purchases and would only be applied to speculators. There is a high chance this could happen, as it would show the markets how serious the SNB actually is about reducing pressure on the franc. Although this may spark fears of “currency wars,” we think there is a high probability of capital controls in the near future, especially if we see the franc start to strengthen again in the coming days.

Overall, intervention risk in the Swiss franc is here to stay. The SNB’s FX reserves are now worth 50% of GDP, up from 10% of GDP when it intervened two years ago. Thus, it has the firepower to weaken the CHF if need be, and the threat of SNB intervention will remain a theme in FX markets for the medium term.

In the absence of a currency peg or floor, we believe that EUR/CHF will trade in a range over the next few days. The 1.1150 level should act as good support, as it is the 21-day moving average (MA), a key technical level. Last week’s high of 1.1550 should act as the range top.

ECB Calms Sovereign Debt Markets

Spanish and Italian bond yields have remained below 5% this past week, out of the danger zone, after it was announced that the ECB bought EUR22 billion of their debt the week of August 8. The Bank is likely to have continued actively purchasing debt this past week. In the past, the bond yields of Europe’s most troubled nations have been positively correlated to stocks. But as stocks sold off heavily last week, yields have remained stable, which is most likely to be down to the ECB.

NEXT: Political Stalemate Keeps Eurozone Risk High

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While the ECB is helping to stabilize Europe, the politicians are having a de-stabilizing effect. Firstly, Angela Merkel and Nicolas Sarkozy highlighted the EU leaders’ resistance to implementing radical measures to bring the crisis to a halt. Sarkozy ruled out the prospect of enlarging the EFSF rescue fund, and German Chancellor Merkel has said that the euro area would be worse off with the Eurobond.

The joint issuance of debt by all members of the currency union has been hailed by some as the only workable solution to the crisis. However, it has divided Europe’s leaders. While Germany is opposed to the idea, Europe’s regulators may try and make Eurobonds legally binding. The head of the EU’s Economic and Monetary Commission, Ollie Rehn, said that a report into the benefits of Eurobonds currently being commissioned will, if appropriate, be accompanied by legislative proposals to make the bond law. He said that these securities would improve fiscal discipline in the long run, however, no other details, like a deadline for the report, were disclosed.

It is unlikely that anything as drastic as Eurobonds will be introduced in the near term since members are still arguing over the second bailout loan to Greece agreed on July 21. On Thursday, Finland announced that it would demand collateral from Greece in return for second bailout loans. This opens the way for other member states to demand the same, and on Friday, the Dutch Prime Minister said that he wants a secured loan before he lends more money to Greece.

As we enter the last week of August, the Eurozone’s sovereign problems seem no closer to being resolved. Combined with this, growth is slowing, and second quarter GDP moderated to a 1.7% annual rate from 2.5% in Q1. German growth also slowed sharply. This week’s PMI data is expected to show a contraction in the manufacturing sector and further weakness in the service sector. This doesn’t bode well, as Europe’s economies need growth to reduce debt levels.

However, the euro remains fairly resilient, and EUR/USD traded between 1.4500 and 1.4250. This range trading is likely to persist, but we think the risk remains to the downside. Even though Europe is suffering from slow growth and a sovereign debt crisis, the US and the UK both have seen growth slow and their debt problems are actually worsening, so we think EUR resilience is only due to others’ weakness. As such, we remain on alert for a renewed flare-up in Eurozone risk perceptions and the potential for a drop below 1.4250 to see a re-test of the more important 1.4000/1.5000 range lows.

By Brian Dolan, chief currency strategist, FOREX.com

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