Cautious Optimism Hits Forex Markets

10/24/2011 11:18 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Traders are hopeful that a comprehensive reform package designed to tackle the European debt crisis will be announced, but while the negotiations persist, trading risk remains quite high.

Major asset markets spent another week see-sawing on headlines emanating from European capitals on the prospects for a credible solution to the debt crisis. They finished out the week nearer to their highs after Germany and France again vowed to find a comprehensive solution. (Recall that markets received a similar boost following the Merkel/Sarkozy summit on Oct. 9, where they issued similar pledges; EUR/USD gained from below 1.34 to the recent high just above 1.39.)

Still, EUR/USD spent the week bouncing around in a 1.3650-1.3900 range for the week, signaling markets are waiting for details before reacting with consequence.

The key issue remains the size of the bailout fund. It needs to be large enough to deter speculators from attacking the government debt of larger economies like Italy and Spain or it’s likely viewed as “not credible.”

The latest word is that the short-term bailout fund, the European Financial Stability Facility (EFSF), may be combined with the long-term bailout fund, the European Stability Mechanism (ESM), for a total capacity of EUR 940 billion, though even that amount is subject to dispute since EUR 190 billion of the EFSF has already been pledged to Greece, Ireland, and Portugal.

Negotiations continue on how best to maximize or leverage the bailout funds, but a significant impasse remains. The French would like the rescue fund to function as a bank, enabling it to borrow essentially unlimited funds from the European Central Bank (ECB), but Germany is adamantly opposed to involving the ECB.

Even if the German government were to acquiesce on the issue, it would still need to be approved by the German parliament, which seems even more hostile to the idea. And for its part, the ECB has given every indication it will not act as the lender of last resort. Until that is resolved—and it seems likely it may not be this week—national governments will be on the hook to provide additional funding for bank recapitalizations and support for government debt markets.

That raises the question of how credible is it that Italy/Spain/France borrows more to support their own government debt or banking sectors?

We think the answer is “not very,” and this suggests that this week will not see a breakthrough moment, but only another postponement of the day of reckoning. Still, markets have been placated in the past by other “kick the can down the road” solutions, at least for a short while.

We do think EU leaders will come up with enough concrete plans for bank recapitalizations, Greek debt haircuts, EU governance, and other issues to allow markets to make lemonade out of the lemons. (We would note that Greece gained EU/IMF approval for the next aid installment on Friday; another band-aid, but a short-term positive development.)

How long markets continue to give the EU leadership the benefit of the doubt remains to be seen, which is why we remain extremely cautious.

In terms of price indications, EUR/USD has built itself into a clearly defined 1.3650-1.3900 sideways consolidation, with a potential double top at recent highs around 1.3910/1.3920. We will be especially alert for a range break that is not sustained on daily closing basis, and we think there is potential for continued extreme volatility.

Our preference, as outlined in the weekly strategy, is to buy EUR/USD on weakness below the lower end of this past week’s range. We would also note price is just below the daily Ichimoku cloud, where the base starts next week at 1.3922 and the cloud top at 1.4022 as additional key daily close price levels.

NEXT: Fed’s QE3 Is Back on the Table

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Fed’s QE3 Is Back on the Table

Fed Governor Dan Tarullo (FOMC voter) spoke this past Thursday on the challenges facing the US economy and highlighted the acute unemployment problems facing millions of Americans and the potential for long-term harm to the US economy. In his remarks, he raised the possibility of the Fed re-initiating purchases of mortgage-backed bonds (a form of QE3) to spur the housing market and thereby bolster the broader economy.

His comments suggest to us that at least some on the FOMC are aware of the risks of doing too little to support economic recovery, which is causing us to keep a more open mind on the potential for QE3 in the near term. While our central view remains for no policy action from the Fed at the Nov. 1-2 meeting, we are starting to have some second thoughts.

In any event, the mere mention of QE3 still appears to elicit a bullish response for risk assets and a bearish reaction by the greenback. We think the broad-based USD weakness seen at the end of the past week was as much to do with the potential for QE3 as on optimism the EU will finally deliver.

We will pay close attention to upcoming Fed speakers (and there are several this week) to see if Tarullo’s sense of urgency is shared by more.

Canada and New Zealand Central Bank Decisions

The Bank of Canada (BOC) is expected to hold rates steady at 1.00% when it announces its policy decision on Tuesday, Oct. 25. We think there is a small risk that the BOC adopts a more dovish response to continued US sluggishness and global uncertainty and eases rates by 25 basis points (bps).

We expect the BOC statement to highlight global uncertainty emanating out of Europe and to express confidence that recent increases in CPI are due to temporary factors, maintaining an overall cautious/dovish stance. We think the loonie will continue to be driven by overall risk sentiment based on European developments.

The Reserve Bank of New Zealand (RBNZ) is also expected to remain on hold at 2.50% when it reports on Wednesday afternoon EDT. We think the RBNZ statement will indicate a firm bias to remain on hold, given global uncertainties offsetting ongoing economic recovery.

See related: Central Banking 101 for Forex Traders

By Brian Dolan, chief currency strategies, FOREX.com

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