Currencies Make Last Moves for 2011

12/27/2011 9:41 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

Low volume is expected in this holiday-shortened week, but big, news-driven price swings are still possible in major currencies including the euro, US dollar, and even risk assets like stocks.

This week sees the final trading week for the year 2011, and we expect market interest to be significantly reduced due to major holidays on each end, likely leading to a largely sideways drift.

However, reduced market participation also has the tendency to see spikes in volatility on news headlines and data reports, as fewer traders seek reduced liquidity in response to breaking events. In particular, we would note month/quarter-end fixing flows late in the week, where asset managers rebalance currency hedges.

Our proprietary models suggest moderate US dollar (USD) selling overall against other major currencies. Fixing flows will be evident in most NY mornings, likely peaking in the hour before the 4 pm London fixing (11:00 am ET). We would note that markets are already mostly long USD, so the potential for a liquidation-driven USD slide is certainly non-trivial.

While we are mostly pessimistic about the risk outlook for next year, we also think the start of the year could see risk rally, as idle money comes off the sidelines and goes back to work. Pre-positioning for such an early bounce could become evident next week as well, potentially sending USD lower/EUR and other risk assets higher.

We will focus on the 79.60 support level in the USD index and the 1.3200/1.3250 resistance area in EUR/USD, where a daily close beyond would suggest further corrections in risk assets. Alternatively, a daily close below recent 1.2940/1.2950 lows in EUR/USD would suggest to us that risk aversion is dominating and signal the resumption of declines.

Data and Event Highlights This Week

Data is mostly light out of the major developed economies (US: consumer confidence and Chicago PMI are highlights; EU: German CPI and retail sales), but Chinese indicators could prove disruptive if they show further declines.

The Chinese November leading index is due out this week, but no fixed date/time is available for the release, while Thursday night ET/Friday in Asia sees the release of the December business conditions survey and the HSBC manufacturing PMI.

Italy is scheduled to auction just over EUR 20 billion in government debt this week, with sub-3-year maturities on Wednesday and longer-dated ten-year bonds on Thursday. Markets will be closely watching the results, and insufficient demand or too high a price (yield) could trigger another risk-negative reaction.

We are optimistic that the short-dated issues will be taken up easily, but are much more cautious on the longer tenors. Italian government bond yields surged toward 7% at the end of the past week, suggesting bond investors are still fleeing the debt-laden country after 3Q GDP dipped into recession territory at -0.2%. Long-term yields at auction above 6.0%-6.5% would be unsustainable and could unleash another wave of EUR pessimism.

ECB Liquidity Measures Highlight Fragility of EU Banks

The past week saw the European Central Bank (ECB) initiate the first of two three-year long-term refinancing operations (LTROs), allowing EU banks to borrow unlimited amounts for three years, and borrow they did, taking up just short of a half trillion in ECB cash.

That figure significantly overstates the amount of new borrowing, as several shorter-term facilities were maturing and were rolled over into the LTROs. Still, markets expressed concern about the size of the borrowing and its negative implications for EU banks’ stability.

We think immediate fears of banking insolvencies should subside shortly, as the ECB has demonstrated a clear commitment to provide EU banks with whatever lending they require. Another LTRO is scheduled for February, and we would expect the ECB to authorize others if demand proves too strong.

At the same time, interbank lending spreads (Libor-OIS, TED) remain elevated at recent highs, indicating EU banks themselves are not showing much confidence in each other. We don’t know if this is a year-end-type funding strain, or if more serious distrust is involved, but we will be watching those spreads closely in the New Year.

As well, the spreads are nowhere near Lehman-era levels, suggesting an imminent default is viewed as unlikely. So let’s call the situation desperate, but not serious, for now, which will likely keep risk sentiment similarly schizophrenic in early 2012.

By Brian Dolan, chief currency strategist,

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