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2 Factors Could Spark Big EUR/USD Move
06/11/2012 11:15 am EST
Potential actions to rescue Spanish banks could spark a relief rally in the EUR/USD, write Kathleen Brooks and Eric Viloria of FOREX.com, while central bank policy decisions in the US and globally must be watched closely as well.
Will Eurozone authorities grab the chance to save Spain? Now that central banks have taken a back seat in this crisis, politicians have had to step up their game. This started with a press conference from US President Obama on Friday, which called for budget cuts in Europe to be slowed down and for concrete actions to be taken to stem the sovereign debt crisis. He sounded concerned that disarray in the currency bloc could hurt the US economic recovery.
Obama’s plea did not fall on deaf ears. At the time of writing, an emergency conference call is scheduled for deputy finance ministers of the Eurozone on Saturday morning. The call is expected to discuss a request for aid from Spain to help it recapitalize its banking sector.
After that, the Eurogroup, which includes the 17 Eurozone finance ministers, will hold a call to discuss the request and potentially approve it, which could lead to an official announcement on Saturday afternoon.
The ratings agency Fitch cut Spain’s credit rating to BBB from A on Thursday, which is just three steps away from junk, adding to the urgency of the Spanish situation. The European authorities may choose to bolster Spain before the Greek elections later this month, which could cause market panic if Greece votes for an anti-austerity party.
The Eurozone needs to find a way to break the link between sovereigns and their banking sectors, as bailing out sovereigns could be more costly for the EU in the long term. Fitch estimated that Spain’s banks need between EUR 60 and 100 billion of capital. This is a serious chunk of change, but if Europe lets confidence erode to such an extent that Spain may be forced out of the capital markets, it could cost a lot more. Once market confidence in a sovereign is lost, it takes a long time to get it back, so Europe could be on the hook for some time.
We will write more about this next week, but if there is an announcement, we will look for two things to determine where the EUR/USD will be headed:
- How much money will be given to the banks, and is it close to Fitch’s estimate (i.e., above EU 60 billion)
- When will the money be dispersed? The sooner the better to help placate the markets
If the aid request is approved and deemed big enough, we could see a sharp relief rally in the markets that could even trump Greek election fears. EUR/USD could break above 1.2625 (a double top from last week) and head back towards 1.30. This could help stocks and commodities to recover as well.
We would expect Spain’s banks to lead the rally in stock markets higher. It would also cause the dollar to fall and the yen and other safe havens like German Bunds and US Treasuries to come under pressure.
In contrast, we would expect Spanish bond yields to fall, but if the outcome of the call doesn’t end up with Spanish banks being recapitalized, or if funds fall short, there could be blood on the street, and EUR/USD could head back towards 1.20, while Spanish bond yields may surge.
The European authorities have a chance to sort this crisis out, so the markets expect them to take it.
Global Central Banks Not Playing Ball
As we start a new week, the markets are still digesting the news that there will not be another round of global economic stimulus at this stage. The European Central Bank (ECB), the Federal Reserve, and the Bank of England (BOE) all seem unwilling to extend more stimuli at this stage, preferring instead to stay on the sidelines. This is significant for a couple of reasons: 1) markets tend to react strongly to official liquidity injections; and 2) investors may have to navigate a very uncertain few weeks without the support of central banks.
The ECB will continue to support banks with medium-term loans (there won’t be any more three-year LTRO, however), and some members on the Committee voted to cut rates, however, Draghi was very clear: governments need to step up to the plate and forge greater fiscal unity and sort out the troubled banking sector.
Back in 2008, Lehman Brothers threatened financial market stability, but it never threatened the solvency of the US government. Today, systemic risks in Spain’s banking sector threaten the health of Spain’s public finances and the very foundations of the Eurozone.
While cheap money and lots of it can help cushion a blow, it can’t return the sector to health. That requires politicians to change the entire structure of the Eurozone so that a Spanish bank account is deemed as safe as a German one, which may help to stem the capital flow that threatens to bring Spain’s banks, and its government, to the brink of financial collapse.
We believe there is little now that the ECB can do, as a cut in interest rates when real rates (adjusted for inflation) are negative anyway. Hence the future of the Eurozone relies on the future actions of politicians.
See also: Abandoning Capt. Merkel’s Ship
Bernanke Keeps QE at Arm’s Length
The Federal Reserve meets this week, and comments from chairman Ben Bernanke and vice chairman Yellen may have a big impact on the markets. Ben Bernanke was testifying in front of Congress last Thursday, and far from sounding overly concerned about the outlook for the US economy after the dismal May jobs report, he sounded remarkably sanguine, even suggesting that the decline in job creation was down to weather-related effects.
Essentially, Bernanke could have been buying himself time, as US Treasury rates are so low already that it’s hard to see how more QE could have much of an impact on the US economy. Thus, he may choose to keep that bullet in his back pocket just in case the Eurozone does explode in the coming months.
We get inflation data out of the US this week, as well as retail sales data, which will be scrutinized by the market. If core prices for May fall below the 2.2% expected rate, then the market may ignore the prior comments from Bernanke and price in the prospects for more QE. Retail sales are likely to be weak in May, especially since job growth was weak and the unemployment rate was higher, hence we don’t think this data will be particularly market moving unless we get a sharp fall in sales. The market expects flat sales, excluding autos.
Overall, QE is dollar negative, and no QE gives the dollar a boost. We expect this theme to continue in the markets for some time.
Can the BOE Continue to Sit on the Sidelines?
The BOE may have remained on hold last week, but the prospect for more QE is not ruled out completely, and we could see another injection of cash in the coming months. This is due to the deteriorating picture for the UK economy.
Although we had better-than-expected service sector PMI for May, the manufacturing sector survey was deep in contraction territory. Added to this, the retail sales picture could have been flattered by the good weather, the early timing of Easter, and the Jubilee Bank Holiday weekend. As a result, sales, which have been extremely strong recently, might not remain so in the future.
We won’t get the minutes of the BOE meeting until June 20, but we wouldn’t be surprised to see more members vote for an increase in QE, especially since some members suggested their decision to remain on hold in May was finely balanced. Thus, the deterioration in the Eurozone crisis and some weak economic signals could force the Bank to act later this summer.
This week, we get industrial production data, which is expected to decline in April, reinforcing the weakness in the UK’s manufacturing sector. Although manufacturing is a small section of the UK economy, the government has spoken of its desire to transform the UK economy towards production and exports. Thus, looser monetary conditions could help to make this happen.
George Osborne and Mervyn King, Governor of the BOE, both speak at the annual Mansion House Dinner this week. King’s words will be scrutinized to see if he has shifted to a more dovish stance in recent weeks. This is likely to keep a lid on GBP/USD, and we believe that this cross will remain range bound.
China Tries to Cushion the Economic Blow
On Saturday morning, we got a raft of economic data from China. The market has interpreted the surprise rate cut from the People’s Bank of China (PBOC) last Thursday as a way to cushion the blow from a potential bout of weak data. Hence, the rate cut didn’t even sustain a rally in the aussie for too long. AUD/USD backed away from parity and could fall further if we get confirmation of a deeper slowdown in the Asian powerhouse, a key export partner for Australia.
Export economies like China rely on strong external demand, thus, the Eurozone crisis remains a potential threat to Beijing. In recent years, Chinese authorities have been primarily focused on inflation pressures and tried to navigate a slowdown in the economy. When they have wanted to loosen policy, they have used a cut to the reserve requirement rate instead as a way to ease pressure on growth without letting inflation get out of control. Hence, the first rate cut in three years is significant because it suggests a shift in focus from Beijing from inflation to growth going forward. If they combine this with expanded stimulus, we could see the AUD/USD start to recover.
RBNZ Not Likely to Follow in RBA’s Footsteps
On Wednesday, June 13, the Reserve Bank of New Zealand (RBNZ) will announce monetary policy, and while the Bank hinted at the possibility of rate reductions in the prior statement, we believe that the Bank is likely to keep policy on hold for now.
At the last meeting on April 26, the Bank indicated that a reduction in rates may be needed if the NZD remains elevated. Since then, global risk aversion and elevated uncertainty have weighed on the kiwi, which saw a significant drop from nearly 82 to current levels of around 76.
The RBNZ will likely note external concerns and a modest domestic recovery. Due to recent weakness in the currency, we believe that, for now, the Bank will maintain the policy rate and remain in a wait-and-see mode. As such, the policy announcement may be a non-event unless a material change in rhetoric is seen in the Bank’s statement.
This is in contrast to New Zealand’s neighbor, Australia, whose central bank has cut rates drastically, delivering a total of 75 basis points (bps) in rate cuts over the past two policy meetings. The most recent was a reduction of 25 bps last week with the Reserve Bank of Australia’s statement noting slowing conditions externally as well as modest domestic growth.
However, data released after the announced easing measures showed that Australia reported strong GDP and labor growth. Therefore, domestically, the outlook may have been understated, as economic activity appears to be picking up by more than originally anticipated.
Moreover, China surprised markets with a cut to its benchmark rate in response to softer Chinese data. The external support and positive domestic releases suggest that the RBNZ may pause on rate reductions for now and go back to a wait-and-see approach.
Bank of Japan, Swiss National Bank to Hold
The Japanese yen (JPY) has strengthened since the last Bank of Japan (BOJ) meeting, and Japan’s economy continues to face the threat of deflation. As noted by several Japanese officials from both the government and the BOJ, the excessive yen strength is hurting the island economy.
The current account surplus fell to JPY 333.8 billion (consensus JPY 440.8 billion), as a strong currency reduces the attractiveness of exports amid weakening global demand. Official rhetoric suggests that additional measures may be taken to support the recovery, however, as we have seen many times before, officials are slow to act and tend to underwhelm the markets when action is taken.
Recent statements by the BOJ head indicate the Bank’s view that “powerful easing” is being conducted, as the Bank is buying “considerable” amounts of Japanese government bonds (JGBs).
The issue that the Bank has been faced with regards to its asset-purchase program has been availability of bonds within its stated maturity range (which is currently up to three years). The Bank has failed to meet its target amount of purchases on more than one occasion due to lack of supply, and the failed operations raise speculation that the Bank may need to alter its approach.
As such, there is risk that an extension of the maturities or a change in composition of the Bank’s purchases may be announced, however, the probability of this is low, as the Bank did not announce such measures at the last meeting after a previous failure to meet its bond-buying target.
Furthermore, Governor Shirakawa noted that the Bank will evaluate the effect of pledged easing, which indicates that no new measures are likely to be taken while the Bank assesses the current environment.
Technically, the USD/JPY continues to trade within its weekly Ichimoku cloud, which suggests range-bound trading on a medium-term view. The top of the cloud is currently around the 80.50 level and is likely to cap near-term upside, while the base of the cloud around the 78 figure may provide support for now. A convincing break of the weekly cloud is needed to signal future direction from a technical perspective.
See also: Trading on Clouds: The Art of Ichimoku
The Swiss National Bank (SNB) will also meet this week to announce policy and we expect the Bank to reiterate its commitment to enforce the cap on the Swiss franc (CHF). SNB reserves have risen to record levels of 303.8 billion francs in May from 237.6 billion in April as the Bank defends the EUR/CHF floor amid increased euro selling.
Switzerland continues to face deflation, and therefore, the Bank is likely to keep policy on hold this week and continue to use firm language to state its intended policy. The Bank may get help from the government, as SNB President Thomas Jordan recently said that government officials are considering capital controls.
By Kathleen Brooks and Eric Viloria of FOREX.com
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