The Forex Trading Week Ahead

07/02/2012 6:00 am EST

Focus: FOREX

Kathleen Brooks of Forex.com outlines the issues currency traders are watching this week.

The EU summit was a curveball for the markets. At an unscheduled press conference early on Friday morning, the EU President announced that there had been a breakthrough: Bailout loans to Spain’s banking sector would not give preferred creditor status to European authorities, and the ESM-EFSF bailout funds would be able to recapitalize banks and buy sovereign debt.

These measures should help to reduce credit risk in Spain and Italy. But Germany did not give in easily. Merkel and Co. got agreement for a common Eurozone banking authority that the EU Commission is tasked with setting up by the end of this year.

Compared to other summits, the European politicians managed down market expectations, only to exceed them with this breakthrough. After the initial positive reaction by risk markets on Friday, this week there may be a closer focus on the details, as investors weigh whether Europe has done enough to stabilize the currency bloc for more than just a few months.

The Positives
Looking at the positives first: these decisions help to break the link between sovereigns and banks. In the case of Spain and Ireland, property busts caused enormous holes to form in the banking sector’s balance sheet, which the state then had to plug. This eventually pushed both countries to bailouts.

Although Spain’s bailout loans were for its banks, the state had to accept the liability that would have increased its debt-to GDP ratio, which meant that the “bailout” actually weakened Spain’s creditworthiness by boosting its debt levels. Since the bailout funds can now fund banks directly, hopefully this link has been broken.

The change to the functionality of the rescue funds means that if a country is getting attacked by bond vigilantes, the ESM can now buy its debt. This has been allowed since the creation of the ESM last year, but it was never activated.

Also, the latest development means that the fund can buy the debt of a country like Italy, without having to sign a bailout agreement first with potential onerous austerity targets. This also goes some way to severing the link between bailout loans and growth-destroying austerity.

Last week’s move is also symbolic, since it shows that Europe’s leaders can reach an agreement on big changes to the way the Eurozone works, which reduces the chance of political risk as fiscal reform is discussed in the future.

The Negatives
The sovereign crisis may not be over just yet. For example, the rescue funds are EUR500 billion in size, yet the total liabilities in Spain and Italy’s banking sectors are EUR2.4 trillion. There could be concerns that the fund is not big enough to ring-fence Spain and Italy, yet we have not heard anything about a further re-capitalization of the ESM.

Added to this, rescue funds won’t be able to re-capitalize banks or sovereigns until a Eurozone banking authority has been set up. The plan is to have this running at the start of 2013, but agreeing on one central authority with the rules of oversight for all of the currency bloc’s banks is no mean feat. Thus, if the timescale slips too much, the market may lose faith that the enhanced rescue fund will get off the ground.

There is also no news (at the time of writing) on closer fiscal unity and, in particular, joint debt liability. Added to this, we don’t know if the new banking authority will guarantee all bank deposits, and whether in future a euro in a Spanish bank is as safe as a euro in a German one.

There is still excess debt in the currency bloc, Greece’s position in it is still precarious, and growth is pretty thin on the ground. So at this stage, it’s too early to declare victory on the Eurozone sovereign debt crisis, and the financial markets still need more action from Europe.

Euro-based assets staged an impressive rally after the EU press conference. EUR/USD was poised to close the European session above 1.2650 after rallies at the start of the European and US sessions. Likewise, European stocks were also higher, and the pan-European Eurostoxx Index jumped above the top of the Ichimoku cloud, suggesting an end to the downtrend, at least temporarily.

Bar a negative surprise, we could see the rally extend, although ultimately we believe EUR/USD is likely to be range-bound into the ECB meeting on Thursday (see more below), although stocks may extend recent gains. EUR/USD gains may be capped around 1.2750—the high post the Greek election—while we believe 1.2550 is good support for the time being.

Central Banks to the Rescue
We have two important central bank meetings next week, the European Central Bank and the Bank of England, which are both held on Thursday, July 5.

The market expects the ECB to cut interest rates by 25 basis points to a euro-era record low of 0.75%, The ECB has been deeply involved in the EU summit and on making plans for eventual fiscal union. Now that the summit has delivered some concrete action by Europe’s leaders, the ECB may be more happy to help in its capacity to change monetary policy to foster the conditions for growth.

Added to this, German inflation has fallen sharply in recent months, and is currently at 1.7% annual pace, below the ECB’s 2% target. Thus, deflation fears may cause the ECB to act later this week.

Up Next: The Impact on the Euro...

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The Impact on the Euro
The primary benefit of a rate cut could be a lower euro. Although the euro has tended to rally when credit risk in Spain and Italy has decreased, we could see Spanish and Italian bond yields fall, but US Treasury yields rise at a faster pace than German bond yields, as rate cuts by the ECB may anchor the front end of the German rate curve at a very low level.

This would give the dollar the yield advantage, and could weigh on EUR/USD. However, with positions stretched to the downside already, we think any downside after a potential rate cut by the ECB could be limited to 1.2400 then 1.2250—the low from early June.

BoE Unlikely to Disappoint
The Bank of England also meets on Thursday, and the market expects a further 50 billion GBP of quantitative easing.

The market has been expecting this for some time. Not only is the UK economy back in recession, but the BOE Governor Mervyn King said that more QE was possible if conditions deteriorated at a recent dinner in the City of London. Thus, if the Bank doesn’t act at this meeting, it risks losing its credibility.

The final reading of first-quarter GDP also made for grim reading last week, when the annualized rate of growth was revised lower to -0.2% from -0.1%. Business investment was also revised lower to 1.9% in the first three months of the year, from 3.6% originally.

If the EU summit puts a lid on the sovereign debt crisis for the medium term, we don’t think the BOE will signal any further action, and will instead wait to see the effects of its latest round of QE. Since this move has been well-flagged, we don’t think that we will see much of an impact on sterling.

GBP/USD is likely to move in line with overall risk appetite, with 1.5730 the near-term resistance level, while 1.58 is another level that could be sticky. 1.5530 remains good support. Sterling is more at risk from a decline against the euro in our view, especially if the sovereign crisis shows signs of stabilization. At the European close EUR/GBP was above the daily Ichimoku cloud at 0.8060. This is a key technical resistance zone, and suggests that Friday’s price move is significant and there may be more upside to come.

Will the World’s Growth Engines Show Signs of Life?
The usual start-of-the-month data dump will be released in the US and China this week, and even those who don’t usually pay attention to the fundamentals should take note. One of the reasons for the decline in investor sentiment in recent weeks has been down to fears that growth in the world’s largest economies may be slowing sharply.

The breakthrough at the Eurozone summit may have eased credit fears, but it hasn’t addressed growth issues in the currency bloc, which threatens China’s economy since the currency bloc is a major trade partner. Monday’s HSBC manufacturing PMI for June and the official figure on Sunday are particularly important due to the correlation between PMI and GDP.

The HSBC survey fell to 48.4, which is contraction territory. The official figure is also expected to fall below 50 to 49.9, which would be the first contraction figure since the end of 2011. [In actuality, the official number did fall, but only to 50.2, beating the race by a whisker for another month—Editor.]

China’s economy is still reliant on exports and thus on global growth and market sentiment. Due to this, its economy is unlikely to pick up until the Eurozone figures out a way to boost growth in its member states’ economies.

In contrast, the US economy has seen economic confidence most affected by the Eurozone debt crisis along with a weak jobs outlook. While the EU summit may ease some of the fears that the sovereign debt crisis will cause global growth to tank, we will get more evidence of the state of the US jobs market on Friday, when Non-Farm Payrolls are released for June.

The market expects an increase of 90,000 jobs in June, up from 69,000 in May. This is still fairly paltry, and not enough to bring down the unemployment rate, which is expected to remain at 8.2%. Unless we get a jobs reading of at least 150,000 or higher, it’s unlikely to ease fears that the US economy is sluggish at best.

There are fears that the US economy could have slipped into recession in May, thus the ISM manufacturing and non-manufacturing surveys for June are also essential pieces of economic data for traders next week. They are released today and Thursday respectively, and are both expected to moderate, although they are expected to remain in expansion territory above 50. This may ease fears of a recession, but weak numbers even above 50 could still cause some concern about the health of the US economy.

Essentially weak economic data increases the chance of more Fed action, including potentially more QE, which is dollar-negative. This prospect is also likely to keep downward pressure on US Treasury yields, even if safe-haven flows into Treasuries decline post the EU summit.

If this happens, that could limit upside for USD/JPY, which tracks Treasury yields fairly closely. We believe this cross will trade between 79.20 on the downside and 80.10 on the upside in the next few days, until we get more clarity on the strength of the US economy.

Japan’s Tankan survey, which measures sentiment in the manufacturing sector, is also released on Monday. This is expected to remain fairly weak in Q2; the forward-looking outlook component is also expected to decline to -4 from -3 in Q1.

However, this may be down to concerns about the Eurozone. If the outcome of the EU summit eases some of those fears, we could see sentiment start to pick up. The yen may rally on a weak reading, which could weigh on USD/JPY.

Kathleen Brooks can be found at Forex.com.

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