Eric Viloria of Forex.com outlines the issues and events of interest to currency traders in the coming week.

For some time now, market participants have been expecting that Spain will eventually request a full bailout in addition to the banking aid that it had already requested. It is also expected that the European Central Bank will come to Spain’s assistance after a formal request is submitted through the region’s rescue fund (currently the EFSF).

Since ECB President Mario Draghi indicated that the Bank plans to buy bonds of troubled nations as long as conditions are imposed, sovereign yields have declined, giving the EUR a boost. Spanish and Italian ten-year yields are currently lower by 71 and 54 basis points respectively since the August 2 ECB meeting, as investors anticipate action (see Figure 1).

No action has been taken, however, as the key players wait. Spain waits for the ECB to provide details of its bond buying plan as indicated by Spanish Deputy Prime Minister Saenz on Friday. The ECB is waiting for the German ESM ruling before finalizing its bond plan. (The ESM is the permanent rescue fund which has yet to go into effect).

The German constitutional court is expected to give its preliminary ruling on the ESM on September 12, and until then it appears that policymakers will be sitting on the sidelines before plans are finalized and action is taken. This also suggests that traders may not receive the clarification on the ECB’s bond buying plan at the next policy meeting ,which comes on September 6, before the German ruling.

This past week, Greek Prime Minister Samaras met with Eurogroup head Juncker and German Chancellor Merkel. Samaras is also scheduled to meet with French President Hollande this weekend. Ahead of the meetings, reports indicated that the Greek PM intended to seek an additional two years to meet its budget deficit reduction targets, and hoped for conditions to be eased.

Juncker indicated that an extension will depend on the Troika report and that the ball is in Greece’s court. Merkel remained firm, saying that Greece must keep to its commitments, and said that no decisions will be made until the Troika report.

As Europe plays the waiting game, we expect price action to remain relatively muted in EUR. EUR/USD volatility has been at low levels and the exchange rate has consolidated higher within a long-term bearish trend channel.

Technical resistance can be seen around the 100-day simple moving average (SMA), which is currently above the 1.26 figure, and key support is currently around the convergence of the 21-day SMA and rising support line, which is around the 1.2350 area. We expect volatility to pick up again when key meetings occur early in September.

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All Eyes on Jackson Hole

The Kansas City Fed Economic Symposium at Jackson Hole, Wyoming will be held next week, with Fed Chairman Ben Bernanke scheduled to speak August 31 and ECB President Draghi due to speak on a panel September 1.

Speculation on additional stimulus from both the Federal Reserve and the European Central Bank have been key drivers of price action of late. The Fed is faced with a disappointing recovery and frustrating labor market, while the ECB is concerned with the transmission of monetary policy due to high sovereign yields in the face of a debt crisis. Furthermore, the Eurozone is likely in the midst of a double-dip recession, as underscored by this past week’s contractionary PMI readings.

Bernanke said on Friday that there is “scope for further action by the Fed to ease financial conditions and strengthen the recovery.” As indicated by the recent FOMC minutes, the Fed appears to be moving closer to providing additional accommodation, and markets have responded accordingly. Treasury yields and the USD have declined while gold has surged.

In addition to outright balance sheet expansion (QE3) by purchasing Treasuries and/or mortgage-backed securities, the bank could lend through the discount window, extend its forward interest-rate guidance, or reduce the interest paid on excess reserves. Markets will be looking for any clues from the Fed Chairman as to what, if any, the next step will be from the Fed.

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In our view, Bernanke is likely to remain noncommittal. This would be supportive of the USD and may see the dollar rebound as expectations of more easing are pushed out. We think that the August employment report will be key for Fed policy decisions moving forward, as it will shed more light into the health of the labor market and may see revisions to the July figures that surprised to the upside.

Since the last Fed meeting, housing appears to be stabilizing, retail sales have picked up, and the trade deficit has narrowed, suggesting a pickup in the pace of the recovery. The Fed’s Beige Book is due next Wednesday, ahead of Bernanke’s Jackson Hole speech, which may provide a more detailed account of economic activity. Also due next week is consumer confidence and the Case-Shiller HPI.

Reports have been swirling about what the ECB could do with the most recent headlines, suggesting the Bank could set target bands for sovereign bond yields via a bond buying program. However as the Bank indicated, there will be no finalized plan until the German ESM ruling (see above). Unlike how Fed action would weigh on the USD, the euro is likely to benefit as the ECB moves closer to action.

Japanese Deflation to Persist Despite “Powerful Easing”
In the week ahead, Japan will release national and Tokyo consumer price data. National CPI excluding fresh food for July is forecasted to show a decline of -0.3% year-over-year from the prior -0.2%, while the more timely August Tokyo CPI ex fresh food is expected to fall by -0.6% on a yearly basis (prior -0.6%).

The Bank of Japan has set an explicit inflation target of 1%, and has been pursuing what it calls “powerful easing” using communication and asset purchases. The Bank has struggled to achieve its inflation target, and the Japanese yen has been a concern due to its current strength.

BOJ Governor Shirakawa spoke early Friday morning and said that the strong yen is putting downward pressure on Japan, and that it is important that the JPY move in line with economic fundamentals. He said that the BOJ will continue powerful easing, and that the Bank considers the yen when implementing policy. Bank of Japan policy has had little impact on the currency recently, as what the bank considers “powerful easing” has underwhelmed market participants.

The yen has been acting as a safe haven amid the ongoing debt crisis in Europe. However, we would note that the key driver for the USD/JPY pair is US Treasury yields, which have declined recently amid increased speculation of additional Fed easing.

The 30-day rolling correlation (based on daily change) between USD/JPY and US ten-year Treasury yields peaked for 2012 around 0.796 on Wednesday, after the release of the FOMC minutes, and the correlation remains high at around 0.782 (see Figure 2).

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Eric Viloria, CMT, can be found at Forex.com.