The Forex Trading Week Ahead

09/24/2012 6:00 am EST

Focus: FOREX

Eric Viloria

Senior Currency Strategist, FOREX.com

Kathleen Brooks and Eric Viloria of Forex.com outline the important issues currency traders should watch in the coming week.

Another week has passed and the ECB’S OMT program has yet to be triggered. The missing link is Spain. It continues to resist the pressure to make a formal request for funds. This is testing the market's patience, and caused some volatility in the Spanish bond market last week.

However as we start a new week, there is hope that Spain will apply for a bailout, after reports on Friday that Spanish officials were in negotiations with the EU to come up with the conditions Spain would be expected to adhere to before they received bailout funds. Reports suggest that Madrid will only request funds if conditions are based on structural changes to its economy rather than more austerity cuts.

There is a good chance that Spain could get what it wants, but only if it applies for a bailout in the coming weeks. If it waits until it has to apply for funds: it runs out of money and struggles to sell debt or pay its bond redemptions, then it could find that the European authorities are less willing to give Madrid what it wants. Thus, if Spain can agree with the EU a list of acceptable conditions in returns for funds, we could see Madrid apply for a bailout or provisional line of credit in the next week or so.

A sovereign bailout for Spain also has significance for the wider market, as it would trigger the ECB’s OMT program. Once this happens, the ECB becomes a lender of last resort for the currency bloc. This is considered an important step to stabilizing the sovereign crisis, and if it happens then we may see Spanish bond yields fall sharply over the medium term.

However, the sticky point is conditionality. We doubt that Spain will willingly accept more harsh austerity terms in return for a sovereign bailout. The government is losing popularity and there have been some violent protests in the streets in recent weeks protesting against cuts currently underway. Thus, it’s hard to see the electorate accepting more cuts.

However, the European authorities may not want to give Spain a free ride, as there is a good chance that it will miss its 2012 deficit target. The latest budget deficit data from Spain showed that Madrid’s budget deficit was 4% of GDP by July, or €39.8 billion, which suggests that a large overshoot of its 6.3% target for 2012 is possible.

Spain is the biggest concern for euro markets at the moment. If it applies for a bailout in the next couple of weeks, we could see the single currency and euro-based assets start to rise. If we don’t, then they could just as easily sell off sharply.

This week, we could be mainly range-bound as we wait to hear more about Madrid’s potential bailout and the conditions that may be attached to it. Also, October is gearing up to be a month full of event risk for the currency bloc, so this could be the calm before the storm.

The key data release next week we believe will be the German IFO data on Monday. The latest weak PMI manufacturing reading for Germany for September could point to declines in this index. Any sign that Germany‘s economy continues to weaken could spook the markets. We expect EUR/USD to trade in a 1.2830 (200-day simple moving average) to 1.3100 range in the coming days.

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Next: Currency Wars and What They Mean

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Currency Wars and What They Mean
Brazilian Finance Minister Guido Mantega has for the second time blamed the US for causing a currency war, where it uses quantitative easing to try and depress its currency, which then causes trouble for other nations, especially emerging markets.

We have already seen the Bank of Japan follow the Fed and boost its QE program last week. Now it looks like Brazil could intervene in its currency market to try and limit the strength of the real.

We have heard a lot about the “race to the bottom” in the currency markets, as a weak currency is an attractive way to try and boost growth by stimulating exports. Mantega is concerned since growth in Brazil has been surprisingly weak; the economy grew by 0.4% in Q2, better than growth rates in Europe, but well below what is expected from an emerging market.

This puts pressure on the Finance Minister to try and stimulate growth in the coming months. Mantega said that taxes could be applied to foreign purchases of real. He also said that interest rates should remain low, and that the recent stimulus provided by the market should feed through to the economy in 2013.

But Brazil’s concerns point to a bigger problem for investors that could impact all free-floating commodity currencies in the long term. If the Fed is going to keep its foot down on the accelerator until the economy recovers, then QE could be with us for the long term, which may keep dollar strength capped and the aussie, kiwi, and real fairly strong.

Australian and New Zealand authorities have pointed out the damaging impact of a strong currency on their economies before. If this gets worse, we could see others follow Brazil and try to manually weaken their currencies. This is bad news for investors, as it heightens political risk and makes the FX market a lot less certain.

Although a full blown currency war could be more of a slow burner, if we get a race to the bottom in the FX market, expect volatility to rise, which is bad news for stocks, commodities, as well as risky FX.

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JPY Remains a Haven
Earlier this week, the Bank of Japan extended easing measures by announcing an increase in is Asset Purchase Program (APP) from ¥70 trillion to ¥80 trillion.

The ¥10 trillion increase will be split evenly between purchases of Treasury bills and JGBs, and the program has been extended an additional six months through the end of 2013. Furthermore, the Bank has removed the 0.1% minimum yield to ensure bondholder participation.

In our view, the new action taken by the Bank is not a game-changer. This is the seventh time that the program has been expanded, and the increase in the APP over a longer period of time has resulted in a reduction in the pace of monthly purchases.

With other major central banks (the ECB and Fed) committed to doing whatever it takes within their mandate to achieve their objectives, the BoJ’s move is seen as limited. While the additional stimulus by the BoJ is certainly welcomed, the weakness that the JPY experienced was only a knee-jerk reaction, and the long term trend of JPY strength is likely to remain intact, as traders have largely dismissed BOJ purchases in the past.

Furthermore, with USD weakness expected to persist over the longer term due to the Fed’s open-ended bond-buying program, the JPY is emerging as a more attractive haven. Recent economic data that showed continued contraction in Europe and China’s manufacturing sector spurred risk aversion which saw the JPY outperform the USD.

As such, we anticipate the JPY to remain sensitive to broader risk sentiment as well as US Treasury yields, while the impact of Japanese monetary policy has had little impact on the currency. While there is potential for continued JPY strength, it is also important to remain cautious as the threat of intervention rises.

Kathleen Brooks and Eric Viloria can be found at Forex.com.

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