Japan Crisis Fuels FX Risk

03/14/2011 10:24 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com


For the week ahead, currency traders will be monitoring the crisis in Japan, ongoing EU debt concerns, and rate policy decisions from several central banks.

By Brian Dolan of FOREX.com

The massive earthquake and tsunami in Japan on Friday further undermined risk sentiment, and this led to JPY strength as yen shorts were rapidly covered. There has been talk of Japanese repatriation of funds to cover insurance costs, but we think this is likely overstated and that risk aversion is the better explanation.

The tragedy there is still unfolding, of course, with additional earthquakes registering through the weekend, and no estimates of damage costs are available at the moment. However, given the largely agricultural nature of the affected region, we don’t think the impact to Japanese GDP will be incredibly severe, but that’s not saying much considering Japanese growth already turned negative in Q4. This assumes the nuclear situation will not worsen. If it does, it adds an entirely new level of uncertainty for the speed of Japan’s recovery.

While we think the near-term pressure will remain on USD/JPY, we don’t think the pair will test the pivotal 80.00 level and it seems most likely to find a base in the 80.50/81.50 area in coming weeks. We think the ministry of finance (MOF) will seek to avoid a further surge in the yen, which would add fresh burdens to the Japanese recovery.

The Bank of Japan (BOJ) is meeting at the start of this week and may announce emergency measures such as additional asset purchases, which could see the JPY weaken sooner. The government will also likely soon pursue a supplementary budget to pay for clean-up and reconstruction, and this may revive fears over the size of Japan’s debt burdens and also cause the JPY to weaken.

European Union Pact on Finances

Without the final details in hand as of late Friday afternoon, we can’t be sure of the ultimate reaction, but price moves ahead of the release of the European Union (EU) pact suggest markets are going to be underwhelmed. The draft of the pact suggested that no concrete rules will be established and that individual governments will operate on a "best-efforts" basis to rein in debts and deficits and stimulate growth. The only enforcement mechanism will be discussions between member states.

If the final pact follows these outlines, markets are more likely, in our view, to voice disapproval. Indeed, in the run-up to Friday’s summit, peripheral EU bond spreads widened to near crisis peak levels from last year, suggesting many still expect defaults and restructuring to follow. Alongside threats to the global recovery emanating from MENA and China, and now Japan, we think the downside for the euro is vulnerable and we will view a break below the 1.3730/1.3750 daily Kijun line/weekly low/21-day moving average as an indication of a euro likely headed back toward 1.3500/1.3550 in the near term. Should the pact contain more disciplined measures, then we would expect to see some further recovery in the single currency, but think it should remain below 1.4000 as growing risk aversion limits the upside.

NEXT: Spain Gets a Wakeup Call


Spain Gets a Wakeup Call 

There are growing signs that the market is losing patience with EU authorities, who have failed to come up with a credible, long-term solution to the region’s sovereign debt crisis. As EU leaders gathered for a summit in Brussels at the end of last week, the markets had low expectations that an effective solution would be found. Bond yields spiked to euro-era records for Ireland and Portugal; Spain and Italy were not immune either as the risk premium to hold their government debt also increased. 

The downgrade of Spain’s sovereign credit rating by Moody’s to Aa2 from Aa1 at the end of last week focused the markets’ attention back on Europe’s troubled banking sector. A third round of bank stress tests is scheduled to be conducted in the next few months. On March 18, the EU authorities will publish the macroeconomic scenarios and the sample of banks that will undergo the tests. This is key for the market, as it will determine whether the tests are strong enough to really give a true snapshot of the bad debts and recapitalization needs of some of Europe’s most troubled lenders, particularly the Spanish caja banks. More details will follow in April when the stress test methodology is disclosed and then again in June when we finally get the results.

There is no doubt that the EU authorities have made a hash of dealing with their financial problems. It has taken three rounds of stress tests to try and make sense of the bad debts still swimming in Europe’s financial system.

Investors will only be happy once they know exactly how bad the problems are. When the US published devastating results of bank stress tests in 2009, it was greeted warmly by the markets and led to a stock market rally. Investors will only be happy to hold assets from Europe’s periphery if they can accurately calculate the risk of doing so. Right now, they are guessing that things are worse than the authorities are saying, hence, bond yields are rising to unsustainable levels. If the truth was out there, then bond yields may even start to moderate. Until the full extent of the debt crisis is known, there can be no remedy. If the results of the tests are published in June, then a solution is unlikely to be found until the end of the year.

By that time, Portugal is most likely to have applied for bailout funds, while Spain just about avoids doing so. But there is a lot of pressure on the larger of the two Iberian nations. Although debt issuance in 2011 is only about 80% of what it was in 2010, Spain still has to tap the markets for an enormous EUR600 billion or more for the rest of this year. Doing so at the same time as the bank stress tests are taking place could test investor patience. If Spain’s banks require significantly more capital than the EUR20 billion the Spanish authorities have disclosed, then its debt could be significantly harder to sell to foreign investors, who have already been cutting back on their exposure to the weaker euro zone states.

The euro has brushed off sovereign debt woes in the past, but they are increasingly weighing on the single currency. It fell back to the 1.3800 level versus the dollar at the end of last week, and the key 1.4000 resistance level is unlikely to be broached for the time being. Technically, EUR/USD is still in an uptrend above 1.3535, but it has fallen sharply, and if we don’t get a bounce somewhere between 1.3600 and 1.3700, we could see a sharper decline over the coming months, especially versus the greenback.

Central Banks Expected to Maintain Policy Rates

Several central banks will meet to determine policy in the week ahead. The Federal Open Market Committee (FOMC) will meet on Tuesday, March 15; the Norges Bank will meet on Wednesday, March 16; and the Swiss National Bank (SNB) is scheduled to meet on Thursday. All of these banks are expected to keep policy rates on hold, with the Norges Bank the most likely to surprise with a hike, however, we do not anticipate a move on rates.

In the US, the Fed has maintained the language that the bank will keep rates low for an "extended period" and the large-scale asset purchase program of $600B through June has a "high hurdle" before altering the plan. While the unemployment rate has dropped slightly, labor data suggests that the recovery may not yet be self-sustaining. Additionally, the CPI has ticked upwards slightly, but it remains at comfortable levels last released at 1.6% year-over-year (YoY) on the headline reading and 1.0% YoY for the core measure. This evidence suggests no change in policy at the Tuesday meeting.

The Swiss National Bank (SNB), whose primary mandate is to ensure price stability (which it defines as inflation below 2%) is likely to maintain rates at 0.25%. Recent data indicates February CPI at +0.4% and a drop in the unemployment rate from January’s 3.8% to 3.6% in February. SNB president Philipp Hildebrand recently noted that the strong Swiss franc lowers inflationary pressures in the near term, however, the Bank noted the need to fight inflation over both the medium and longer term, as it sees its price-stability threshold being breached in 2013.

The Norges Bank has signaled that it will resume tightening by the middle of 2011. The bank last raised rates in May and has provided guidance through the end of 2014. It expects its benchmark rate to average 2.25% this year and 3.25% next year. This indicates an expected 25-basis-point hike each quarter from June 2011 until the end of 2014. Thursday’s release of February CPI showed a slowing to +1.2% from the prior month’s +2.0%, which is supportive of no change in policy at the upcoming meeting.

Mixed Picture in China; Further Tightening Still Needed

The past week of data released out of China has confounded many market participants. On one hand, the February data showed elevated risks to inflation-Feb. PPI was 7.2% versus expected 7.0% YoY and Feb. CPI was 4.9% versus expected 4.8% YoY. However, on the other hand, Feb. retail sales came in much weaker at 15.8% YoY and Feb. trade balance turned negative for the first time in 11 months, coming in at -7.31 billion versus expectations of +4.9 billion. Finally, it appears their efforts to slow the rapid rise in real estate is beginning to have knock-on effects, however, a considerable amount of this may also be attributed to a robust Chinese New Year.

In the end, China still has been unable to control the more pressing issue of inflation. While food prices remain the main driver of CPI (which have somewhat moderated of late), higher energy and commodity prices continue to remain the underlying concerns to PPI. Moreover, we’ve seen that commodity pricing pressures tend to lead Chinese PPI, and with crude oil and industrial metals near their respective highs, rising inflation looks like it’s a problem that is unlikely to go away anytime soon. Therefore, we believe the People’s Bank of China (PBoC) will continue to remain active over the coming weeks/months, with our central case looking for two further interest rate hikes-50 basis points in total-before the end of June. We also envision additional hikes in order to further withdrawal liquidity from their financial system.

As China tightens to manage liquidity and control inflation, we may see periodic setbacks in risk sentiment, as well as dips in commodity prices and the prices of commodity currencies (AUD, CAD, and ZAR), however, we believe such pullbacks are likely to be relatively short lived and should be viewed as potential buying opportunities.

By Brian Dolan, chief currency strategist, FOREX.com

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