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FX: What Rise in French Yields Say about EUR Rally

Last updated 10/24/2011 4:17 PM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

THE STORIES IN THE CURRENCY MARKET

• FX: WHAT RISE IN FRENCH YIELDS SAYS ABOUT EUR
• USD: FED OFFICIALS STILL TALKING ABOUT MORE STIMULUS
• GBP: TESTING 1.60
• CAD: BOC TO LEAVE RATES UNCHANGED
• AUD: HITS 1 MONTH HIGH DESPITE SLOWER PPI GROWTH
• NZD: HIGHER COMMODITY PRICES LIFT NZD
• JPY: TRADE RETURNS TO SURPLUS, THREATS ON INTERVENTION

EXPECTATIONS FOR UPCOMING FED MEETINGS

FX: WHAT RISE IN FRENCH YIELDS SAYS ABOUT EUR

The recent volatility in the euro can be best summed by the phrase “two steps forward, one step back” where the currency is tacking on gains on a daily basis against the U.S. dollar, but the progress has been choppy and not smooth.  The EUR/USD edged higher for the fourth straight trading day, but not before experiencing some wild swings during the European and North American trading sessions.  With the EU Summit still underway, the volatility in the EUR/USD has been largely triggered by continued speculation about the size and scope of the EU’s rescue package for the region.  The rally in currencies and equities indicates that investors are optimistic that a deal will be reached by Wednesday and based upon comments from European officials, there is no question that they are serious about announcing a comprehensive rescue package after the EU Summit because the consequences of not doing so would be severe.  However we are intrigued by the movement in European bond yields that point to growing concerns that France could lose its AAA rating.  One of the big stories today is that French bond yields have jumped 120bp over German Bund yields, which is 3 times the normal level.  The fear is that if France is asked to recapitalize its banks (which seems like a near certainty at this point), the country could lose its AAA rating.  Last week, Moody’s warned that they could slap France with a negative outlook and the French government rushed to defend their AAA rating, knowing that the consequences would be troubling.  As the second largest economy in the Eurozone whose contributions constitute 22 percent of the EFSF’s funding, if France is no longer AAA, the EFSF could lose its flawless credit rating, which would be a major problem for the Eurozone because much of the EU’s rescue package hinges upon the region’s ability to attract private investment.  This makes the rally in the EUR/USD particularly perplexing because it suggests that currency and equity traders could once again be falling victim to blind optimism.   Nonetheless, as skeptical as we may about the EU’s ability to end the sovereign debt crisis once and for all, we cannot ignore the overall strength of the EUR/USD, the market’s general optimism and their desire to push the EUR/USD above 1.40.  The S&P 500 and the EUR/USD have been moving in lockstep on a near daily basis this month and we do not expect this relationship to break anytime soon as the outlook for the global economy hinges upon the outcome of the EU Summit. 

So far, here's what we know about the new rescue package:

1. The ECB's balance sheet will not be used to increase the rescue fund

2. The dollar amount of bank capitalization will be between EUR100 to 110 billion with a core capital ratio target of approximately 9%.  Banks will need to raise funds privately first before accepting government recapitalization

3. Haircuts of at least 50 percent on Greek debt

4. EFSF will not be turned into a bank

5. EFSF first loss insurance still being considered along with the creation of an SPV to attract foreign capital and the funds would be used to buy EZ debt.  The goal is to raise between EUR750 to EUR1.25 trillion. 

With the size of bank recapitalization and the target for the core capital ratio at the upper band of the market's estimates, the EU's plan should at bare minimum meet the market's expectations. With the details of the Summit stripping away the EU's element of surprise, shock and awe can only come from the total sum of the rescue package.  Otherwise, the EUR/USD would be at risk of a buy the rumor, sell news type of reaction.  With that in mind however, we don't expect significant downside in the euro because the extension of the EU Summit reflects the seriousness of European leaders to finally solve the region's debt troubles.  The pressure is on for Europeans to deliver on Wednesday and officials will need to tackle the fundamental problems head on with clear and decisive action to permanently bring down bond yields and CDS spreads and lift the EUR/USD well above 1.40.  Anything short of that will erase the gains in the euro because economic data including this morning’s PMI numbers show that economic activity in the euro area overall has weakened in the month of October.  

USD: FED OFFICIALS STILL TALKING ABOUT MORE STIMULUS

The U.S. dollar traded lower against all of the major currencies as risk appetite improved and Federal Reserve officials continued to talk about the need for more stimulus.  No U.S. economic data was released today but the decline in the greenback is consistent with the rally in equities.  Investors are optimistic that euro area policymakers will deliver on a comprehensive rescue plan that could reduce or possibly even eliminate the need for an ECB rate cut.  For the new head of the European Central Bank, the decision will be down to the wire.  If the markets respond positively to the EU’s rescue plan and the G20 launches their own version of support for the region, a rate cut by the ECB may no longer be needed.   Although the same could be true for the Federal Reserve, recent comments from FOMC officials suggests that they are far more inclined to push the button on more stimulus than their European counterparts.  Over the weekend and even today, Federal Reserve officials went out of their way to remind us of the additional steps that could be taken to stimulate the economy.   According to Fed President Dudley, the Fed hasn’t run out of bullets to stimulate growth and that giving more clarity of rate plans is being discussed vehemently within the ranks of the central bank.  Fisher on the other hand cautioned the Fed on using additional tools because there is a lot of liquidity out there already and it is not clear yet whether Operation Twist has worked.  He added that the Fed doesn’t need to act at every meeting, which suggests that not everyone is on board with more stimulus to the same degree. Lets also not forget recent comments by Federal Reserve Vice Chair Janet Yellen who said further asset purchases could occur “if evolving economic conditions called for significantly greater monetary accommodation.”  Although she seems to support the idea of tying interest rates to a piece of economic data such as the unemployment rate or inflation, she also explains that the main challenge of doing so would be the confusion that it would cause about the committee’s longer term objectives.  In addition, removing the economic data benchmark could also cause future volatility and uncertainty in the U.S. dollar.  Consumer confidence, the Richmond Fed and House Price Indices are the only pieces of economic data scheduled for release from the U.S. on Tuesday.  With the University of Michigan reporting weaker consumer confidence and Investor’s Business Daily reporting an improvement, it is difficult to tell exactly how the Conference Board report will fare.  Either way, the degree of consumer confidence fade in comparison to overall sentiment in the market and expectations for Wednesday’s EU Summit, which will continue to drive the price action in the currency and equity market.  

GBP: TESTING 1.60

With no economic data released from the U.K. today, the gains in the British pound were fueled largely by the market’s risk appetite.  Sterling extended its gains against the greenback, touching 1.60 in the process.   With investors still weary of the EU’s ability to surprise, the pound has held onto its gains against the euro.   There is not much in the way of U.K. economic data this week. Tomorrow’s current account balance will be one of the few meaningful reports on the calendar.  The current account deficit is expected to narrow slightly in the second quarter despite deterioration in trade activity.  Like many other central banks around the world, their degree of concern largely hinges upon the market’s reception to the Eurozone’s sovereign debt troubles.  Bank of England monetary policy committee member Broadbent said this weekend that the central bank would undertake more or less QE depending on how the economy develops and how the Eurozone crisis plays out.  He downplayed expectations of a further increase to the QE program announced this month where they boosted their asset purchase program by GBP75 billion.   Although the housing market in London remains strong, reflecting some wealth in the U.K. economy, household finances remain stretched as British citizens struggle with soaring prices and falling job security.  According to Markit’s Household Finance Index, 37% of U.K. households believed that their financial situation worsened in October, as the index fell to a 6 month low.   Their appetite for major purchases also weakened materially, pointing to softer future retail sales.  With that in mind however, the GBP/USD can still power higher if investors believe that the EU’s rescue plan for Europe will end the crisis once and for all.  At the end of the day, despite its low yield, the British pound is a risk currency and the country’s outlook relies heavily on the stability of Europe.  

CAD: BOC TO LEAVE RATES UNCHANGED

The Canadian, Australian and New Zealand dollars climbed to a one month high against the greenback on the heels of better than expected economic data from China. It is no secret that the commodity producing countries rely heavily on Chinese demand and for Australia and New Zealand the performance of the Chinese economy overshadows all other global market developments.  Last night, we learned that manufacturing activity in China accelerated in the month of October. Chinese manufacturing activity has contracted for the past 3 months and the country has finally been able to enjoy an expansion.  This data shows that despite the uncertainty in Europe and sluggish growth in the U.S., the Asia Pacific region is still growing. The region is singing to its own tune with Australia and New Zealand benefitting from the recovery.  As the Chinese economy expands, domestic demand is picking up the slack, which should commodities.  At the same time, the rebound in risk appetite has lifted oil, gold and copper prices. All  of these factors have benefitted the comm dollars.  The Bank of Canada has a monetary policy announcement tomorrow and we fully expect rates to remain unchanged at 1.00 percent. Although some economists predict that the BoC will downgrade their economic outlook, we believe that this is unlikely considering the sharp increase in job growth last month.   More than 60k jobs were created, dropping the unemployment rate to 7.1 percent, the lowest level since December 2008.   Inflationary pressures also increased and according to the IVEY PMI, manufacturing activity has improved significantly since the last monetary policy meeting where the IVEY was at 46.8. In addition to the BoC rate decision, retail sales will also be released and we expect the improvement in the labor market to support demand.  Meanwhile Australia was the only country of the three with economic data released overnight.  Producer prices grew by 0.6 percent in the third quarter, which was slightly less than the prior release and the market’s expectations.  On an annualized basis, PPI growth slowed to 2.7 from 3.4 percent as cheaper manufactured goods and construction costs offset the rise in utility prices.  For the Reserve Bank, the decline in inflationary pressures will add to the case that rates will remain unchanged for the foreseeable future.   When the central bank last met, they outlined the terms needed for a rate cut to occur.  One of those is a sharp decline in CPI growt,h which we do not expect to have occurred in the third quarter.  New Zealand has consumer prices on the calendar this afternoon and like Australia, inflationary pressures are expected to slow. 

JPY: TRADE RETURNS TO SURPLUS, THREATS ON INTERVENTION

The Japanese Yen strengthened against the U.S. dollar and British pound but weakened against all of the other major currencies.  The biggest story for USD/JPY is the fact that the Japanese Yen is trading within a whisker of its record high against the dollar.  As an export dependent country, Japan is highly sensitive to the value of its currency.  Finance Minister Azumi has warned that the government is ready to take decisive action on excessive speculative forex moves and that on Sat, he instructed the MoF to be prepared to take steps to stem the Yen’s rise. Threats of intervention have intensified and if USD/JPY remains at current levels, it should only be a matter of time before the MoF/BoJ step in.  However deciding on intervention this month will be tougher than in August.  Short USD/JPY positions spiked upwards when the currency pair hit a record low that month and the trade surplus turned into a massive deficit.  This month however, net speculative long yen, short dollar positions have fallen to their lowest levels since 2004 while the trade deficit returned to surplus in September, showing only a limited impact of a strong yen. Exports rose 2.4 percent which was stronger than the market’s 1.0 percent forecast.  The Bank of Japan typically intervenes in the Yen when net long positions are at extreme levels because they get the most bang for their buck by stopping out long yen short dollar traders in the process and right now Yen positions are not extreme enough to give them that advantage.  Nonetheless supermarket sales fell 3.6 percent, a sign that domestic demand remains weak.  This evening, small business confidence is scheduled for release – sentiment is not expected to improve dramatically and the impact on the Yen should be limited as investors continue to be on the watch for Bank of Japan intervention. 

USD/CAD: Currency in Play for Next 24 Hours

Our currency pair in play for the next 24 hours will USD/CAD.   Canadian retail sales will be released at 8:30 AM ET or 12:30 GMT followed by the Bank of Canada’s monetary policy announcement at 9:00 AM ET or 13:00 GMT.   From the U.S., consumer confidence, the Richmond Fed and House Price indices will be released at 10:00 AM ET or 14:00 GMT.

The improvement in risk appetite has drive USD/CAD to a one month low.  Having traded as high as 1.0657 earlier this month, the currency pair is now comfortably in a downtrend which we define using Bollinger Bands.   Support is at parity (1.00) but if this level is broken, it could be clear sailing to the 200-day SMA at 0.98.   Should the currency pair recover, resistance should be found at 1.0170, the 38.2% Fibonacci resistance of the July to October rally.  

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.