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EUR: EU Summit, Resolution or Delays?

Last updated 10/25/2011 4:57 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

• EUR: EU SUMMIT, RESOLUTION OR DELAYS?
• USD: WEAKER DATA REINFORCES FED CONCERNS
• GBP: LIFTED BY SURPRISE IMPROVEMENT IN CURRENT ACCOUNT
• CAD: DRIVEN LOWER BY DOVISH BOC COMMENTS
• AUD: OIL AND GOLD SHARPLY HIGHER
• NZD: RBNZ TO LEAVE RATES UNCHANGED
• JPY: BE WARY OF INTERVENTION

EXPECTATIONS FOR UPCOMING FED MEETINGS

EUR: EU SUMMIT, RESOLUTION OR DELAYS?

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Surprise, surprise, euro traders were taken on another rollercoaster ride today courtesy of the European Union who announced the cancellation of tomorrow’s EU Finance Ministers Summit.  The euro sold off initially when the news broke but has since recovered all of those losses and managed to hold onto to its recent gains against the U.S. dollar.  The recovery in euro suggests that investors remain optimistic that EU Juncker is speaking the truth when he says he sees a “final, even groundbreaking decision” tomorrow. We will know very soon with the EU Leaders Summit scheduled for 6pm local time (12:00pm ET) in Brussels and the Euro-area Leaders Summit at 7:15pm local time (1:15pm ET) exactly how much progress has been made.  The cancellation of the EcoFin meeting means one of two things - either the rescue plan has been completely hashed out and another EcoFin meeting is no longer needed to finalize the details or the talks have broken down and the EU has given up hope that a comprehensive rescue plan will be ready by Wednesday.

Given how euro area officials have acted so far, we are inclined to believe that the cancellation of the EU Finance Ministers meeting means more delays than progress on euro area talks. With that in mind however, the rally in the euro shows that investors still expect euro area policymakers to come up with a deal.   There have been some reports that an agreement on bank recapitalization and leveraging of the EFSF is close but other reports say that certain nations do not want to agree on a bank recapitalization plan that does not include enhancements to the EFSF. This suggests that the chance of tomorrow’s summit being the summit to end all summits is slim.  A decision on the Special Purpose Vehicle (SPV) will be a difficult one and if the outcome of EU Summit does not include specific numbers for bank recapitalization or expanding the EFSF, it will be very negative for the euro because it prolongs the uncertainty. There are number of different ways that tomorrow’s Summit could go wrong but an announcement of some sort will still be made because the consequences of not doing so would be severe. The only thing that could be agreed upon is a haircut for Greece but even then investors will immediately start to worry about whether the haircut will trigger a credit event.   If we are experiencing the same Kabuki style performance that we saw during the U.S. debt ceiling talks however, where a deal is inevitable despite the public spats, the outcome could be very positive for the euro because today’s developments have injected a level of uncertainty into the markets.  In our opinion, it is only a matter of time before they come up with a bank recapitalization/Greek haircut/ EFSF leverage plan and for this reason every dip in the euro has been met with recovery.  It is still smart however to put on those tin hats because trading over the next 36 hours can get hairy.  

To review, here are the 3 pressing issues that the EU needs to address:

1)      What to Do with Greece

Given that the latest problems stem from the possibility of a Greek default, it is the number one priority for the EU.  Based upon their current fiscal finances, it will be impossible for Greece to meet their near and medium term financing obligations.  As a result, a haircut needs to be imposed on bond holders, which would reduce the amount of money that they would receive in return. Back in July, a haircut of 21 percent was agreed upon but according to EZ finance ministers Greek bondholders may have to settle for a cut between 50 and 60 percent.  A smaller haircut will be short term positive for banks but long term negative for risk because it would still leave Greece vulnerable to missing future debt payments. A deeper haircut on the other hand will mean greater upfront losses for banks which could hurt equities but will be a more sustainable solution to the sovereign debt crisis in the long run. If the troika decides to release the sixth tranche of aid to Greece, it would also lend support to the euro. 

Larger haircuts mean further losses for banks that are already suffering from unwillingness by investors to provide short term funding.  To boost investor confidence, the EU may force banks to increase their core capital ratio from 5 to 9 percent within the next six months.   Banks that are unable to reach the capital requirement could be forced to accept government capital, which effectively nationalizes the banks. In response, banks have announced plans to sell assets and reduce lending which would help cut their need for recapitalization.  Unfortunately that may not be enough to attract investors in the private sector.   A strong recapitalization plan is needed to stabilize investor confidence.  The number floated being floated around is approximately $100 billion. Anything short of that will be negative for the euro.  Banks will most likely be asked to find ways to recapitalize themselves through private capital first, which could be a challenge because private investments are hard to come by in this type of market environment. 

The third issue that the EU needs to address is how to protect the rest of the region from contagion.  One way would be to increase the size of the EFSF but given the amount of time it took to boost the fund to EUR400 billion, expanding it to 2 trillion euros would be an even greater challenge.   One way to skirt around the political, legal and financial difficulties of increasing the EFSF outright would be to lever the EFSF by guaranteeing initial losses up to 20 percent of the face value on the loans.  This is a plan that is supported by many in the region including the Germans. The larger the first loss insurance, the more positive it will be for the euro. The French want to give the EFSF a credit line from the ECB but opposition from the central bank and the German government makes the chance of this happening slim. After accounting for the current commitments, the EFSF only has about EUR 270 billion left for leverage, which is just enough to cover 20 percent of the gross funding needs for Italy, Spain and Belgium.  

USD: WEAKER DATA REINFORCES FED CONCERNS

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Weaker economic data out of the U.S. may have weighed on USD/JPY but did little stop the greenback from rising against the euro and commodity currencies.  The sell-off in U.S. equities drove investors back into the arms of the low yielding currency but the demand for dollars remain limited with the greenback still trading near a one month low against other major currencies. According to the latest reports, consumer confidence fell to the lowest level since March 2009.  The Conference Board’s consumer confidence index dropped to 39.8 from 46.4 in October, which was the steepest monthly decline since 2002.  A weak labor market, volatility in stocks and concern about wages made investors less optimistic and unfortunately this means that spending could suffer. House prices also fell 0.05 percent in August while the house price index fell 0.1 percent.  Manufacturing conditions in the Richmond region held steady at -6 which would not be bad if not for the fact that economists were looking for a sharp improvement.  Overall the latest economic reports explain why Federal Reserve officials have remained so dovish, warning that more stimulus could be needed because there are reasons to believe that the prior improvements in U.S. data could reverse.   Durable goods and new home sales are scheduled for release tomorrow but they should play second fiddle to the EU Summit with the dollar trading almost exclusively on the market’s appetite for risk over the next 24 hours. 

GBP: LIFTED BY SURPRISE IMPROVEMENT IN CURRENT ACCOUNT

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Of all the major currencies, the British pound has proved to be the most resilient.  Thanks to better than expected current account data, sterling ended the day marginally higher against the euro and U.S. dollar, shrugging off pessimistic comments from the MPC.  Stronger investment income drove the current account deficit to its lowest levels in 3 years. According to the Office for National Statistics, the deficit narrowed to 2.0 billion from an upwardly revised 4.1 billion in the second quarter.   As a percentage of GDP, this is the smallest current account deficit since 1998 and explains why investors reacted so warmly to the report.  This is a rare piece of good data that has lent support for the currency on a day when risk aversion dominates trading.  However the gains in the pound were limited because monetary policy committee members remain weary of the outlook for the U.K. economy.  MPC member Martin Weale said the country is experiencing its weakest recovery of any recession in 7 decades and believes that there is a heightened risk for a double dip recession.  It was not that long ago that the Monetary Policy Committee decided to increase stimulus and one piece of relatively dated economic data will not change their bias.   Loans for house purchases declined in September, showing continued strains in the U.K. housing market.  According to Bank of England Governor King, there is a “very large squeeze” on U.K. households and because of that the BoE will do what is necessary with monetary policy.   To defend their decision to increase stimulus in the face of high inflationary pressures, King said they see very little evidence that CPI expectations have increased and instead saw a real risk of inflation falling below target.   The CBI industrial trends survey will be released tomorrow and a marginal improvement is expected in manufacturing demand.  

CAD: DRIVEN LOWER BY DOVISH BOC COMMENTS

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Risk aversion drove the Canadian, Australian and New Zealand dollars lower against the greenback despite a sharp rise in commodity prices.  The sell-off was led by the Canadian dollar which fell victim to dovish comments from the Bank of Canada.  According to the BoC's statement, the central bank has not been swayed by the recent improvements in Canadian and U.S. data. Retail sales may have risen 0.5 percent in August while the labor market experienced its strongest job growth since January but a grim outlook for the U.S. economy and the possibility of a brief recession in the euro area has prompted the central bank to lower its growth and inflation forecasts. The BoC left interest rates unchanged at 1 percent, which was in line with market expectations but what killed the loonie was the disappearance of the words "need to withdraw stimulus" from their monetary policy statement. The BoC's concern about the U.S. and Eurozone is so engrained that they opted to send a strong message to the market that can be interpreted to mean rates will remain unchanged until the middle of 2012. The BoC may have stopped short of making any mention of easing monetary policy, keeping interest rates low and stimulus in place leaves them far more dovish than most investors had anticipated. As a result, the Canadian dollar soared against all of the major currencies. With recent improvements in Canadian and U.S. economic data along with the possibility of a resolution to the European sovereign debt crisis this week, the central bank's dovish comments caught many people by surprise. The BoC's decision to downgrade their growth and inflation outlook also implies that a rate cut is not off the table. The BoC reduced their 2011 growth forecast from 2.8 to 2.1 percent while growth in 2012 was also downgraded from 2.6 to 1.9 percent. Total inflation is now expected to slow to 1 percent by the middle of next year. Unlike the Reserve Bank of Australia, who expressed optimism about growth in the region, the Bank of Canada does not have their rose tinted glasses on. One month of better than expected economic data is clearly not enough to convince the BoC that the outlook for the global economy has improved. Canada relies more heavily on U.S. demand than Chinese demand which explains why the recovery in oil prices has not led to increased optimism. Instead, the BoC opted to focus on the continued risks that the economy faces including the prospect of weaker domestic and external demand. This is bad news for the Canadian dollar and will put a halt to the currency's march towards parity.  Australian consumer prices will be released tomorrow along with Canada’s monetary policy report.  The Reserve Bank of New Zealand has a monetary policy meeting Wednesday afternoon (Thursday morning local time) and interest rates are expected to remain unchanged with the RBNZ most likely sounding cautious following weaker CPI numbers.

JPY: BE WARY OF INTERVENTION

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With the Japanese Yen rising to a fresh record high against the U.S. dollar, we are on intervention watch. The last time the BoJ intervened was back in August when USD/JPY was trading around 77.   We are now comfortably below that level and it should only be a matter of time before the Japanese government bites the bullet and decides to intervene in the Yen.  In fact, we expect intervention to occur within the next 48 hours if USD/JPY does not rise back above 76.50.  Threats of intervention have been flooding out of Japan with government officials warning that they will take decisive measures against the strong yen if necessary.  The last time the BoJ intervened to sell yen and buy dollars, USD/JPY jumped more than 300 pips. This is the type of reaction that is indicative of Japanese intervention.   Anything short of a 150+ pip move in a matter of minutes cannot be assumed to be BoJ intervention.  Japan’s Finance Minister reminded everyone last night that they have instructed their staff to be prepared for all possible steps on forex and so we caution our traders against shorting USD/JPY at such low levels.   Although the strong Yen did not have much of an impact on exports, small business confidence retreated this month.   Retail sales are due for release tomorrow and consumer spending is expected to contract for the third straight month.  The Bank of Japan will also begin its monetary policy meeting today and there is a very good chance that they will follow in the footsteps of the Bank of Canada and downgrade their growth forecasts.  Aside from facing the same headwinds of slow U.S. and Eurozone growth, the strong Yen serves as a triple blow for economic growth.  

NZD/USD: Currency in Play for Next 24 Hours

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Our currency pair in play for the next 24 hours will be the NZD/USD.  U.S. durable goods orders are scheduled for release at 8:30 AM ET or 12:30 GMT followed by the new home sales report at 10:00 AM ET or 14:00 GMT.   New Zealand’s central bank will make their monetary policy announcement at 4:00 PM ET or 20:00 GMT which will then be followed by their trade balance report at 5:45PM ET or 21:45 GMT. 

Having risen to a one month high on Monday, the NZD/USD fell nearly 1 percent today in a move that broke the currency pair’s uptrend and put it back into the range trading zone, which we define using Bollinger Bands.  Should the RBNZ disappoint and the NZD/USD head lower, support will be at 0.7860, an area of recent lows followed by 78 cents, which is the 23.8% Fibonacci retracement of the August to October sell-off.  If the NZD/USD rallies, resistance should be found at the 50-day SMA and today’s high of 0.8077. 

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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.