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EUR: Kiss Of Death From Rating Agencies

Last updated 1/13/2012 4:53 PM ET (GMT -5) 1 Comments

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Kathy Lien

Director of Currency Research, GFT

THE STORIES IN THE CURRENCY MARKET

• EUR: KISS OF DEATH FROM RATING AGENCIES
• SAFE HAVEN DEMAND SENDS USD HIGHER
• GBP: DECLINE IN PPI OPENS DOOR TO MORE QE
• CAD: TRADE RETURNS TO SURPLUS
• AUD: EMPLOYMENT NUMBERS DUE NEXT WEEK
• NZD: OIL AND GAS PRICES DECLINE
• JPY: RISES ON RISK AVERSION

EXPECTATIONS FOR UPCOMING FED MEETINGS

EUR: KISS OF DEATH FROM RATING AGENCIES

We all know how much trouble rating agencies can cause. During the financial crisis they were criticized for failing to predict the risk in asset backed securities. These days, they can be blamed for exacerbating the negative movements in the euro. Talk of Standard & Poors planting the kiss of death on France and Austria sent the EUR/USD to its lowest level in 18 months. By the NY close, the news was confirmed by S&P with France cut AA+ from AAA with a negative outlook, Spain cut to A, Italy cut to BBB+, Austria to AA+ and Portugal to junk. Unfortunately the downgrades are bad for the short and long term outlook for the euro. The price action in the currency market confirms that investors share the concerns of rating agencies and realize how bad France’s downgrade is for the Eurozone amid the world in general. It exacerbates the European sovereign debt crisis and puts the efforts of policymakers back a few steps because it is a strong sign that the crisis is spreading. France is a greater problem than Italy or Spain because its rating and that of the European Financial Stability Facility (EFSF) are basically joined at the hip. However with all 3 countries downgraded at the same time, the euro is in for some serious trouble. Short EUR/USD positions rose to a record high this past week and will likely increase further in the coming week.

What a French Downgrade Means for the Eurozone

The most immediate impact of a downgrade is higher borrowing costs for the countries that have come under the chopping block. With 10 year bond yields at 3 percent, France can afford to pay more. However the bigger problem aside from hurting Mr. Sarkozy’s re-election bid is that a downgrade of France will most likely lead to a downgrade of the EFSF. S&P put the long term credit rating of the fund on creditwatch negative in early December so they are certainly open to the idea of lowering the fund’s rating. In fact they said if they were to lower the rating, it could be by up to two notches. Collectively, Germany and France, the two largest countries in the Eurozone contribute 80 percent of the guarantees and over-guarantees from AAA rated countries to the EFSF. With France losing its AAA status, only EUR293 billion of the EUR451 billion would be valued at AAA. As a result a downgrade of the EFSF would come almost automatically. The only way to avoid a downgrade would be if the Germans committed more funds to the EFSF, which is unlikely. A downgrade of the EFSF would mean a higher borrowing cost for the facility which would undoubtedly be passed onto trouble nations, making it even more difficult for them to meet their financing needs – a slippery slope that the Europeans will have to contain quickly. The EUR should have a much more significant reaction to a downgrade of France than the USD had to a downgrade of the U.S. because of severity of the sovereign debt crisis and the global ramifications. European bonds are not the same as U.S. Treasuries – Treasuries are often perceived as some of the safest investments in the world but investors do not feel the same about German and French bonds. The path of least resistance of the EUR/USD is still lower with a possible move below 1.25 in the coming week. Clearly Mario Draghi spoke too soon yesterday when he expressed his satisfaction with the recent movements in the credit markets – a downgrade of France draws back volatility and necessitates additional measures by the ECB. U.S. markets are closed on Monday for MLK day but European markets will be open which means trading could still get hairy.

SAFE HAVEN DEMAND SENDS USD HIGHER

Safe haven flows eased into the U.S. dollar, driving it higher against every major currency with investors seeking safety as the troubles in the Eurozone grow. We had a handful of U.S. economic reports released this morning along with comments from Federal Reserve officials but with Europe grabbing the headlines and France becoming the new ground zero for the European crisis, how the U.S. economy is performing is all but a sideshow. Throughout the European debt crisis, the dollar has been a harbor for safety and on this day when the troubles are expected to boil over, investors have flocked back into greenback.  This had nothing to do with U.S. data, even though the University of Michigan consumer confidence report provided cause for optimism. According to the UMich survey, consumer confidence rose to its highest level since May. Even though lower unemployment has not necessarily translated into more spending, it has certainly translated into more confidence. Whether or not this will be sustained remains to be seen because the latest troubles in Europe also impact the U.S. Aside from UMich, trade and inflation numbers were also released but the data was completely ignored by currency traders who care little about backwards looking numbers that do not impact Fed policy. In the month of November the U.S. trade deficit widened from -$43.3B to -$47.8B which was much weaker than expected. The disappointment was caused by exports which fell 0.9 percent to a four month low and imports which rose 1.3 percent. Demand for crude oil and automobiles were so robust that it offset weaker orders for consumer goods. The U.S. trade numbers confirm that the fourth quarter was a tough one for many countries. Inflation is not much of a concern with import prices falling 0.1 percent.  Producer and consumer prices are scheduled for release next week and the downtick in import prices points to lower inflationary pressure. Manufacturing and housing market numbers will also be released along with the Treasury International Capital flow report.

GBP: DECLINE IN PPI OPENS DOOR TO MORE QE

Weaker economic data and risk aversion drove the British pound lower against the U.S. dollar. It is worth noting that sterling managed to recover all of yesterday’s losses against the euro as investors turn on the single currency. In fact the pound has performed the best of the 3 European currencies, rising against the euro and Swiss Franc. This suggests that some investors look at the British pound as Europe’s primary safe haven but we caution our readers against looking at the pound too positively because the U.K. is extremely vulnerable to Europe’s woes. Throughout this week we have seen a number of downside surprises in economic data and today was no different with producer prices falling sharply in the month of December.   Input prices dropped 0.6 percent while output prices fell 0.2 percent. This was the first time in more than a year and a half that factory gate prices declined. According to our colleague Boris Schlossberg, “Excluding the volatile food and energy sector wholesale prices fell by -0.7%. This was the largest month over month fall in more than two years indicating that UK price pressures may finally start to ease in 2012. Today’s subdued price data however, suggests that the BOE may now have the opportunity to expand its monetary policy further by increasing QE sometime in the near future as policymakers seek to stimulate the moribund economy.” Next week’s heavy economic calendar will help us understand how close policymakers are to increasing stimulus. On the calendar are U.K. consumer prices, employment and retail sales.

CAD: TRADE RETURNS TO SURPLUS

The sell-off in U.S. equities and increased uncertainty drove all three commodity currencies lower against the U.S. dollar. Despite their vulnerability to risk appetite, the commodity currencies have held up well compared to many of the other higher yielding, high beta currencies. The Australian and New Zealand dollars for example remain near their 2 month highs. No economic data was released from either country but next week Australian employment and New Zealand consumer price figures will be released. The market is currently pricing in easing by the Reserve Bank of Australia this year which makes the employment report extremely important in setting the tone for trading this month and determining whether expectations are misplaced. Canada was the only country with data today – they reported a much stronger than expected trade balance. In fact the country’s deficit returned to surplus in November with the balance of goods imported and exported rising to CAD1.07 billion from –CAD0.49 billion the prior month. Canadian dollar traders applauded the move initially but gains were stripped away quickly amidst European downgrade rumors. Next week the Bank of Canada is scheduled to make a monetary policy announcement. Last month the BoC sounded surprisingly optimistic and even though recent improvements in U.S. data validate their outlook, the uncertainty in the Eurozone could prevent them from stepping up their optimism.

JPY: RISES ON RISK AVERSION

The Japanese yen strengthened against all of the majors with the exception of the US dollar. With no economic releases from Japan, traders bought the yen amid dampened risk appetite. Government deleveraging remains a pressing issue for the Japanese Prime Minister Yoshihiko Noda as he reshuffles the Cabinet to win opposition support for the tax hike proposal. Noda aims to rein in the ballooning fiscal deficit by raising the sales tax. The critics of the bill, including the powerbroker Ichiro Ozawa argued that an increase in tax could deal another blow to the already weakened economy. Noda’s latest attempt to reconcile the divided ruling Democratic Party and the parliament points to the political instability in Japan, which has seen a new PM every year for the past six years. In addition to the political concern, the economy also faces more complication amid US sanctions of Iran. Japan is heavily dependent on imported oil and natural gas in meeting its energy needs, and Iranian oil accounts for about 9 percent of the oil imports. Noda said Friday the government has yet to decide on whether it will reduce oil imports from Iran in line with US sanctions. Noda retreated from the strong support voiced a day earlier by his finance minister, Jun Azumi. “We need to consult with the business community, and we need to work out details with U.S. officials. We have to think about the implications for Japanese banks, and what measures are needed to resolve possible negative impact,” said Noda. Looking forward to next week, the machine order for November is forecasted to print an increase of 5.1 percent on Monday, followed by household confidence. We also expect tertiary industry index, machine tool orders, industrial production, and leading index from Japan.

EUR/USD : Currency in Play for Next 24 Hours

The EUR/USD will be our currency pair in play for Monday. While there is no economic release from the US, Germany will release its wholesale price index at 2:00AM ET/ 7:00 GMT. In addition, the price actions of the pair will largely hinge on the development of the S&P downgrades.

The collapse of the EUR/USD has kept the pair trading in a downtrend, which we determined using the Bollinger Bands. The nearest support lies at 1.2623, today’s low. The pair could find further support at the psychologically significant 1.25. On the upside, 20-day SMA could serve as the first resistance level at 1.2916. If EUR/USD ‘s rally is sustainable, the pair could target 1.3048, where the upper first std. dev. Bollinger Band and 61.8% Fibonacci level converges. We drew our Fibonacci retracement from the record low in June 2010 to the swing high in May 2011.

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Comments (1)

Pablo_beja

January 15, 2012 at 03:28 PM ET

Hi Kathy. Big follower here. Would like to thanks first for all the insights and inspiration. Have read 2 books of you.
I would like you to suggest me any good backtesting softwere in your opinion. It would be great for fx360 to share an article about that subject. Thanks a lot.

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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.