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EUR/USD down ahead of ECOFIN
EUR/USD touched its lowest level in two years ($1.2255) early Monday ahead of the EU finance ministers meeting, but then bounced to $1.2290.
A two-day Eurogroup/ECOFIN Finance Ministers meeting (July 9-10) attracts the market attention. The policymakers are to discuss the details around the decisions from the EU Summit: on the top of the agenda is the Spain's and Cyprus' rescue. According to the EU diplomats, EU ministers will grant Spain one additional year, until 2014, to meet the 3% deficit target. Moreover, the new Greek Finance Minister will report on efforts to put the country's reform program back on track.
The post EU-summit optimism has been rather short lived as yields on Spain’s and Italy’s 10-year bonds exceeded the pre-summit levels (above 7%) on Monday. The Sentix Investor Confidence index dropped to a 3-year low, coming out below the expectations and adding to investors’ concerns.
Image: Michael Shue
European irony: French yields decline
There are always plenty of interesting things happening in the euro area these days. For example, the yields on 2-year French debt fell from the levels around 0.6% where they had been in the recent weeks to only 0.17% today.
As borrowing costs in troubled Spain and Italy went up again, France has become the main destination point of safe-haven flows. One may think that being a safe haven in Europe is Germany’s prerogative. However, German yields are already negative and if the situation continues this way, French ones will soon turn negative as well.
Source: Bloomberg
This means that despite the fact that France’s new president Francois Hollande is a socialist who favor spending, the nation is regarded as too big to fail. Spain and Italy, on the contrary, aren’t enjoying investors’ confidence no matter how much effort they show to reign in their fiscal problems.
Danske Bank: bullish on AUD/CAD
Analysts at Danske Bank are bullish on AUD/CAD in the medium term. The specialists think that the pair has bottomed out around 0.9955. In their view, if Aussie overcomes resistance in the $1.0455 zone (June 29 maximum), it will be able to rise to 1.0520 (19 March maximum), 1.0665 (28 October 2011 maximum) and then to 1.0785 – the bank recommends taking profits here. In the longer term, the bulls may push the pair to 1996 maximum at 1.1090.
Chart. Daily AUD/CAD
Banks' forecasts for FX majors
Here are banks' forecasts for FX majors. Data were submitted on July 6.
Source: FX Week
EUR's role as a funding currency grows
The single currency becomes more attractive as a funding currency for carry trade operations in the wake of the ECB rate cut on Thursday. The regulator lowered the borrowing rate to 0.75%, while the deposit rate – to zero, so in the nearest future investors are likely to use the euro as a “whipping boy” on the FX market.
Traditionally, investors chose the Australian and the New Zealand dollar to benefit from higher interest rates offered there. However, these days some speculators switch attention to the Hungarian forint, the Polish zloty and the South African rand. Hungary's 10-year bonds, for example, bring nearly 8% compared to just 3.1% in Australia. AUD and NZD, however, remain the most reliable currencies for carry-trade operations: emerging European currencies are less liquid and much riskier.
No matter which currency investors choose for their assets, euro will be the loser anyway as the market players will borrow in euro to invest elsewhere. This is a significant bearish factor for EUR.
July 10: economy and currencies
Risk aversion dominates the FX market on Tuesday: commodity currencies weaken amid concerns that the European financial authorities may fail to answer the important questions at today’s meeting.
The single currency is trading on the downside today remaining close to the minimal level since July 2010 at $1.2255 hit yesterday.
In Europe French and Italian May industrial production figures draw the most of attention today as the economists are looking for contraction by 0.9% and 0.3% m/m respectively. The data for the whole euro area will be released on Thursday, July 12.
The officials’ comments also weighed on euro. The ECB Mario President Draghi signaled yesterday that the central bank consider another interest-rate cut if necessary. The EU Economic and Monetary Affairs Commissioner Olli Rehn claimed that Spain will have to take additional measures soon to meet budget targets – that’s doesn’t help to ease the market’s worries about the nation’s future. Spanish 10-year yields reached 7.06% on Monday. Yesterday there was a meeting of the Eurogroup (euro zone’s finance ministers). Luxembourg
Prime Minister Jean-Claude Juncker said that Spain will get 30 billion euro for its banks by the end of July. Today there’s the gathering of EU27 financial chiefs (ECOFIN).
High Spain’s and Italy’s bond yields raise demand for safe havens, especially JPY. AUD/USD is near to a one-week low after a report showed China’s import rose less than expected. Chinese growth slowdown will surely affect Australia’s economy. Australian business confidence index fell to a 10-month low in June amid uncertainty about the euro zone and China. NZD/USD is also moving down: New Zealand business confidence dropped to a lowest since Q2 2011.
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Key options expiring today
Market prices tend to move towards the strike price at the time large vanilla options (ordinary put and call options) expire. It happens (all things equal) as each side of the deal seeks to hedge its risk exposure. This action is most noticeable ahead of 10 a.m. New York time when the majority of options expire (2 p.m. GMT).
Here are the key options expiring today:
EUR/USD: $1.2300, $1.2400, $1.2475;
USD/JPY: 80.75, 80.85;
GBP/USD: $1.5300, $1.5700;
AUD/USD: $1.0000, $1.0175, $1.0200;
EUR/GBP: 0.7900, 0.8125;
USDS/CHF: 0.9560, 0.9600.
RBS: bears on EUR/GBP
Analysts at RBS remain bearish on EUR/GBP in a medium term. In their view, a bear flag pattern is targeting 0.7695 (2008 minimum).
Chart. Weekly EUR/GBP
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Analysts: comments on AUD/USD
Specialists at Shelter Harbor Capital, an investment advisor, are bearish on Aussie and recommend going short on AUD/USD at $1.0200 with a stop at $1.0330 and a target of $0.9100.
In their view, Australian economy becomes highly dependent on mining sector. Meanwhile, China, Australia’s largest trading partner, aims to help its economy move to a more developed, postindustrial stage. As a result, China’s demand for resources is likely to decline. Moreover, Australia’s economic growth is slowing and the RBA is expected to keep cutting rates.
This week China is to release a bunch of important economic data (GDP, consumer price inflation, industrial production and retail sales). Where the nation’s economy is heading? BMO Capital analysts point out that China’s GDP growth below expectations (consensus forecast: 7.9%) would raise investors’ concerns and weigh on AUD. Westpac specialists expect China to cut rates further.
Analysts at Aspen Trading Group think that the technical picture for AUD/USD will remain positive as long as it stays above parity.
Chart. Daily AUD/USD
The United States: a ‘timid’ rebound part 2
Financial exposure
Financial effects of the euro zone debt crisis deserve a more profound analysis. Once again we start with direct impact.
Banks are commonly in the first row to take the blow. European problems did not begin yesterday. Certainly more that 2 years is enough time to hedge preparing for the doomsday. In comparison with 2008, the amount of leverage in the financial system has gone down. Global policy makers were not seating still and tried to encourage this process. Of course a new crisis could reveal that American banks are still undercapitalized, but they are certainly in better shape than they used to be 4 years ago. However, we have to make an important remark here.
In January US Securities and Exchange Commission (SEC) requested American banks to provide reports containing specific descriptions of loans and trading positions relating to Europe. It turned out that the exposure of 5 big American banks’ to Portugal, Ireland, Italy, Greece, and Spain accounts for more than $80 billion. Cumulatively, the banks have hedged their positions by $30 billion, mostly through investing in credit default swaps. The banks analyzed include Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, and J.P. Morgan Chase.
It is necessary to note, however, that the SEC has managed to collect only partial information on the banking sector’s exposure to the European debt as many banks tried to present things in better light than they actually are by concealing some vital details.
For example, American banks revealed the net figures of exposure. That means that US financial institutions diminished the actual size of their European assets by taking into account offsetting items or, in other words, some undisclosed hedges and short positions. The problem is that a bank might not be able to collect all the offsets if the crisis strikes really hard, because many of the US hedges are made in Europe – for instance, through French banks.
This is the main problem of the modern financial sector: no one may be allowed to fail as one failure provokes a chain reaction – the domino effect. Firstly, if European banks get into trouble, they may not be able to honor any payments which they owe on trades American banks have made as a hedge. Secondly, collateral often comes in the form of cash euro or European government bonds and many of the banks’ hedges are credit default swaps which presume prospective payouts to be made in euro . If euro collapses as a currency, that will surely be a disaster.
We admit that the European Central Bank’s decision to inject about 1 trillion euro into European banking sector will help to save the banks from running out of liquidity and, consequently, reduce the risk of the credit crunch. Never the less, the Fed’s Chairman Ben Bernanke has pointed out that although US banks are now less exposed to the sovereign debt issues in Europe, there will be a great number of different channels through which euro zone’s crisis may affect US financial system.
Apart from the banking sector, the US is also vulnerable because households and governments are still in the midst of deleveraging from the last financial crisis and policy makers are running out of ammunition to stimulate economic activity. In addition, US and European markets are closely correlated. Of course, American equities outperformed the European ones during the last few years which were marked by severe tensions in the euro area. At the same time, though the Euro Stoxx 500 and the S&P 500 move in different magnitudes, they are quite rarely entirely out of step with each other.
Let’s look back to the notorious 2008. The fault in the global financial system made economies all over the world suffer in unison, no matter how intense was their trade with America. There are no doubts that if Greece or another struggling European nation defaults on its debts and quits the euro zone, the future of monetary union will be in question. That will certainly trigger turmoil in markets. Business investment would stall, while banks would pull back on credit, equity prices fall and consumer spending contract. Commodity prices would plunge, helping importers but hurting growth in export economies. The extent of the damage would depend upon how quickly global policymakers could calm the markets.
Economists propose different scenarios of further developments in the euro zone. Hence, the impact on US will differ from weakening growth to severe recession. Even if all goes relatively well – political situation in Greece stabilizes and the nation stays in the monetary union, Spain recapitalizes its banks and EU integration gradually advances – the ongoing volatility in financial markets and slow-to-mildly negative euro zone growth would continue weighting on US growth prospects. All in all, we come to the conclusion that the risks associated with Europe can be contained, but not isolated.
US economy: challenges and prospects
As we have uncovered above, American economy will suffer from the negative influence of the European debt crisis and euro zone’s poor economic performance. However, the hurdles for US economic rebound do not end here.
Debt crisis is not a unique European issue. Analysts at Deloitte claim that US debt problems are “bigger than you think”. Last summer after fierce debates between Democrats and Republicans the nation’s policymakers have increased the debt ceiling by $2.1 trillion to $16.4 trillion. Note that at the end of Q1 2012 the nation’s GDP was equal to $15.5 trillion. Anyway, this was only a temporary solution and the critical debt level may be reached already around the end of the year.
Mounting debt represents a great burden for US economic growth. According to Deloitte, American government will need to spend at least $4.2 trillion in interest payments during the next 10 years. These are immense amounts of money that could be otherwise invested in increasing US competitiveness. Moreover, spending cuts touch the areas which are most connected to competitiveness, such as education and R&D.
Automatic spending reductions of more than $1 trillion are taking effect in January, while bush-era tax cuts expire at the end of 2012. No doubts that this will increase the negative pressure on the economic agents the next year. On the other hand, the Congressional Budget Office said that an extension of these cuts and current Medicare spending without monetary policy change would make the federal debt climb in 25 years to twice the size of US GDP.
At some point the Fed will probably have to introduce additional monetary stimulus whether extending Operation Twist or purchasing more government debt. There is scope for such action: US consumer prices increased by 1.7% in the 12 months ended in May showing the smallest 12-month gain since January 2011. The Fed’s mandate is to target 2% inflation. Inflationary pressure decreased due to the decline in gasoline prices.
At the same time, the more the Federal Reserve loosens its policy, the less room for maneuver it has: the interest rates are already extremely low, so their further decline probably won’t be efficient enough. As you may see on the chart below, the central bank’s balance sheet has more than doubled since 2008.
It’s also necessary to note that opinions in the Fed are divided. Although the FOMC has turned more dovish this year, there are those who think injecting more money into the economy is risky. Some officials claim that US economic outlook hasn’t significantly darkened yet. The annual Federal Reserve’s August meeting in Jackson Hole will be likely marked by the key monetary decisions as it was in the last couple of years.
In conclusion we would like to underline that without the European threat American economy would continue recovering with the press of huge debt looming over the US in the longer-term. However, the United States isn’t isolated from the uncertainty and risks of contagion which have been constantly emanating from Europe during the recent years.
US Treasuries still represent the largest and the most liquid sovereign debt market: the yields went down even after the nation has been downgraded by the Standard & Poor’s as US debt securities and the greenback remain the market’s final refuge in the absence of worthy alternative elsewhere. Yields on US 10-year government debt touched the record minimum of 1.44% in June. The Dollar Index added 10% since last summer.
Risk aversion will keep supporting US currency against its counterparts. However, the door for more monetary easing in America is still open. Both QE1 and QE2 led to the decline of the DXY by approximately 16% in 2009 and 7% in 2010-2011.
In the near future US policymakers are not as limited in their choices of further actions as the European ones – it’s even harder for more numerous and more divergent euro zone’s governments to reach consensus than for US parties. America’s manufacturing industry is in better shape and US markets seem more stable. Rating agencies confirmed American credit ratings for now, though with negative outlook. The tensions between Republicans and Democrats will keep on: the first will continue insisting that any increase in the nation’s debt limit should be matched by spending cuts of the same magnitude, while the latter will keep supporting the idea of economic stimulus. For now we do not see a way out of this stalemate. With the presidential elections at the end of 2012 there is a political battle coming, so the words “recovery”, “debt” and “Europe” will stay in the center of the polemics.
Elizaveta Belugina
Kira Iuchtenko