Brave New World

FX Outlook for Week ending 20 Feb 16/02/2009

With little in the way of data and the Presidents Day holiday in the US the FX market was extremely quiet today, with poor liquidity from late afternoon UK time. Of note, the JPY was up slightly against the USD and the crosses as disasterous Japanese GDP figures released overnight led to increased risk aversion. 

As variation in the level of risk appetite is the main driver in the FX markets, with the USD and JPY performing in periods of uncertainty and the GBP and commodity currencies- particularly the AUD- performing in periods of renewed confidence, the future direction of and attitude towards the world’s two biggest economies is of interest.

With the JPY seriously hurting from a collapse in world trade and overvalued JPY, shrinking about twice the rate of the US or UK, something has got to give. The economy, while briefly recovering earlier in the decade under Prime Minister Koizumi never achieved levels of growth or prosperity enjoyed by the other G7 economies. And yet it finds itself at the bottom of the heap. The Bank of Japan and Ministry of Finance do not generate confidence in their ability to turn the Japanese economy around, given their performance of the last two decades. Indeed, the BoJ’s head researcher Kazuo Momma is reported as saying that we should be prepared for a Q1 in 2009 worse than the last quarter, which posted an (annualised) decline of 12.7%. There must surely come a point at which the yen loses its safe haven status. given the macroeconomic picture. USDJPY has worked itself into a terminal wedge, which precipitates a large breakout. With an unwinding of the carry trade largely out of the way, the JPY is looking weak against the USD which has also benefitted from its safe haven status and looks set to continue this role. The potential is for a serious breakout to the upside, as early as this week.

EURUSD is also forming a terminal wedge and so a large breakout is also possible. Again, the USD looks like being the victor as there seems to be little to support the single currency. Dismal GDP figures at the end of last week- with Germany posting a bigger decline in Q4 than either the debt ridden US or UK- as well as worries about inaction by the ECB and the deteriorating creditworthiness of some of the weaker members of the eurozone paint a gloomy picture for the region. In Ireland Credit Default Swaps on 5 year government debt, rated AAA by Fitch, jumped 49 bps to 377 on 13 February. That is 18 basis points more than the cost to protect the debt of Costa Rica, a BB rated nation by Fitch, or 11 grades lower than AAA. If that wasn’t enough, as report on my “Systemic Collapse” posting, Western European banks are faced with a potential default of $400bn on loans from Eastern Europe. All in all the USD should, again, win this battle. If EURUSD breaks the strong support of 1.2700, perhaps as early as tomorrow, we could see the pair target 1.20.

The outlook for GBP is, as per usual in this climate, volatile. CPI figures out tomorrow, Bank of England minutes, and Retail Sales figures all have the potential to create large movements, particularly against the USD. However, in keeping with my bullish view on the greenback, the bias should be to the downside in Cable, particular as risk appetite is subdued in this uncertain time. Confidence remains low among investors, as witnessed by a sub 8000 Dow Jones last week and a strong rally in gold. The UK currency is also closely correlated to bank stocks, which are experiencing a new wave of selling pressure following the profit warning given by Lloyds and the possible requirement of the government to inject a further GBP 10bn into the troubled bank. Added to the the insouciant attitude expressed by the government and Bank of England in recent days and the bias is strongly toward the negative. However, if EURUSD breaks below 1.2700 I would expect EURGBP to also weaken.