Brave New World

Midday FX Update 18/02/2009

Investor sentiment has continued to deteriorate towards the economies of Eastern and Western Europe, with Credit Default Swaps for 5 year government debt continuing to widen, gold continuing to rise and reports questioning the ability of stimulus initiatives in the region to deal with an escalating financial crisis. EURUSD touched 10 week lows in Asia, reaching the below the 1.2560 level before squeezing higher to above the 1.26 handle. USDJPY edged higher, from an overnight low of 92.10 to the 92.80 level as Japanese data continues to astonish; the most recent data being a jaw-dropping 84% year on year drop in machine tools orders in January, with a large percentage of this decline coming from the auto industry. GBPUSD did not react much to the minutes of the BoE, released this morning, which showed a 9-1 decision to cut rates by 50bps. Blanchflower advocated cutting immediately to zero. No real surprises about quantitative easing, hence little movement. Earlier, GBP was weakened by reports in the Daily Telegraph that Standard and Poors was revisiting the UK’s AAA rating due to the scale of the bank bailout. GBPUSD had threatened to break 1.4300, before retreating to 1.4097 on the news. 

The market has plenty of fundamental data to absorb from the US today, particularly relating to the housing and manufacturing sector. Both building permits and housing starts are expected to post new record lows, as the housing sector suffers from poor demand resulting from tight credit conditions. Industrial production is expected to post an additional drop of 1.5% following a contraction of 2.0% in December. Such a dismal economic picture may add to an already bleak market sentiment, further boosting the USD. Later President Obama will announce measures to boost the housing market, through the subsidizing of mortgage payments. This may reverse sentiment or at the very least, drive up volatility in the FX market.

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.