USD weaker, EUR resilient, JPY supported, CHF pressure

Why has the USD come under pressure even after Fed Chairman Bernanke failed to signal more QE? The answer is that Bernanke offered hope of more stimulus and gave a shot in the arm to risk trades even if QE3 was not on the cards. Consequently the USD has looked vulnerable at the turn of this week but we suspect that a likely batch of soft US data releases over coming days including the August jobs report at the end of the week, ISM manufacturing survey on Thursday and consumer confidence today, will erase some of the market’s optimism and leave the USD in better position. The FOMC minutes today may also give some further guidance to the USD as more details emerge on the potential tools the Fed has up its sleeve.

The EUR’s ability to retain a firm tone despite the intensification of bad news in the eurozone has been impressive. Uncertainty on various fronts in Germany including but not limited to concerns about the outcome of the German Bundestag vote on the revamped EFSF on September 30, German commitment to Greece’s bailout plan and German opposition party proposals for changes to bailout terms including the possibility of exiting the eurozone, have so far gone unnoticed by EUR/USD as it easily broke above 1.4500. EUR was given some support from news of a merger between Greece’s second and third largest banks. Likely weak economic data today in the form of August eurozone sentiment surveys may bring a dose of reality back to FX markets, however.

The lack of reaction of the JPY to the news that Japan’s former Finance Minister Noda won the DPJ leadership and will become the country’s new Prime Minister came as no surprise. The JPY has become somewhat used to Japan’s many political gyrations over recent years and while Noda is seen as somewhat of a fiscal hawk his victory is unlikely to have any implications for JPY policy. Instead the JPY‘s direction against both the USD and EUR continues to be driven by relative yield and in this respect the JPY is likely to remain firmly supported. Both US and European 2-year differentials versus Japan are at historic lows, with the US yield advantage close to disappearing completely. Until this picture changes USD/JPY is set to languish around current levels below 77.00.

EUR/CHF has rebounded smartly over recent weeks, the latest bounce following speculation of a fee on CHF cash balances, with the currency pair reaching a high of 1.1972 overnight. The pressure to weaken the CHF has become all the more acute following the much bigger than anticipated drop in the August KOF Swiss leading indicator last week and its implications for weaker Swiss growth ahead. The ‘risk on’ tone to markets following Bernanke’s speech has provided a helping hand to the Swiss authorities as safe haven demand for CHF lessens but given the likely weak slate of economic releases this week his speech may be soon forgotten. Nonetheless, the momentum remains for more EUR/CHF upside in the short term, at least until risk aversion rears its head again.

No QE3 but Bernanke gives some hope

Not only did Federal Reserve Chairman Bernanke not discuss the potential for more quantitatiive easing QE3 but he also did not discuss many other options for Fed policy at Jackson Hole last Friday. The onus has now shifted to the 2-day Fed FOMC meeting on September 21 where markets are looking (hoping) for fresh policy measures. Such hopes helped US equity markets bounce back after initially reacting negatively to Bernanke’s speech.

Bernanke provided some hope to markets that the US economy wasn’t sliding into the abyss while offering the potential for further Fed stimulus even if QE3 wasn’t quite on the cards. This hope was sufficient to spur markets higher. However, importantly Bernanke noted the limitations of monetary policy in stimulating growth over the medium term.

In this respect there will be plenty of attention on President Obama’s speech on September 5 in which markets will be looking for a response from the administration at a time when the economy is becoming an increasingly important issue for the electorate.

In the meantime there are plenty of data releases to contend with this week including the August US jobs report, ISM manufacturing survey, US consumer confidence and various confidence surveys in Europe. Unfortunately the news will not be positive as the data releases are set to reinforce concerns of economic slowdown. The US jobs report is likely to reveal a limited, around 75k increase in non-farm payrolls according to consensus while the ISM manufacturing survey is set to drop into contraction territory.

Consequently markets may start the week in risk on mood but this is unlikely to last given renewed economic worries. Moreover, Eurozone peripheral country travails continue to exasperate markets, with concerns that some members of German Chancellor Merkel’s coalition plan to vote against the revamped EFSF bailout fund and news that two German banks have yet to commit on Greece’s bailout plan. Against this background the EUR continues to defy gravity around the 1.45 level versus USD but may yet come down to earth with a bang.

All Eyes On Jackson Hole

It’s all about Jackson Hole and ahead of the Fed symposium the USD index is likely to maintain its place in towards the middle end of its recent 73.47 – 75.12 range helped by weaker equity markets. Expectations or hopes that Fed Chairman Bernanke will announce or at least hint at a fresh round of quantitative easing have receded allowing the USD to escape further pressure. Bernanke will likely keep all options open but there are still some in the FOMC who do not want to embark on QE3.

Although the USD may be saved from a further drubbing the commitment to maintain exceptionally accommodative monetary policy through Q2 2013 has contributed to a relative reduction in US bond yields and in turn is acting to restrain the US currency. A likely revision lower to US Q2 GDP will not help the USD in this respect.

One currency in particular that is reactive to yield differentials is USD/JPY, which registers an impressively high correlation with US – Japan yield differentials. Attempts this week by the Japanese authorities to encourage capital outflows and a downgrade of Japan’s credit ratings by Moody’s have done little to weaken the JPY.

Even the usually bearish JPY Japanese margin traders have been scaling back their long USD/JPY positions over recent weeks while speculative investors remain overly long (well above the three-month average) JPY according to IMM data. The risk of a shake out of long JPY positions is high but unless yield differentials reverse renewed JPY weakening looks unlikely in the short-term.

Eurozone peripheral issues will be put on the backburner ahead of the Jackson Hole meeting but that doesn’t mean they have gone away. As the continued pressure on Greek bonds shows markets continue to be fixated on the country’s problems and there may be growing nervousness ahead of the decision to distribute the next IMF loan tranche at the end of September. Nervousness also extended to Germany, with ratings agencies having to confirm the country’s AAA rating.

So far this week EUR has shown impressive resilience despite weak data in the form the German August IFO business and ZEW investor confidence surveys. However, there is a risk of EUR weakness should Bernanke not hint at QE3, with the currency already trading around the bottom of its multi-day range.

AUD has failed to recoup its end July losses and is still some 5% below its high above 1.10 versus USD. There is scope for some AUD appreciation especially as AUD speculative positioning has dropped sharply over recent weeks reducing sharply the net long overhang in the currency.

Moreover, markets have become overly aggressive in pricing in interest rate cuts in Australia and as evidenced from the AUD bounce following RBA Governor Stevens comments this morning (in which he referred to inflation data as still being concerning) there is an asymmetric risk to the AUD on the upside.

Nonetheless, AUD has experienced an increase in sensitivity to risk over recent weeks and will continue to be driven by gyrations in risk appetite. In this respect it is too early to assume the worst is over, suggesting that any further gains in AUD will be limited.

Japan FX Measures Underwhelm

Currencies continue to show remarkable stability in the face of elevated risk aversion which has prompted huge volatility in other asset markets. Although FX volatility has risen over recent weeks its rise is nothing compared to the jump in the VIX ‘fear gauge’ equity volatility measure. FX markets are in some form of limbo where there are conflicting forces at play and where there is no obvious currency to play. The lack of clarity in markets suggests that this situation will not change quickly.

The USD (index) is trading at the lower end of its recent ranges and verging on a retest of its July 27 low around 73.421, with the currency perhaps suffering from expectations that Fed Chairman Bernanke will announce a desire to embark on more quantitative easing at Friday’s Jackson Hole symposium. Its losses could quickly reverse as such expectations are quickly dashed.

Indeed, while Bernanke will likely keep all options open any hint at QE3 is unlikely as the Fed maintains a high hurdle before any prospect of further quantitative easing is entertained. One option on the table is ‘sterilised’ large scale asset purchases which would not result in an increase in the size of the Fed’s balance sheet. This would be far less negative for the USD than a fresh round of QE and may even prompt a rally in the currency as markets shift away from the idea of QE3.

The USD will benefit from high risk aversion except against safe havens such as the CHF and JPY. In this respect the USD remains a better bet than the EUR which has failed to garner much benefit from renewed ECB peripheral bond buying. Nonetheless, data yesterday failed to feed into negative EUR sentiment despite mixed manufacturing surveys and a sharp drop in the German ZEW investor confidence survey. EUR/USD remains trapped in a broad 1.42-1.45 range.

News that Moody’s ratings agency has downgraded Japan’s sovereign ratings by one notch to Aa3 is unlikely to have much impact on the JPY. Moody’s left the outlook stable while unlike the US and Europe around 95% of Japanese debt is held domestically, suggesting little FX and JGB impact. USD/JPY continues to garner some influence from yield differentials and given that the US bond yield advantage versus Japan has continued to narrow, USD/JPY continues to face downward pressure.

Japan announced measures to deal with JPY strength including the creation of a $100 billion emergency credit facility. However, the main impact on the JPY could come from increased monitoring of FX transactions with firms having to report on FX positions held by dealers. The statement made no comment on FX intervention and this is where there will be most disappointment for JPY bears. Overall, the actions are somewhat underwhelming and are unlikely to have much impact on the JPY. If anything, the JPY may actually strengthen given the lack of comment on FX intervention. USD/JPY downside could face strong technical support around 75.93, however.

Pressure, panic and carnage

Pressure, panic and carnage doesn’t even begin to describe the volatility and movements in markets last week. If worries about global economic growth and the eurozone debt crisis were not enough to roil markets the downgrade of the US sovereign credit rating after the market close on Friday sets the background for a very shaky coming few days. All of this at a time when many top policy makers are on holiday and market liquidity has thinned over the summer holiday period.

The downgrade of US credit ratings from the top AAA rating should not be entirely surprising. After all, S&P have warned of a possible downgrade for months and the smaller than hoped for $2.1 trillion planned cuts in the US fiscal deficit effectively opened the door for a ratings downgrade. Some solace will come from the fact that the other two main ratings agencies Moody’s and Fitch have so far maintained the top tier rating for the US although Fitch will make it’s decision by the end of the month.

Comparisons to 2008 are being made but there is a clear difference time this time around. While in 2008 policy makers were able to switch on the monetary and fiscal taps the ammunition has all but finished. The room for more government spending in western economies has now been totally used up while interest rates are already at rock bottom. Admittedly the US Federal Reserve could embark on another round of asset purchases but the efficacy of more quantitative easing is arguably very limited.

Confidence is shattered so what can be done to turn things around? European policy makers had hoped that their agreement to provide a second bailout for Greece and beef up the EFSF bailout fund would have stemmed the bleeding but given the failure to prevent the spreading of contagion to Italy and Spain it is difficult to see what else they can do to stem the crisis.

Current attempts can be likened to sticking a plaster on a grevious wound. Although I still do not believe that the eurozone will fall apart (more for political rather than economic reasons) eventually there may have to be sizeable fiscal transfers from the richer countries to the more highly indebted eurozone countries otherwise the whole of the region will be dragged even further down.

Where does this leave FX markets? The USD will probably take a hit on the US credit ratings downgrade but I suspect that risk aversion will play a strong counter-balancing role, limiting any USD fallout. I also don’t believe that there will be a major impact on US Treasury yields which if anything may drop further given growth worries and elevated risk aversion. It is difficult for EUR to take advantage of the USDs woes given that it has its own problems to deal with.

Despite last week’s actions by the Swiss and Japanese authorities to weaken their respective currencies, CHF and JPY will remain in strong demand. Any attempt to weaken these currencies is doomed to failure at a time when risk aversion remains highly elevated, a factor that is highly supportive for such safe haven currencies. From a medium term perspective both currencies are a sell but I wouldn’t initiate short positions just yet.

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