JPY, SEK and GBP view

USD/JPY remains stuck within a tight range having reversed its recent break higher towards the 80.00 level, once again settling back below 79.00. Once again the main determinant of the exchange rate appears to be yield differentials and notably the JPY has had a very low sensitivity to gyrations in risk over recent months.

For JPY bears it it’s worth noting that US 2-year bond yields have began to edge higher this week, suggesting some upward pressure on USD/JPY. The speculative market remains net long JPY suggesting scope for a drop in JPY speculative appetite too, but any upside is set to be gradual, with a technical hurdle at around 79.37 likely to be tough level to break above.

EUR/SEK has edged higher over recent days following its dramatic multi month drop. Why has the currency pair turned now? One of the key factors appears to be an increased sensitivity to risk which is playing negatively now that risk aversion is rising again. Indeed my risk barometer has been moving higher since around the middle of the month, in turn dragging SEK lower.

My quantitative model estimate based on interest rate differentials, relative equity performance and risk aversion, suggests that the SEK has further to weaken especially against the EUR. Based on the results of the model I suggest playing for such a move, targeting 8.7252, with a stop loss at 8.1616.

Another currency for which I am bearish on versus EUR is GBP. Although the move higher in EUR/GBP has been a slow grind, I continue to see value in this trade. Indeed, my models show that there is still much upside potential left for EUR/GBP based on the current levels of yield differentials and risk aversion.

As for cable (GBP/USD) it appears to be stuck to the coattails of EUR/USD but I expect it to lag any move higher in EUR/USD going forward. Moreover, if as I expect EUR/USD loses momentum into next week, this will leave GBP/USD rather exposed to downside risks.

Euro firmer, AUD vulnerable to risk gyrations

A surprise drop in US August consumer confidence which dropped to its lowest since November last year put a dampener on markets and notably the VIX index edged higher. Consequently treasuries rose and equities slipped despite a firmer than expected increase in US house prices in June. The confidence data adds the pressure on Fed Chairman Bernanke to give some indication of a further round of quantitative easing during his speech at Jackson Hole on Friday.

An upward revision to US Q2 GDP and a bounce in July pending home sales today are unlikely to change this perspective although the Fed’s Beige Book will likely show some moderate improvement providing the Fed with useful information.

Separately decent debt auctions in Spain and Italy helped to calm Eurozone market nerves further amid hopes of European Central Bank (ECB) action next week despite the news that Spanish region Catalonia formally asked for EUR 5 billion in funding. As a result the EUR retained a firmer tone.

Contrary to expectations, EUR/USD continued to push higher. Just why the currency is strengthening given the significant event risk in the days and weeks ahead is questionable although in part the move is attributable to an ongoing short squeeze. Hopes of constructive ECB action next week taken together with Fed quantitative easing expectations have helped to put the USD on the back foot, allowing the EUR to take advantage.

Admittedly the drop in Eurozone peripheral bond yields is certainly helpful for the EUR, while my short term quantitative ‘fair value’ estimate for EUR/USD suggests more upside too. Nonetheless, given the risk that so much could go wrong in the weeks ahead I am loathe to get on the bullish EUR bandwagon. While EUR/USD and EUR on the crosses will likely remain firm ahead of Jackson Hole I expect the EUR to struggle to hold onto gains into next week.

AUD has lost ground since around 10 August. This has roughly coincided with a rise in risk aversion over recent weeks. Indeed, AUD maintains a strong correlation with risk aversion and is therefore highly susceptible to swings in risk appetite. Additionally renewed China worries have also dampened the attraction of the AUD given the increasing dependency of Australia’s economy to China both directly through trade and indirectly via commodity prices.

While I remain positive on the AUD over the medium term, the high level of speculative positioning in the currency suggests some vulnerability to profit taking over the short term, with AUD/USD vulnerable to a drop to technical support around 1.0282. Much will depend on news out of China in terms of AUD direction, with Chinese stock market gyrations also providing some influence.

Market fear rising

In what was fairly subdued trading conditions in the wake of a UK holiday the most interesting market move was the jump in the VIX ‘fear gauge’ which has been on a steady increase since 17 August. The rise in equity volatility suggests that the relative calm experienced over the summer may be ending.

Major events over coming days and weeks including the Jackson Hole Fed symposium on Friday, IMF/EU review of Portugal today, ECB meeting on September 6, Dutch general election on 12 September, German constitutional court decision on the ESM permanent bailout fund on the same day, as well as the Fed FOMC meeting on September 12-13, highlight the potential for more volatility and uncertainty.

Yesterday’s fourth consecutive drop in the German IFO index was all but ignored as attention turns to Jackson Hole. Nonetheless, the announcement of the formation of a working group between France and Germany suggests some improvement in coordination towards finding a solution to the Eurozone crisis, while the ECB’s Asmussen further heightened speculation that the upcoming ECB meeting would detail the ECB’s proposed bond buying program.

Meanwhile, although the Fed’s Evans (non voter) highlighted his preference for more Fed quantitative easing an improvement in consumer confidence in August expected to be revealed today, will add to data playing against imminent QE.

All of the above leaves FX markets in limbo. The USD remains restrained by expectations of Fed QE but relatively better economic data compared to the Eurozone, suggests that any USD decline will be limited. Moreover, the fact that aggregate speculative USD positioning turned negative for the first time since September 2011, suggests that there is now some scope for short covering.

Conversely, hopes of ECB bond buying offer the EUR some solace but as noted, the many events over coming weeks in Europe, highlight the risks to the currency and we suspect that EUR/USD has topped out around 1.2500.

Market tensions set to return

Having returned from my summer break it appears that markets are in reasonable shape. Volatility is low, while equities have registered solid gains over recent weeks and markets in general appear to be more settled. In part this is due to hopes and expectations of further stimulus measures in the US and Europe. The coming weeks may be much less calm than experienced over the summer.

Having lost steam over recent weeks the USD may benefit from renewed market nervousness over coming weeks. On the one hand there are hopes of more Fed stimulus in September following comments by Fed Chairman Bernanke that there is “scope for further action”. More information will likely come from the Jackson Hole Fed symposium on Friday and expectations of more quantitative easing could restrain the USD.

On the other hand, it increasingly appears that the summer rally in risk assets is beginning to fade, a factor that will help the USD. The latter effect is likely to be more dominant on the USD especially as it is far from clear that another round of Fed quantitative easing will be USD negative. My analysis suggests that the impact on the USD from QE is ambiguous.

There is plenty of event risk over coming weeks which could feed potential nervousness in the market and help the USD. Markets have to contend with the IMF / EU review of Portugal’s aid program tomorrow which takes place against the background of reports that deficit targets have slipped amid weakening growth. In addition, the 6 September European Central Bank (ECB) meeting will be a major focus given expectations of a further cut in policy rates and other policy steps to purchase Eurozone peripheral debt

Aside from these events, Dutch general elections on 12 September could provoke more uncertainty given that polls currently show a split outcome while the decision by the German constitutional court on the ESM permanent bailout fund on the same date will add to tensions especially as the outcome remains unclear.

Meanwhile, discussions and speculation on Greece’s future within the Eurozone or at least some easing in its bailout terms and a potential formal request for Spanish bailout from the EFSF temporary bailout fund will run alongside these other uncertainties.

To cap it all off, these events combined with the the Eurogroup / Ecofin meeting on 14-15 September will leave markets with plenty to fret about over coming weeks. EUR/USD will struggle to extend upon its gains against this background, with moves above 1.2600 likely to provide better levels to sell EUR.

EUR to drift lower, AUD supported, JPY flatlines

EUR/USD has failed to retake the 1.2400 handle and as noted yesterday looks set to gradually make its way lower again. News that the German government lent its support to the European Central Bank (ECB) bond buying plan helped to limit losses overnight, but there is likely to be little news on the policy front over coming weeks as Europe moves into full blown summer holiday mode.

No news is perhaps good news, but market patience continues to run thin and the EUR will eventually be punished should policy makers fail to deliver which has been so often the case. With only German factory orders in terms of data releases of note today, EUR/USD is set to settle into a range, but with a downside bias.

The RBA meeting today is likely to prove relatively uneventful. Almost all analysts polled expect a no change outcome from the Reserve Bank. As this is the largely priced in, the main influence on AUD will be the accompanying statement. The market is overly aggressive in pricing in 75 basis points of policy rate cuts over the coming months and in this respect it will require a particularly dovish statement to validate these expectations.

More likely, the RBA will sound neutral reflecting on relatively firm data (except the June jobs report) releases since the last meeting and a better global environment. Combined with strong attraction to ‘carry’ trades and a firmer tone to risk appetite, AUD looks well supported, with technical support seen around 1.0437.

USD/JPY continues to flat line just above the 78.00 level ahead of this week’s Bank of Japan meeting. There is unlikely to be much excitement from the BoJ meeting but the pressure to take more aggressive steps to reach their 1% inflation goal as well as to weaken the JPY remains strong. The 78.00 level appears to be an uncomfortable equilibrium for markets and Japanese policymakers.

Although low implied FX volatility suggests that there is little expectation of a move in either direction Japanese officials continue to remain concerned about the strength of the JPY. Similarly, the US Treasury bond versus Japanese JGB yield differential (2 year) remains relatively steady, suggesting little directional impetus in the short term. Given hopes / expectations of more Fed quantitative easing it seems unlikely that USD/JPY will make much traction on the upside over coming weeks.

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