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.

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