Will the ECB intervene to support the Euro? (Part 2)

May 23, 2010 — Mitul Kotecha

Click here to read Part 1

The last official intervention by the European Central Bank (ECB) in the currency markets took place in November 2000 and at the time the Bank stated that “the external value of the EUR does not reflect the favourable conditions of the euro area”. The ECB also noted the impact of a weaker EUR on price stability, with inflation at the time running above the ECB’s 2% threshold. This followed intervention a couple of months earlier in September 2000 when the ECB jointly intervened with the US Federal Reserve, Bank of Japan and other central banks in a concerted manner due to “shared concerns about the potential implications of recent movements in the euro exchange rate for the world economy”.

Conditions in the euro area could hardly be described as favourable at present, suggesting that this rationale would be very unlikely to be used to justify intervention. Conversely, a weaker EUR may actually contribute to making conditions in the eurozone more favourable. The rationale used for the September 2000 intervention holds more sway in the current environment. Nonetheless, the move in the EUR is very unlikely to do any serious damage to the world economy even if some Japanese exporters are suffering.

In the past the ECB has given various verbal warnings about the volatility of the EUR being too high, and this could potentially be utilized as rationale for FX intervention. However, implied volatility in EUR/USD is not particularly high when compared to the levels it reached during the recent financial crisis. Currently 3-month implied volatility is at its highest level since June 2009 but well below the peak in volatility recorded in December 2008. Clearly if EUR/USD volatility continues to rise there will be a greater cause for concern but at current levels the ECB is unlikely to even crank up verbal intervention let alone actual FX intervention.

One of the main benefits of the decline in the EUR is the support that it will provide to the eurozone economy. At a time when growth in Europe is slowing EUR weakness will be particularly welcome. Germany and other countries in Northern Europe will be major beneficiaries of EUR weakness given their export dependence. Given such benefits and the currently limited risks to inflation, the ECB is highly unlikely to intervene to strengthen the EUR.

Given the current very negative mood in the market, officials in Europe would do better to rectify some of the structural issues that markets are concerned about. This may provoke a more sustainable rally in the EUR but until there are concrete signs of progress on the fiscal front sentiment towards the EUR will remain negative. Against this background FX intervention to prop up the EUR would face more of a risk of failure, and in turn damage to the credibility of the ECB. This is perhaps as good a reason as any not to expect intervention.

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Shock and Awe

May 10, 2010 — Mitul Kotecha

The Greek crisis spread further last week, not only to Portugal and Spain, but in addition to battering global equity markets, contagion spread to bank credit spreads, OIS-libor and emerging market debt. In response, European Union finance ministers have rushed to “shock and awe” the markets by formulating a “crisis mechanism” package with the International Monetary Fund (IMF). The package includes loan guarantees and credits worth as much as EUR 750 billion. The support package can be added to the EUR 110 billion loan package announced last week.

In addition, the US Federal Reserve (Fed) announced the authorisation of temporary currency swaps through January 2011 between the Fed, European Central Bank (ECB), Bank of Canada (BoC), Bank of England (BoE) and Swiss National Bank (SNB) in order to combat in the “the re-emergence of strains” in European markets. Separately, the ECB will conduct sterilised interventions in public and private debt markets, a measure that was hoped would be announced at the ECB meeting last week, but better late than never. The ECB did not however, announce direct measures to support the EUR.

The significance of these measures should not be underestimated and they will go a long way to reducing money market tensions and helping the EUR over the short-term. Indeed, recent history shows us that the swap mechanisms work well. The size of the package also reduced default and restructuring risks for European sovereigns. However, the risk is that it amounts to a “get out of jail free card” for European governments. A pertinent question is whether the “crisis mechanism” will keep the pressure on governments to undertake deficit cutting measures.

The Greek crisis has gone to the heart of the euro project and on its own the package will be insufficient to turn confidence around over the medium term. In order to have a lasting impact on confidence there needs to be proof of budget consolidation and increasing structural reforms. Positive signs that the former is being carried out will help but as seen by rising public opposition in Greece, it will not be without difficulties whilst structural reforms will take much longer to implement. Confidence in the eurozone project has been shattered over recent months and picking up the pieces will not be an easy process.

Some calm to markets early in the week will likely see the USD lose ground. There was a huge build up of net USD long positioning over the last week as reflected in the CFTC IMM data, suggesting plenty of scope for profit taking and/or offloading of USD long positions. In contrast, EUR positioning fell substantially to yet another record low. Some short EUR covering is likely in the wake of the new EU package, but EUR/USD 1.2996 will offer tough technical resistance followed by 1.3114.

The EU/IMF aid package will help to provide a strong backstop for EUR/USD but unless the underlying issues that led to the crisis are resolved, EUR/USD is destined to drop further. Perhaps there will be some disappointment for the EUR due to the fact that the package of support measures involves no FX intervention. This could even limit EUR upside given that there was speculation that “defending the EUR” meant physically defending the currency. In the event the move in implied FX volatility over the last week did not warrant this.

Posted in central banks, Currencies, Economics, Economy, emerging markets, equity markets, Europe, eurozone, Federal Reserve, Financial crisis, Fiscal/Budget, FX, Germany, Greece, IMF, Interest rates, Japan, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , . 1 Comment »

Shaping up to be a “risk on” week

April 15, 2010 — Mitul Kotecha

It’s most definitely turning into a “risk on” week. On the earnings front both JP Morgan Chase and Intel beat forecasts whilst data releases did not disappoint either. In particular, US retail sales came in much stronger than expected. The Fed’s Beige Book also gave markets some good news to chew on. The reports from the twelve Federal Reserve Districts noted that economic activity “increased somewhat” since the March 3rd report.

The positive tone will continue today with the release of the March industrial production data, expected to show a strong gain over the month (consensus 0.7%), whilst both the Empire State and Philly Fed manufacturing surveys are set to post small gains in April, consistent with strengthening manufacturing activity in the months ahead.

Fed speakers have also been helpful for market sentiment. Fed Chairman Bernanke sounded a little more upbeat on the economy but highlighted the “significant restraints” remaining in the US economy. Bernanke maintained the “extended period” of low rates statement despite some speculation that the Fed was verging on removing this. The net impact of the testimony, improved data and earnings and firmer risk appetite is to keep the USD on pressure. In contrast, commodity currencies including AUD, NZD and CAD, will benefit, both from firmer risk appetite and an upturn in commodity prices.

Despite the positive reception to Greece’s debt auction there is not a lot of faith in the ability of Greece to weather the storm. Reports that Greece will need far more funding than has been initially promised by the EU/IMF – potentially as high as EUR 90 billion over coming years – together with worries about selling the loan package to the public in Germany and other eurozone countries, as well EU comments that Portugal will need further fiscal consolidation, have not done much good for confidence. Technically EUR/USD will see plenty of resistance around 1.3692.

After Singapore’s move to tighten monetary policy via the SGD revaluation, and following close on the heels of India, Malaysia and Vietnam, attention has turned to who’s next in line. South Korea must be a prime candidate, especially following data yesterday revealing a drop in the unemployment rate. Of course, China is very much in the spotlight and is set to embark on monetary tightening measures as well as CNY revaluation soon.

India is set to move again as early as next week, with inflation data today likely to seal the case for another hike (consensus 10.37% in March). The risk remains however, that many Asian central banks are moving too slowly to curb building inflation pressures and may find that they ultimately need to tighten more than they otherwise would have done.

China’s heavy slate of data released will if anything fuel greater expectations of an imminent CNY revaluation as well as monetary tightening. China’s economy grew a very strong 11.9% in Q1, above already strong consensus expectations, whilst CPI rose 2.4% YoY in March.

The growth data alongside further evidence of accelerating real estate prices highlight the risks of overheating in the economy and the need to act quickly to curb inflation threats. Given this expectation, firm risk appetite, and more follow through from Singapore’s FX move, the outlook for other Asian currencies remains positive.

Posted in Asia, central banks, China, Commodities, Currencies, Economics, Economy, emerging markets, Europe, eurozone, Federal Reserve, Fiscal/Budget, FX, Germany, Greece, IMF, India, Interest rates, Monetary Policy, Singapore, South Korea, US. Tags: , , , , , , , , , , , , , , , , , , , , , . 1 Comment »

What To Watch This Week

March 13, 2010 — Mitul Kotecha

A “crisis over” mode is being adopted across markets as worries about Greece wane and economic data provides support to recovery hopes, whilst importantly allaying fears of a “double-dip”. Equities, bonds and currencies are reacting accordingly; equities are close to year highs, bond yields have risen and spreads have narrowed, whilst the USD and JPY are weaker, and conversely risk currencies are stronger. Even EUR/USD pushed higher on its way to 1.3800 as a number of stops were cleared and shorts were squeezed.

The coming weeks will be important to determine whether there is any staying power in the upward move in risk assets. A lot of the February data in the US will likely be obscured by bad weather however, including industrial production figures this week, leaving markets with little to go on. In Europe, the key release is the March German ZEW investor confidence survey, and better news in Greece, will likely prevent a sharper decline in confidence.

After both the Swish National Bank (SNB) and Reserve Bank of New Zealand (RBNZ) unsurprisingly left policy unchanged last week this week sees the turn of the US Federal Reserve and Bank of Japan (BoJ). Neither central bank is likely to shift policy but the Fed statement will be looked upon for guidance on the timing of rate hikes. The comment in the FOMC statement that the Fed Funds rate is expected to remain low for an “extended period” is set to be retained, even if some FOMC members are itching to remove it soon.

The BoJ meeting will be particularly interesting. I have just returned from a week long trip in Japan and on the ground there is plenty of speculation that the BoJ will take extra action to combat deflation and weaken the JPY. Additionally comments by Japan’s Prime Minister and Deputy PM have highlighted the potential for action to weaken the JPY although the usual market hesitation to sell JPY into fiscal year end and repatriation talk may mean a weaker JPY path is not straightforward.

Greece will not move too far from the spotlight, with EU officials likely to give the official stamp of approval on Greece’s deficit cutting measures and plenty of discussion at the Eurogroup Finance Minister’s meeting and Ecofin meeting early in the week. Moreover, weekend press reports suggest that a bailout up to EUR 25 billion is close to being agreed. Other topics of conversation will include the possible formation of a European Monetary Fund, though this looks like it will be a non-starter given the many objections to it.

Overall, risk appetite is set to continue its upward trajectory, likely keeping the USD on the back foot. Some deterioration in USD sentiment was reflected in the fact that net long aggregate USD speculation positioning has turned negative again according to the latest CFTC Commitment of Traders (IMM) report. Much in terms of FX direction will depend on what the FOMC says rather than does tomorrow.

EUR/USD may take a crack at resistance around 1.3840 on improving Greek news but it is difficult to see much upside from current levels. The one to watch will be the JPY, especially if the BoJ embarks on aggressive actions at this week’s meeting, leaving USD/JPY plenty of scope to test resistance around 92.16.

Posted in Bond markets, central banks, Currencies, Economics, Economy, equity markets, Europe, Federal Reserve, Financial crisis, Fiscal/Budget, FX, Germany, Greece, Interest rates, Japan, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , . Leave a Comment »

Fed discount rate move boosts dollar

February 19, 2010 — Mitul Kotecha

The Fed’s move to hike the discount rate by 25bps has set the cat amongst the pigeons.   Although the move was signalled in the FOMC minutes yesterday a hike in the discount rate was not expected to happen so soon.  The Fed sees the modifications which also include reducing the typical maximum maturity for primary credit loans to overnight, as technical adjustments, rather than a signal of any change in monetary policy. 

Nonetheless, the market reaction has been sharp, with the USD strengthening across the board and short term interest rate and stock futures falling.  Although the reaction looks overdone and will likely be followed by some consolidation over the short term, the move will be interpreted as the beginning of a move towards monetary policy normalisation despite the Fed’s insistence that this is not the case.  The firm USD tone is set to remain in place for now but the bulk of the strengthening has likely already occurred following the announcement.  

The Fed’s desire to reduce the size of its burgeoning balance sheet, which at $2.3 trillion is roughly around three times its size before the financial crisis began, will imply further measures to reduce USD liquidity over the coming months.   A withdrawal of liquidity could have positive implications for the USD but given that the Fed is still some months away from hiking the Fed Funds rate, interest rate differentials will not turn positive for the USD for a while yet. 

The move has however, changed the complexity of the FX market and likely shifted currencies into new lower ranges against the USD.  There were plenty of reasons to sell EUR even before the Fed move and the discount rate hike inflicted further damage on EUR/USD which dropped below the key psychological level of 1.35.  GBP and commodity currencies were also big losers, with GBP/USD below 1.55.  Key technical support levels to watch will be EUR/USD 1.3422, GBP/USD 1.5374 and AUD/USD 0.884.

US Federal Reserve Balance Sheet ($trillion)

Posted in Australia, central banks, Currencies, equity markets, Europe, Federal Reserve, FX, Interest rates, US. Tags: , , , , , , , , , , , , . Leave a Comment »
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