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For financial markets, August was one of the most tumultuous months since the 2008 financial crisis. Depressed by signs of a slowing global economy and slammed by deterioration in European debt markets, traders fled into the relative safety of the Japanese yen, Swiss franc, and US dollar. As September begins, calm appears to be returning, but the potential for violent exchange rate movement remains. Global Outlook
Two themes are likely to exert significant influence over the currency markets in the month ahead:
Monetary Safety Net Unravels
Financial markets are kicking off September after being kicked in the teeth throughout August.
Economic pessimism began to set in when a series of negative employment, manufacturing and purchasing reports landed on trading desks in the early part of the month. Sentiment was given a further knock when Standard & Poor’s downgraded the United States in early August. Although the move was widely expected, and did little to dissuade investors from purchasing US dollar debt, it certainly served to damage faith in the real economy.
Buffeted by these crosswinds, investors spent much of the remainder of the month awaiting a magic show performed by Ben Bernanke and his Federal Reserve.
However, if developments over the last few years have established anything, it is that central banks are unable to resurrect economies on their own. The Federal Reserve may have the monetary rabbit, but it doesn't have the fiscal hat.
As a result, we expect central bankers to do their best to anchor policy expectations further into the future, while avoiding repeats of the massive asset-buying programmes seen over the past few years. The risks are too large, and the rewards too unclear.
Financial markets will be forced to ride on their own, without the support of government-provided training wheels. Asset prices are vulnerable, and traders will remain cautious around the growth-linked currencies for the foreseeable future.
The ride may be a little wobbly and prone to crashes in the coming months, but one hopes that an old skill is relearned by the turn of the calendar year.
European Trainwreck
The word ―crisis‖ has lost its capacity to describe the unfolding European sovereign debt disaster.
In the three years since the financial collapse, the pattern has become formulaic. Bond markets grow fearful about debt in one country or another, and yields surge to unsustainable levels. Policymakers then meet to defuse the problem, and after much debate they effectively socialize more debt by taking it out of private sector hands and putting it under common ownership. The markets are initially placated, but soon turn their sights on another haplessly indebted European country, and the cycle repeats.
August saw this occur yet again, when investors fled the Italian bond market and began to fear a French credit downgrade. Yields jumped once more, and the European Central Bank was forced to step in. The ECB purchased the bonds of at-risk countries, and succeeded in temporarily stabilizing the demand side of the equation, but failed to alleviate longer-term concerns about the survivability of the euro project.
Once more, economists called for greater fiscal integration across the common currency area, and once more, they found their hopes dashed by politicians beholden to an increasingly uneasy public.
German and French voters have grown uncomfortable with the roles that have been thrust upon them, acting as financial saviours for the fiscally irresponsible ―peripheral‖ countries. Discussion has begun about whether repeated rescue efforts are constitutionally legal under German law, and opposition parties have begun to campaign on anti-euro platforms. In recognition of this, leaders in the core countries find themselves with little room to manoeuvre.
Deeper political union may be achieved incrementally, by stealth, but true fiscal integration remains a distant prospect. As a result, the scale of the problem continues to increase, and markets continue to worry about the euro's staying power.
Schadenfreude would be tempting, if it were not for the fact that Europe's problems are the world's problems. With the US appearing to slow, and the emerging markets decelerating, a downturn in European sentiment is the last thing the world needs. Unfortunately, recent German data would suggest that is exactly what it will get.
Thus, the financial markets are entering September in an incredibly vulnerable position. Further turmoil is likely, and currency volatility is the only certainty.
EUR
Going into the final month of Q2 the Eurozone looks rather forlorn—to say the least. All the assurances and pledges by the Troika (EU, IMF and ECB) are not doing anything to calm global markets. But rather than hitting the euro alone, this situation is slamming global sentiment as a whole. The euro continues to benefit from its comparative strength against a flagging dollar due to its higher interest rate yield and general unease about the future of the Greenback, rising to 1.4549 in the final week of August.
With ever-fewer ―safe‖ places to put their money, investors are still choosing to buy into the single currency. Considering the dire straits the 17-nation union is in, this seems somewhat counterintuitive, but the markets remain volatile, unpredictable and flighty. Underneath this brittle euro strength lays a torrid sea of trouble. The figurehead of EMU growth, Germany, posted a shocking 0.2% GDP figure for Q2, down from 0.8%. If the only economy that was really performing is halting growth, what hope is there for the rest of the bloc? French GDP was even worse, coming in flat for the quarter. The PIIGS disaster that we have discussed at length here all year continues to hurtle along with no real resolution. Apparently the ECB and European commission are considering a radical plan to prevent a fresh European debt credit crisis, involving policymakers offering central guarantees on certain types of bank debt. Again, this sounds like a lot of very expensive hot air with no decisive action. New head of the IMF Christine Lagarde has warned that European banks need to raise more capital, a concern that has been rife throughout this crisis. So, heading into September we have a strong euro but an exceptionally weak Eurozone. Investors are now predicting no further interest rate rises for the rest of the year. Comments last week by European Central Bank President Jean-Claude Tichet have alluded to a central bank that is now concerned that periphery sovereign debt will trouble economic growth and expansion in the coming months. Previously, Trichet has stuck to the ―constant vigilance‖ on inflation rhetoric. However we may see a U-turn on this particular policy as downside risks to growth become the central bank’s main concern. Will new ECB President Mario Draghi take this U-turn on policy and cut rates? This, in the short-term, seems like the only way the euro will fall back.
Nadia Georgiou, Corporate FX Dealer - London
USD
Those hoping that the US dollar would receive some short-term direction from Fed Chairman Bernanke by mapping out a path for a third round of quantitative easing were left disappointed Friday. Although not surprising to most, Bernanke was relatively mum about the finer details of any potential stimulus to stroke the economy, simply referring to the ―availability of resources to aid the economy should it be warranted.‖ With no new details on what would warrant further intervention, the Fed will continue its focus on economic growth, unemployment and any potential risk of deflation, which does not look likely in the current environment. With further commentary likely at the Federal Open Market Committee meeting scheduled for this month, the markets will be closely focused on any developments from the Central Banker. August’s downgrade of the US credit rating from S&P coupled with a dovish outlook was not enough to materially weaken the dollar, although it did prompt the fed to commit to the depths of the rates pool well into 2013, which should add to long-term Greenback pressure. The DXY has remained within its current range of 73.5 to 75.5 as buying of US treasuries has been complementing a weakening economic outlook.
In the near term, data is still mixed, with a bias to the downside. Core Inflation is hovering at a reasonable 1.8% and annual inflation at 3.6%.The concern for the Fed is how lethargic unemployment has been when benchmarked against these figures. The dollar has, of late, returned to weakening when risk appetite is rising and strengthening during flights to safety. Speculation that the US economy could slip into another recession is still present, although it seems to have subdued as equity market volatility settles. On a macro basis, the global economy still faces many possible risks, including the Eurozone debt burden weighing on overseas markets. Any major development will see a USD reaction, especially if the heavily traded EURUSD is on the move. Expect these current trends to continue and many of the drivers of the Greenback to remain constant going into the dog days of summer.
Adam Smith, Corporate FX Dealer - Vancouver
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