Sunday, July 29, 2012

Week ahead in the Foreign Exchange Markets.

The Foreign Exchange markets are coming off a strong week with the major currencies rallying significantly off of previous week’s lows. 

The big news of the week came on Thursday morning when financial markets rallied around the world after European Central Bank President Mario Draghi declared "the ECB is ready to do whatever it takes to preserve the euro...and believe me, it will be enough."

By suggesting that rising sovereign bond yields could "hamper the functioning of the monetary policy transmission channel," Draghi seemed to identify a loophole that will allow the ECB to act more aggressively to address the crisis, including a Fed-style round of quantitative easing.

What's important here is not so much Draghi's pledge to preserve the euro, which was understood, but his opening the door to QE -- direct bond purchases by the central bank vs. the "cash for trash" program it offered the banks earlier this year, known as LTRO. To some market watchers, this is the "big bang" out of Europe that could mark the beginning of the end of the crisis.

"There is finally light at the end of the tunnel," writes Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubish. "When the ECB is done there won't be a short against the Euro left on the planet."

Indeed, the euro rallied against the dollar in response to Draghi's comments while yields on Spanish and Italian debt yields fell dramatically. European stock bourses and industrial commodities jumped in reaction and U.S. markets rallied at the open in New York. In recent trading, the Dow Jones average was up 260 points.

Conversely, there was selling in 'safe havens' such as German bunds and U.S. Treasuries.
After myriad "false dawns" in Europe in recent years, it's tempting to be skeptical that Draghi's comments will have any lasting impact.  "We're seeing another instance of central bankers trying to save the day with the threat of their printing machine," writes Miller Tabak's Peter Boockvar.

There are questions about what actions Draghi will actually take (and when), whether the Germans will support him and if ECB action can really change the trajectory of Europe's economy.  But throughout the crisis, critics have said the ECB needed to do more and Draghi opening the door to a Bernanke-style monetary policy in Europe is a big deal -- at least for the financial markets.

These actions have created what many traders now call a “floor” under the Euro and aggressive buying continued right through the close of business on Friday.  The Euro traded with a 1.23 handle, the GBP with a 1.57 handle and the Yen was quoted in the low 78 region.

During the week, we saw yields on Spanish government bonds creep up toward 7.75%, indicating a bailout of potentially greater than anticipated magnitude was in the works. 

In Japan on Monday, Nomura CEO Kenichi Watanabe has resigned in the wake of an insider trading scandal that has tarnished the reputation of Japan Inc. and its biggest investment bank.  Takumi Shibata, another top executive at the bank, also resigned.

Watanabe, 59, will from Aug. 1 be replaced by Koji Nagai, the president of Nomura Securities Co., which is part of the Nomura banking empire and at the center of the insider scandal.  Japan's financial regulators are investigating Nomura Securities for leaking information to clients ahead of planned securities offerings by Energy Company Inpex, Mizuho Financial Group and Tokyo Electric Power Co. in 2010.  Nomura has admitted that some its employees were involved in leaking inside information.

The Euro-zone on Monday featured more news from Greece.  Greek political leaders struggled to clinch agreement on an 11.5 billion-euro ($14 billion) package of budget cuts, as international creditors began a review of Greece's progress that may determine its future in the euro.  Prime Minister Antonis Samaras and his coalition partners are to meet again on Monday July 30 to determine the savings required to receive the funds pledged under Greece's two rescue packages totaling 240 billion Euros.

Greece, which held consecutive elections in May and June as public opposition to spending cuts grew, risks running out of money without the disbursement of 4.2 billion Euros due last month as the first installment of a 31 billion-euro transfer. Citigroup Inc. (C) said there's now a 90 percent chance Greece will leave the euro in the next 12 months to 18 months.

In the UK, The Bank of England is certainly coming under some pressure after GDP figures released last Thursday showed the UK economy contracted 0.7% during the 2nd quarter.  The BOE is now expected to embark on further emergency measures to try and stimulate growth as the country continues to slide deeper into a double dip recession.  UK officials pointed to the Euro-zone crisis as the reason for the slowdown, and it is widely believed that the economy will bounce back during the 3rd quarter thanks to the Summer Olympics.   

Weak economic data in the US was also featured this week, however the GDP figures released last Friday showed a slightly better-than-expected view of the US economy.  Final first quarter GDP numbers were revised to show an increase of 2.0%, up from 1.9% previously reported.  The preliminary second quarter GDP numbers showed a gain of 1.5% - up from consensus estimates of 1.2 – 1.4% increases. 

The GDP figure was better than investors' worse fears, but still weak enough to potentially push the Fed closer to pumping more money into the economy.  "The Fed's concern and mandate is employment. Annualized GDP growth at 1.5 percent cannot begin to mend the unemployment picture," said Joseph Trevisani, chief market strategist at Worldwide Markets in Woodcliff Lake, New Jersey.  Fed Chairman Ben Bernanke and other policymakers "will have all the rationale they need to open the liquidity spigot." 

In Australia, the Aussie moved above $1.04 and continues to inch higher in concert with the kiwi.  The RBA won't meet until August 7th, but investors are now betting the reserve bank will keep rates unchanged after figures released yesterday showed inflation had accelerated.  Currencytraders had been betting the RBA would cut rates after comments by RBA Governor Glenn Stevens following the July meeting suggested he may be leaning toward cutting rates.  Reports showing that the Chinese economy is slowing added to the chances for a rate cut in Australia, but recent comments from Stevens suggest the Australian economy will continue to perform well.  Australia's economy is expected to post a GDP increase of 3.5% this year, extending a stretch of uninterrupted annual growth since 1992.  The economy grew at 4.3% during the first quarter, the strongest performance of all the 'advanced' economies. 

More on Greece: The dismal economic and political news coming out of Greece suggests that Greece's days in the euro currency arrangement are numbered. Private analysts are now projecting that Greece's economy will contract by over 7 percent in 2012 and its rate of unemployment will exceed 24 percent of its labor force by year-end. This would follow a 16 percent decline in the Greek economy over the past three years, which Greek policymakers are now correctly characterizing as the Greek equivalent of the U.S. Great Depression. 

The virtual collapse of the Greek economy is eroding Greece's tax base and is causing Greece's budget performance to fall far short of that required of the country by its IMF and European Union lenders. By its own admission, Greece's weak coalition government is struggling to get its budget back on track or to come up with anywhere near the 5 ½ percentage points of GDP in additional public spending cuts that are being demanded of it by the IMF and European Union as a necessary condition for continued IMF-EU financial support. Without such support, Greece will almost certainly be forced both to default on its official debt and to exit the euro. 

German Response: Undaunted by the prospect of a Greek exit from the euro, senior German officials are now making it abundantly clear that Germany will not support further IMF-EU financial support to Greece unless that country fully complies with its previous IMF-EU commitments. In this context, German officials seem to be willfully oblivious to the fact that the overwhelming majority of Greeks are now vehemently opposed any notion of further budget austerity measures. This has the real potential to precipitate a Greek exit from the euro well before year-end.

Drag on US Economy: Sadly, as Chairman Bernanke noted last week, a further intensification of the European debt crisis would have serious consequences for the U.S. economy and could very well push the U.S. back into recession. This is partly because Europe constitutes the largest export market of the U.S. and exports to Europe would plummet were Europe to sink further into recession. It is also because a marked weakening in the euro, which would be occasioned by further stress in Europe, would give Europe a competitive advantage over the United States in exporting to countries like Brazil, China, and India.

If, as seems more than likely, the European crisis does come to a head over the next couple of months, President Obama might learn that what goes around in politics all too often comes around. For much as he was swept into the White House some four years ago by the Lehman bankruptcy in mid-September 2008, he very well could find himself swept out of office by a European crisis this fall over which he has virtually no control.

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