Market Drivers September 17th, 2012
Slight risk off as tensions in China weigh
Merkel reaffirms EU unity
Nikkei closed Europe -0.53%
Oil at $98.70/bbl
Gold at $1770/oz.

Europe and Asia:
NZD Westpac NZ Consumer Confidence 102.55 vs. 99.9
GBP Rightmove House Prices -0.6% vs. -2.4%

North America:
CAD Existing Home Sales 9:00

A very quiet start of the week in the FX market with a slight risk off tone due to continued geo-political tensions between China and Japan where a dispute over a series of small islands has turned into a wave of anti-Japanese protests across China. The resulting demonstrations, some of which have turned violent, has caused some of the Japanese multi-nationals to temporarily close down their plants and for Japanese authorities to call on their Chinese counterparts to protect life and property from crowd assault.

While the situation has not reached a crisis point, it nevertheless underscores the tensions existent between the two countries and also highlights the difficulties Japan faces in its key export market as fears of boycott of Japanese products weigh on investor’s minds. Over the past several weeks USDJPY has drifted lower approaching its record lows on continued selling due to further QE measures by the Fed.

However, as we’ve pointed out before such yen strength is simply unsustainable under current economic conditions where Japan faces continued contraction of its Trade balances. The latest tensions with China will only serve to exacerbate it already serious trade problems which is why we believe that further downside in USDJPY is limited as Japanese authorities seek to weaken the currency. Friday’s key reversal in the pair suggests that it may have set a near term bottom and could begin to stage another rally towards the 80.00 figure despite the overhang of QE 3 flows from the US.

Meanwhile euro remains steady at the 1.3100 barrier but as we noted earlier, further upward progress may be limited as the currency faces headwinds on three fronts. Spain remains the key focus for the currency market as the country needs to refinance approximately 30 Billion euros of sovereign debt over the next six weeks while at the same time staging local elections amidst an atmosphere of economic hardship. Prime Minister Rajoy has been coy about asking for direct aid from EU as the recent decline in rates has eased the need to do so. Given the upcoming elections Spanish politicians will be highly reluctant to ask for a direct bailout and much will depend on how well the markets absorb the new supply of issuance into the year end. If yields begin to climb once again, the EURUSD could quickly resume its descent.

On the political side support for euro continues to wane in the region’s largest economy. The latest poll by Die Welt shows that nearly half the Germans think that their lives will be better without the EU. Such pessimism, while greatly misplaced, could be a major obstacle to further EU integration efforts by Ms. Merkel especially if Spain and Italy decide to combat any additional austerity efforts. Meanwhile reports today about the precarious financial state of Deutsche Bank – Germany’s largest bank , could signal serious problems as well. The bank’s leverage ratio ( a ratio of its assets to capital) was approximately 40 to 1 indicating that a mere 3% decline in the value of its portfolio would render the bank insolvent.

Lastly even as the macro picture begins to ease the focus back on the micro economic data may send investors out of the euro as the week proceeds. On Thursday the markets will get a glimpse of the PMI data – which is the best snapshot of the latest economic conditions of the ground. Most forecasts are looking for steady to slightly better results, but if the readings miss to the downside they could trigger a sell off towards the 1.3000 level as the week proceeds.

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