Why Currencies Did Not Track Recovery in Equities

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Daily FX Market Roundup 07-12-12

Why Currencies Did Not Track Recovery in Equities
EUR: Don’t Expect ECB to Stem EUR Weakness
GBP: No Data from the UK Until Next Week
AUD: Hit Hard By Weak Employment Numbers
CAD: Was Only Currency to Benefit from Equity Recovery
NZD: Consumer Confidence Improves
JPY: No Fresh Stimulus from the BoJ

Why Currencies Did Not Track Recovery in Equities

While currencies and equities ended the day lower, U.S. stocks staged an impressive intraday recovery that saw the Dow Jones Industrial Average temporarily rise into positive territory after being down more than 100 pips at the start of the U.S. trading session. There were reports that the better than expected jobless claims contributed to the recovery but with the data released an hour before the stock market open, we are not sure how much merit there is to this claim. Also, the numbers were distorted by a shortened holiday trading week – jobless claims were reported to have dropped to 350k, the lowest since March 2008. If the jobs number made investors more optimistic, currency pairs such as the EUR/USD, GBP/USD and AUD/USD would recover more significantly but they did not. This suggests that the recovery in equities is caused by expectations for additional liquidity from central banks, which would be consistent with the weakness in currencies.

The sell-off in the currency market today has been driven by risk aversion and deleveraging. The decision to cut interest rates by the central banks of South Korea and Brazil over the past 24 hours confirms that policymakers around the world are intimidated by the risk of slower global growth in the second half of the year. South Korea’s rate cut was their first in 3 years and while Brazil reduced interest rates earlier this year they took them to a record low on Wednesday. Second quarter Chinese GDP numbers are due for release this evening and investors are worried that Chinese growth has slipped below 8% for the first time since the 2008-2009 Financial Crisis. The prospect of a simultaneous slowdown in 3 of the world’s largest economic centers set off a wave of deleveraging that drove investors into the arms of the U.S. dollar and Japanese Yen. As we have warned previously, the second half of the year will be weaker than the first, which means there will be more action from central banks this year. Relative balance sheet expansion isn’t as much of an issue because it will be difficult for the Federal Reserve to stand on the sidelines with their hands up in the air for much longer when everyone else is increasing support for their economies. Producer prices and the University of Michigan Consumer Confidence report are due for release on Friday – neither of these are game changers for the U.S. dollar.

EUR: Don’t Expect ECB to Stem EUR Weakness

The recent weakness in the euro put significant pressure on central banks around the world that are struggling to contain the strength in their currencies. Denmark for example has been forced to cut interest rates to negative levels in order to stop investors from seeking refuge in the Krone. The Swiss National Bank has fought aggressively against strength in the Franc for the past month and judging from the price action of EUR/CHF continues to do so. Unfortunately they can’t rely on the European Central Bank for any help because the fact of the matter is, the Eurozone needs a weak currency. For the ECB, the constant pressure on the EUR/USD is nothing but good news. As an inflation targeting central bank, the ECB should be concerned about an overly weak currency but with soft domestic demand and the prospect of even slower growth ahead, inflation is predicted to trend lower. At least week’s press conference, ECB President Draghi said that inflation could fall below their 2% target before the end of the year. This means that a weak euro poses no immediate problems for the ECB and will in fact help in the central bank’s efforts to stimulate their economy. With domestic demand threatened by austerity, a falling currency will help boost export and tourism industries. For our friends in Australia, there’s been no better time to travel to Europe. In other words, while the ECB will never admit it publicly, if inflation is not a problem, they will welcome a weak currency. Also, the euro is not very cheap on a historical basis. Over the past 10 years, the EUR/USD has averaged around 1.2850, which means that it is only 4.5 percent below its 10-year average. If we expand this period to include the launch of the euro, the currency is still trading above its lifetime average of 1.21. Also on the basis of purchasing power parity, the euro is still overvalued against the U.S. dollar. For these reasons, the ECB won’t feel any pressure to stop the euro from falling. In fact, we don’t expect the ECB to bat an eye at the euro’s weakness until the EUR/USD falls below its 2005 low of 1.1640.

GBP: No Data from the UK Until Next Week

With no U.K. economic data on the calendar today, the breakdown in the British pound was driven entirely by risk aversion. Sterling dropped to a 1 month low against the U.S. dollar and pulled back from a 3 year high against the euro. The latest move in GBP/USD opens the door for a further decline to the pair’s 5 month low of 1.5270. While the British pound has been considered a safe haven for Europeans, it is still a high beta currency that is particularly sensitive to risk appetite. If the markets continue to sell-off, the GBP/USD would follow. The economic calendar remains devoid of any meaningful U.K. data until next week at which time the British pound will be in play. The release of consumer prices, the Bank of England minutes, employment and consumer spending numbers will turn the focus back onto sterling as these reports will give us better insight into whether the BoE will ease again this year.

AUD: Hit Hard By Weak Employment Numbers

The Australian and New Zealand dollars fell sharply against the greenback on the heels of weaker economic data and risk aversion. Interestingly enough the Canadian dollar recovered its earlier losses to end the day only slightly lower. Last night’s employment numbers from Australia were surprisingly weak and the deterioration in the labor market leaves the door open to further easing by the Reserve Bank of Australia. Disappointments in the domestic economy may not be the RBA’s only motivation for more stimulus. China is Australia’s most important trading partner and because of this Australian dollar has been hit hard by any sign of weakness in China’s economy. Second quarter GDP, industrial production and retail sales numbers are due from China this evening and the pace of Chinese growth will determine whether the AUD/USD makes a run for parity. In terms of the employment numbers, a net total of 27k jobs were lost last month as labor demand contracted for the first time since February. As our colleague Boris Schlossberg pointed out, decline in labor was even worse than it initially appears as the Australian economy lost -33.5K full time jobs while gaining only 6K part time jobs. The labor participation rate also declined to 65.2% form 65.5% the month prior while the unemployment rate ticked up to 5.2% from 5.1% the month before. While Australia disappointed the markets, New Zealand consumer confidence ticked higher in July with families growing more confidence about the economic outlook and more willing to purchase major household items.

JPY: No Fresh Stimulus from the BoJ

The Japanese Yen strengthened against all of the major currencies. Last night, the Bank of Japan expanded its asset purchase program by 5 trillion yen to 45 trillion yen ($564 billion) but cut their loan facility by 5 trillion yen to 25 trillion yen, which makes their move balance sheet neutral. Asian stocks fell on the disappointment with the Nikkei 225 Index dropping 130.99 points, 1.48%, to 8,720.01 and the yen rose in response. After the failure of attracting enough bids in a six month credit lending operation, the BOJ said it may purchase more treasury bills and remove the minimum bidding yield for the securities. This action may smooth its operations after failures at previous auctions. The BOJ also kept its forecast of 0.7% consumer inflation in the following year unchanged after setting a goal of 1.0% in February. Economic growth is forecasted at 2.2% and 1.7% in the following 12 months. Meanwhile former Democratic Party of Japan leader Ichiro Ozawa officially formed his party to oppose Prime Minister Yoshihiko Noda’s consumption tax. The party is called The People’s Lives Come First and they also set sights to reduce nuclear energy to zero. The new group will place 37 members in the lower house and 12 in the upper house. This is not enough to influence policy, which is why Ozawa is looking to form an alliance with Osaka Mayor Toru Hashimoto. Hashimoto became one of country’s most popular politicians by advocating less central government control and spending cuts. Tomorrow will be the release of Japan’s monthly report and industrial production which is forecasted to remain unchanged at -3.1%.

Kathy Lien
Managing Director

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