The Top Concern is the Euro Debt Crisis

September 16, 2011

Next week’s main anticipated event will be the FOMC meeting on Tuesday and Wednesday, but the central problem weighing on global financial market psychology continues to be the euro area’s sovereign debt crisis.  Greece remains the likeliest domino to fall.  A default by Greece before yearend is considered  likely, and Greek long-term interest rates remain in the stratosphere although not at their recent peaks.  The probability and timing of Greece leaving the euro zone is fraught with greater uncertainty than the possibility of a default, but the latter alone could produce plenty of collateral damage to European banks, other euro members, and the whole global financial system’s plumbing and foundation. 

Investors are unnerved by how much current circumstances feel like 2007-08, only with less cohesion among the policymakers of different countries and fewer degrees of freedom to maneuver because inflation is higher, interest rates are lower, and fiscal policies are maxed out in many countries.  This past week saw some gratifying cooperation among governments both within Europe and between Europe and other G20 nations, and the dollar settled back except against the Australian and British currencies.  Given the number of previous reprieves in the euro debt crisis that were temporary, confidence is rightfully not strong that the situation will improve progressively from here.  China’s role remains murky for one thing.  Regrettably, too, the problem all too often is being addressed as a lack of appropriate liquidity in places that need such, when as in 2008 the real issue is one of improper solvency.  While the ongoing evolution of the euro debt problem is highly uncertain, as are other dangers like deteriorating growth prospects around the world, it’s extremely certain that more spikes in risk aversion lie ahead on this bumpy journey. 

In Switzerland and Japan, officials have already elevated currency management to a top priority to counteract deflation and recession.  The Swiss National Bank on September 6th drew a line in the sand at 1.2000 francs per euro and yesterday added the belief that the currency even at that level remains high and ought to trend lower still over time.  In the first full calendar week under this unilaterally defended program, the euro fluctuated between a high of CHF 1.2094 and a low of CHF 1.2013, not far at all from the target minimum.  The balance of market forces affecting the franc — and that includes speculation on where it will end up — remains skewed to the bid side. The same is true of the yen, and the factors for why Japan’s currency is staying so strong is discussed in an article posted September 14 on Currency Thoughts.  The franc and yen are suitable hedges against global financial and economic uncertainty.  Without ending elevated risk aversion, it’s going to be an uphill fight to prevent renewed appreciation, but the efforts so far are working.  Dollar/yen this past week traded narrowly between 77.58 and 76.51, with the dollar as of 15:10 GMT today showing a net drop of 0.7% compared to weekly losses in the greenback of 0.9% against the euro and the franc.

Since August 9 when the Federal Open Market Committee last met, both gold and the dollar have risen, which is odd for a market dominated by the ebb and flow of risk aversion.  Demand for the yellow metal tends to be driven by fears of inflation and a debasement of the dollar, so its correlation to the dollar is usually inverse.  Gold on balance advanced 4.6% since August 9 but has trimmed its climb through September 5 in half.  Against key European currencies, the dollar as of 15:10 GMT had appreciated 21.2% against the Swissie, 4.2% relative to the euro, and 3.2% versus sterling.  It was virtually unchanged against the yen.  Movement against commodity-sensitive currencies were mixed in direction and smaller than 1% in size. 

The FOMC in August did not introduce more quantitative easing but managed to promote its goal of lower long-term interest rates by extending its prediction of a very low federal funds rate to mid-2013.  Investors have been conditioned to expect the launch of Operation Twist after the September FOMC meeting.  This, too, would be a fairly limited stimulus initiative intended to flatten the yield curve still further.  All other things being the same, one would expect a little support for equities and a mildly negative reaction in the dollar. 

All other factors will not be the same, however.  The euro debt crisis never sleeps, and the coming week offers a new set of critical talks toward resolving the problem.  Since this week ended on a better note for Euroland than the prior week, the see-sawing pattern of this crisis suggests that next week is due for some worse news that would elevate risk and aid the dollar and other asset havens.  Currencies will also be sensitive to feedback on the impact of newly elevated global financial strains on business confidence and economic demand.  Some of the data highlights will be the release of Euroland’s preliminary purchasing manager survey findings, Japan’s all-industry index and customs trade numbers, and U.S. housing starts and existing home sales.  On the central bank front aside from the FOMC statement, markets will comb over minutes from the Bank of England’s September meeting of the Monetary Policy Committee, which in August took a tilt in the direction of greater willingness to consider quantitative easing.

The week of September 23rd ends on the autumnal equinox.  For currency trading purposes, however, the autumn season begins at the U.S. Labor Day holiday and finishes at yearend.  Historically, autumn has been a difficult period for the dollar, but the U.S. currency this autumn is off to a decent start.  Nevertheless, a great deal can happen in the remaining fifteen weeks of 2011.  One can imagine different scenarios that could either weaken the dollar back to the 1.40s against the euro or strengthen it to the 1.20s by the end of December.  Just think of 2008 for recent reminders of how much can change in these few months.

Copyright 2011, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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