Forex Market Update

By IBTimes Staff Reporter | August 10 2010 6:43 AM

The USD continued to win back ground in Asian hours as the market digested the possibility that the Fed may not extend its balance sheet any further at this evening's FOMC. The fact that the uptrend in EUR/USD has persisted since early June is also likely a factor behind the overnight short-covering in the USD. It is possible that gains in the USD will be extended further if the Fed does not announce additional steps to stimulate the US economy this evening. However, it is likely that any further USD gains will be short-lived.

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While there has been so much attention focused on the Fed over the past couple of weeks, it has actually been the subtle changes in the positioning of the ECB which have had a greater impact on EUR/USD over the past few months. In June the ECB announced that its covered bond purchase program would be completed by the end of that month. At around the same time last year's 12 mth EUR 442 bln ECB loan matured. To ease the pressure in the money market the ECB allocated funds for 3 mth and then for 6 days, but Euribor continued to tick higher.

The spread between 2 yr bund-t-notes has been trending higher since late May and is well correlated with the move in EUR/USD. Since June the ECB has continued to reel in its emergency liquidity provisions. The bond buying program it initiated in May has almost ground to a halt. Although it is very unlikely that the ECB will hike interest rates before the middle of next year the contrast between the 'normalisation' in ECB policies and the continued caution at the Fed has been sufficient to create a sea-change in market sentiment.

The ability of the ECB to display greater confidence has most likely been drawn from the continued improvement in the German economy. Rising production has allowed for 13 consecutive month of improvement in unemployment. Yesterday's data brought an increase in imports which suggest that the improvement in the labour market may be feeding through into German domestic demand. In turn this should help shore up growth in the rest of the EU.

German growth data due at the end of the week could be crucial insofar as this could bring clues as to the positioning of the ECB going forward. While the result of the FOMC meeting has the potential to cause waves in the fx market this evening, it is possible that it will be the quiet changes at the ECB will be remain the determining influence in EUR/USD through the remainder of the summer. Any dips in EUR/USD following this evening's FOMC meeting could be decent EUR buying opportunities.

USD/JPY was generally soft overnight though the USD has performed better in London hours. As expected the BoJ kept rates unchanged at 0.1% at its regular policy meeting. Comments from Governor Shirakawa that the Japanese economic recovery was withstanding the yen's advance will offset some of the recent talk of possible intervention in the fx market.

The UK June trade deficit recorded a better than expected narrowing this morning, though sterling failed to gain much ground given news from RICS of a drop in UK house prices last month and a weaker tone of the BRC's retail monitor. Sterling is still around 20% weaker vs the EUR relative to its average in 2007, though to date the impact of this on the external sector has been disappointing. The narrowing in the trade deficit in June was both on the back of an increase of exports and a fall in imports; the latter could reflect weakness in domestic demand.

Weaker Chinese import data and a drop in Australian business confidence to 14 mth lows provides further reason for the RBA to keep policy on hold for the next few months. AUD/USD is pushing down against the 0.9100 level ahead of the US open.

The FOMC will dominate this afternoon. Canadian housing starts, US productivity and ABC confidence data are also due.

Jane Foley

Research Director FOREX.com jfoley@forex.com +44 207 398 5024