Wednesday May 19, 2010

Another day of heresy for the euro as it yet again reaches a four-year low, this time at $1.2144 in overnight trading. After a revival of sentiment the euro has reversed course having recovered to $1.2450 on Tuesday. The latest catalyst is the threat of increased German regulation in its markets. Yesterday that story was shaped by the suggestion from German lawmakers that they'd back a plan to levy a tax on financial institutions. Today Germany banned certain financial trades that might undermine markets. The head of BaFin, its financial regulator told a parliamentary committee that the euro is under attack. Investors today raised the stakes in irritation that the authorities are refusing them legitimate targets to take pot-shots at. One policy failure seems to follow another leaving the intraday behavior of euro itself as the ultimate barometer of risk.

Euro - Chancellor Merkel banned short stock sales on certain financial instruments and prevented speculators from taking naked positions in credit default swaps. In other words, if you want to take out insurance on the underperformance or even the default of bonds issued by one of the covered financial institutions, you'll first need to own the bonds.

It would be all too easy to poke fun at the measures implemented and say they have failed immediately. Instead of creating stability, sentiment in the European markets has again dipped. At this point the measures implemented apply only to German markets, although as the largest European market the moves will not be utterly ineffective. The shock of the move today has aroused suspicion, which explains why investors suddenly became more risk averse, while the question now is whether other regulators will follow the German lead. On reflection, when the SEC banned short sales in the U.S. it was first taken as a predictor of worse to come for the market and equities duly cheapened. This could be the case today, which is probably why the euro is also behaving badly.

Aussie dollar - The Aussie dollar swooned against the Japanese yen and has lost ¥10 yen within 2 weeks. Today it slipped 3% as investors gave up on shorting the world's least expensive currency in order to bask in the sunshine of a 4.5% short-term Aussie yield. The Aussie slipped to ¥76.50 before recovering to ¥77.25. Concerns continue to mount from both directions for the Aussie economy.

The mounting worries over European affairs raises question marks over a global recovery, which loops right into demand in its own back yard as investors fret about the state of Chinese growth. As a result, risk bets were once again removed and the unit slid against the dollar to an eight-month low at 83.95 U.S. cents. That's a six-cent decline in just two weeks. Further evidence that the RBA's string of interest rate rises has been successful as a key consumer confidence gauge from Westpac and the Melbourne Institute showed a 7% decline and the biggest drop in 19-months.

British pound - The perceived failure of European politics and the rising fears surrounding a sovereign debt crisis once again unleashed on the pound today, which dropped to a 13-month low versus the dollar at $1.4239. the pound is currently weaker per euro at 85.67 pence.

U.S. Dollar - An early-morning bout of profit-taking on short euro positions is currently reversing the direction of the dollar index, which is now slightly weaker on the session. The dollar was also losing ground to the Japanese yen, which weighed on the index. Consumer price data due this morning is unlikely to change the dollar's direction given the current amount of excess slack in the economy and limited signs of price pressures evident in producer prices.

Canadian dollar - It's now two-and-a-half-weeks since the Canadian dollar last traded at parity with the U.S. dollar and today the prospect of repeating the achievement looks like a broken dream. The Canadian dollar reached a low of 95.07 U.S. cents before a rebound to 95.56 cents. Weakness in commodity prices are rooted in an escalation in the value of the dollar and compounded by fears that such a rise portends future economic weakness resulting in lower commodity demand.

Japanese yen -The yen was off to the races as fear premiums expanded. Against the dollar overnight the yen rallied to ¥91.07 as investors moved out of carry-trades in which the short yen is used as a convenient and inexpensive manner to fund higher-risk bets. Market stories of margin calls in Tokyo created a further wave of stop-loss selling of everything in order to buy yen. The euro slumped to ¥110.85 and extremely close to the low reached on the day of the flash-crash which resulted in panic-related selling in exchange for yen.

Andrew Wilkinson Senior Market Analyst