Wednesday July 21, 2010

The euro is coming under a little pressure midweek as selling pressure builds in admittedly thin summer trading conditions ahead of the publication of European banking stress tests. Market players are learning in a piecemeal fashion the likely contents of the reports and as such investors are trying to form opinions on what's next for global currencies. Will the report seal the deal or undermine the euro's recovery?

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Japanese yen - As we await it's the Japanese yen that is on the move. On Wednesday it gained across the board as investors cast their focus on the fast-dissipating yield differentials between the yen and the dollar. Theory has it that a slowing U.S. economy leaves policy makers on either side of the Pacific equally impotent, which at this stage leaves the dollar on the back-foot more so than the yen. Dealers are also tossing the ball back into the Bank of Japan's court at this point as they buy the yen. Buying pressure for the typically safe yen has been mounting after evidence has grown that the global economy is slowing down. While that independently strangles the fuel pipe for the Japanese manufacturing sector it also harms the bottom-line profits as exporters face fewer buyers of their now relatively more expensive products. Today the dollar rescinded some of Tuesday's gains falling to ¥87.05. The yen strengthened to ¥111.61 against the euro while it accelerated per Australian dollar to ¥76.97 as concerns rose over the strength of the global economy.

U.S. Dollar - The fear-based bid behind the dollar on Tuesday disappeared as quickly as it had arrived with investors reversing an earlier disdain for equities. Concern has been growing very recently that the domestic slowdown leaves authorities hemmed in and unable to further fuel a recovery. Starting today Fed Chairman Bernanke will spend two days in Washington addressing the Senate Banking Committee and the House Financial Services Committee in his semiannual account of the health of the economy. Some speculation has mounted that he will discuss the potential for reducing the deposit rate applied to bankers' excess reserves, which would be a further quantitative ease. The dollar index is stronger today at 82.92.

Euro - The euro reached $1.2791 for its weakest reading in six days as the results of the stress test slowly draws to a conclusion. Actually inconclusion may be a more appropriate term to describe the outcome. According to European banking regulators the report will reveal the stance of the 91 banks under three scenarios. The primary test will review the health of each named bank using a 2011 benchmark to review its Tier 1 capital. The second scenario will review under a so-called adverse scenario, while the third will imply a sovereign shock, which presumably means that the bank's balance sheet will be stressed to reflect the haircut it would face if a government reneged on its debt.

We also know that banks shown to fail the test will be given time to go out and raise capital. After the results are published and the stresses are evident, credit analysts will be able to tell us how much capital any given back would need to get its house back in order. It will actually be a positive development to find that several banks are in need of a make over as it will underscore the integrity of the testing process. Watch out if everyone scores an A, however.

British pound - The pound rose following the publication of recent Bank of England minutes where of course policy was left on hold. For a second back-to-back meeting Andrew Sentance rowed against the other crewmembers favoring an upwards adjustment to monetary policy. The pound added to Tuesday's gains and reached its highest point against the dollar at $1.5336 before a bout of dollar strength washed gains away leaving the unit adrift at $1.5262.

Discussion addressed the recent emergency budget and concluded that while it was too early to fully assess the impact of its measures, one thing was for sure. A sales tax coming in to effect in 2011 would add to an already difficult inflationary profile. Data for April saw the pace of consumer prices reach a 17-month peak while the most recent data showing a 3.2% pace of inflation remains beyond the 3% ceiling. Investors are not yet looking for a monetary policy increase, however, but feel assured that the Bank will likely be an early mover even if we have to throw in the word eventually.

According to a Dow Jones Newswire story yesterday, policymaker Adam Posen was quoted as saying that in his opinion the next move from the central bank on the current assessment is lower rather than higher. His remarks seem to surround addressing quantitative measures as opposed to cutting official interest rates in light of the challenge posed by price pressures. The pound continues to outperform the continental euro on the view that the domestic economy is less bruised than that of the Eurozone with the euro weaker today at 83.95 pence.

Aussie dollar - The Aussie suffered on the hang-ups investors have over global growth concerns. Yesterday's revelations over further monetary policy tightening initially buoyed the dollar, but subsided as investors focus shifted to safety of the yen. The common belief is that the Aussie needs a further monetary stimulus to provide an incremental yield benefit if it is going to hurdle the 90.00 U.S. cent barrier. The preconditions for further action as laid out in the RBA minutes are blue skies following the European banking tests and an uncomfortable second quarter inflation reading due next week. Forex dealers relaxed the odds of a double-win here and sold the Aussie earlier as it fell to 88.18 cents before it rebounded to 88.59.

Canadian dollar - The Canadian dollar has torn the greenback to shreds following Tuesday's 25 basis point increase at the Bank of Canada. The surprising thing, however, is that the Bank sounded cautious about any further moves, which initially sent the loonie reeling to an intraday low. However, since then it hasn't looked back and has flown off the handle to as high as 96.54 U.S. cents or roughly two cents over yesterday's weakest point. Crude oil and several base metals prices rebounded also sparking demand for the commodity-sensitive currency.

Andrew Wilkinson

Senior Market Analyst       

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