Currency Market Trepidations Ahead of G20

Highlights
The US dollar continues to trade choppily against the major foreign currencies as corrective pressures encounter the underlying bearish sentiment.   The unexpected rise in the German IFO (107.6 vs consensus 106.5 and 106.8 in Sept) and talk of sovereign interest helped the euro recover after nearing $1.3850.  Sterling retested the week’s low near $1.5650, as both the UK Prime Minister and the Chancellor of the Exchequer have encouraged the Bank of England to ease monetary policy (QEII) if the recovery falters.  It too recovered as the European session progressed.   The yen is the only major currency that has gained on the dollar this week (~+0.34%) , but it remains confined to narrow trading ranges.  It seems no matter what the dollar does against the other major currencies, it is bouncing along its trough against the yen. 

Ahead of the G20 meeting in Seoul, Asian will most likely end on a positive note – albeit just barely positive. The MSCI Asia Pacific is up 0.1% today, but down this week for first time in 8 weeks. Japan’s Nikkei added 0.5% as higher-than-expected company earnings and a drop in US jobless claims boosted confidence.  China’s Shanghia Index fell for a second day as banks and brokerages dropped on concern that the rise in inflation may stoke future interest rate hike.  There were also advances in Taiwan, Korea, India, Shanghai, Singapore and Australia. Hong Kong’s Hang Seng slipped 0.3%.  In Europe stocks fell, dragging the Stoxx Europe 600 from a six-month high, as investors speculated that the additional liquidity being pumped into the system from central banks will fail to sustain the recent gains.  The drop in the European stocks was led by basic materials and health care, though technology shares outperformed on the day.   

Overnight bonds were mixed. Japanese bonds slipped, and are poised to drop for the second week. The yield on the 10-year JGB is up 1 basis point to 0.89% today, up 1.5bps on the week.  In Europe, the Irish government considered extending its banking guarantee beyond the end of the year to ease bank’s access to funding.  The Eligible Liabilities Guarantees plan, covering deposits and new senior bonds with maturities of up to five years is set to expire on 12/31/10 and reports suggests that the guarantee may be extended.  10-year German bund yields are down 3bps, while Greece’s yields are up 6 bps. Treasuries gained a little ground, particularly at the longer end as the 10-year slipped 2 bps.

Currency Markets

There are two important takeaways from this week’s price action.  First, the dollar’s downside momentum has faltered after falling relentlessly since early last month.  We have found that the 5- and 20-day moving averages often provide useful insight into trend changes.  As we discuss in our SpecialFX (to be published later today) the euro’s five day moving average is likely to cross below the 20-day early next week for the first time since mid-Sept.  But the euro has been relatively resilient.  The moving averages crossed yesterday and will cross today or Monday for the Swiss franc.  Second, while QEII has weighed on the dollar like a pallet of bricks, US interest rates have begun stabilizing.  The real driver of the euro-positive interest differentials is coming from the European side of the equation.  We have put emphasis on the 2-year US-German spread.  The US-2yr yield is off 1 bp this week, while the German yield is up 18 bp.  The surprising strong string of Germany data (ZEW, PMI, IFO), hawkish comments from ECB officials highlight the divergent paths.    While the moving average development may be a early warning of a trend change, an important driver of exchange rates—interest rate differentials—has not turned.  Prudence would suggest reducing short dollar exposure, but medium term participants may want to get past the event risk posed by the FOMC meeting in early November. 

US Treasury Secretary Tim Geithner kicked off the G-20 meeting today having sent a letter to all the finance ministers.  In the letter he suggested targets for current account imbalances and urged countries to refrain from unfair exchange rate policies. He also said to rebalance global demand, countries should promise “to refrain from exchange rate policies designed to achieve competitive advantage by either weakening their currency or preventing appreciation of undervalued currency.” He added that countries with persistent current account surpluses should “undertake structural, fiscal, and exchange rate policies to boost” domestic demand. Japan’s finance minister Yoshihiko Noda gave some cautious feedback on the current account balance target idea. He also suggested that countries should work together to limit currency devaluations – though he admitted he was unclear whether the official statement will have anything about FX in it. And there’s the rub: to us it seems to be a bit of a stretch to look for some sort of unified currency policy to come out of G20.  In fact the advanced countries and EMs are arguing from different premises; where advanced countries believe that EM currencies are undervalued and EMs feel that the advanced country’s ultra low interest policies are pushing “hot” flows into EMs.  Both are correct so, therefore, a near term panacea is intractable. It’s hard enough to get any sort of consensus in G7, and so adding a bunch of EM countries to the mix (all with different exchange rate preferences) suggests that any coordination is unlikely to yield any sort of workable solution. Consequently, we get the status quo.  Which means, instead of currency appreciation, countries will continue to take unilateral actions to optimize their own exchange rates, with little regard for the effects on other countries. Global currency coordination and correcting global imbalances are a process that will take years, if not decades.

German business confidence unexpectedly climbed in October to the highest level in three years.  The German Ifo figure jumped to 107.6 in October, from 106.8 in the previous month. The market expected a modest decline in the Ifo reading but following yesterdays surprise jump in German PMI,  the rise in the Ifo is not a total surprise. Indeed, the fact that the rebound was not entirely driven by the current conditions indicator, but mainly by a marked rise in the future expectations index to 105.1 from 103.9 is very encouraging. On the whole, it suggests that economic activity picked up at the start of the fourth quarter, against fears of a double dip recession. Meanwhile, French business confidence also surprised on the upside and today’s quarterly reading showed a marked improvement in future output expectations, which together with the rebound in German numbers will support the arguments of the hawks at the ECB and the central bank’s decision to continue with its gradual exit from emergency liquidity measures.  Overall, strong readings for the eurozone and buoys the case for continued currency performance. 

Upcoming Economic Releases

At 8:30 EST / 12:30 GMT Canada reports August retail sales with the market expecting the m/m figures to remain unchanged at -0.1%.  In Mexico the bi-weekly CPI figures are reported at 10:00 EST / 14:00 GMT with the market calling for the figures to remain unchanged, although the trade balance is expected to widen to -911 mln from -699 mln.  Additionally, the unemployment is expected to fall to 5.35%.  FOMC non-voter, Plosser, speaks at 13:00 EST.