The outcome of important central bank policy meetings in the Eurozone, the UK, and Australia will be among the primary drivers of world currency markets this week, writes Kathleen Brooks of FOREX.com.
The Eurozone crisis continued to deteriorate last week with fears about the economic effects of the crisis taking center stage. Eurozone unemployment reached 11%, the highest since the euro came into circulation, and the latest manufacturing surveys for March were weak for Europe, China, the UK, and even the US.
The severity with which investors have ditched risky assets and moved into bunds, Treasuries, and gilts suggests that the markets are now pricing in the potential for a global recession. Without official action it’s hard to see how we can break out of this cycle of risk aversion, and this week, there are three pivotal central bank meetings including the Reserve Bank of Australia (RBA), the European Central Bank (ECB), and the Bank of England (BOE).
No Fireworks from the ECB
At the end of last week, rumors that the ECB was buying Spanish sovereign debt helped to boost risk assets. EUR/USD closed the European session just below 1.24 after falling as low as 1.2280 after the non-farm payrolls (NFP) release, and Spanish bond yields closed at 6.53%, 17 basis points lower than the peak they reached earlier in the week. This highlights two important things: 1) the markets are deeply oversold, especially risky FX and European equities; and 2) if there is remedial action by the ECB or other European authorities, then there could a powerful relief rally.
This Wednesday’s ECB meeting will be the most important event in the currency bloc for the coming week, though we don’t think the ECB will be too radical.
ECB head Mario Draghi was speaking last week and reiterated that governments should do more to stem the crisis. He also added that conditions in the markets are not as stressed as they were in November prior to the Bank’s LTRO auctions. This is true to an extent.
While Spain has come under intense pressure along with Italy, the core European nations like France, Netherlands, Belgium, Austria, etc., have not seen their bond yields come under selling pressure from the markets. In fact, the French-German ten-year bond spread has actually been narrowing, suggesting that there is demand for French bonds even after the Socialist victory in the Presidential election.
The ECB is likely to say that it will offer support to Europe’s banks to prevent them from going under, but Draghi and company are likely to stop short of offering a more sustainable solution to this crisis.
Of course, the Bank could also cut interest rates, which currently stand at 1%, a record low for the currency bloc. The manufacturing sector PMI remained in deep contraction territory in May, and the unemployment rate surged to a record high of 11% in April. Added to that, the flash estimate for May CPI fell to 2.4% from 2.6% in April, which could give the ECB more room to cut rates. However, the Bundesbank is still a powerful hawkish element in the central bank, and it is likely to resist such a move until the situation deteriorates even further.
This is bad news for the periphery, which needs lower interest rates. However, the lack of action from the authorities is likely to weigh on the euro, which could benefit their export markets (if they manage to stay in the currency bloc, that is).
There were signs last week that Germany might be willing to adjust fiscal targets after an official in Berlin said that Spain is unlikely to meet next year’s 3% fiscal deficit target. But the radical action that some expect, including Eurobonds or using ESM funds to re-capitalize Spanish banks, don’t appear to have made much traction in Brussels.
If the ECB is fairly muted in its response to the crisis this week, then the baton is passed to the EU leaders when they meet at the end of June for the next EU summit. So, the markets are left waiting for political action, and Europe’s politicians don’t walk to the market’s beat. This combined with the Greek elections on June 17 are likely to keep uncertainty high and leave risk assets vulnerable to more downside.
There is a pre-election poll blackout in Greece from this weekend in the two weeks leading up to the elections, which only adds to the uncertainty and increases the chance of a selloff. Added to that, Spain issues 2014, 2016, and 2022 bonds this week. Any signs of weak demand for its debt could cause a fresh bout of risk aversion.
The euro had a dreadful May versus the dollar, having fallen 6%. It is now looking very oversold from a technical basis. However, the fundamental picture remains bleak, and the euro is still sensitive to headline risk, both positive and negative.
If it can make its way back to 1.2510, then we may see a deeper pullback towards 1.2710. However, below 1.2350 opens the way to retest 1.2290, then 1.2150, and eventually 1.20. Without remedial action from the ECB or EU authorities, it is hard to see how this pair can resist further downward pressure.
BOE: Increased Chances for More QE
The extremely weak PMI data at the end of last week, which showed the manufacturing index plunge to its lowest level for three years along with the escalation of the Eurozone crisis, has increased the chances that the Bank of England will expand its QE program when it meets on Thursday.
We believe that the Bank will do more QE in the coming months, and the sharp deterioration in the manufacturing PMI could be enough to prod the Bank into doing more this week, which is not the market’s central scenario.
The minutes from the May meeting suggested that the decision to remain on hold was finely balanced, and even Adam Posen, who recently moved to the neutral camp after having consistently voted for more stimulus, said that his decision was tough.
The inflation report was also more dovish than some expected, with growth for 2012 revised lower. Although inflation is expected to remain higher than the 2% target this year, the Bank sets policy with a two-year time frame and expects inflation to fall below target in the coming years. Thus, with the much-worse-than-expected PMI number, it could shift some members to take action now to prevent deflation later.
The British pound (GBP) followed the euro lower last week, but managed to stage a recovery on Friday after falling below 1.5300 against the dollar. We believe that a breach of this important support zone would be a very bearish development for this cross, and may open the way to 1.50 and then potentially to the 1.45 lows from 2010. However, this pair is starting to look oversold, so any remedial action from the European authorities to sort out the sovereign debt crisis could boost sterling and negate any of the negative impact from more QE from the BOE.
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