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European Tension Escalates, ECB Intervenes
- Euro Stabilizes on Intervention, Japanese Vote of Confidence
- Aussie Falls on Flooding
- Interest Rate Momentum Sustaining Canadian Dollar
- Inflation Back?
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Euro Stabilizes on Intervention, Japanese Vote of Confidence
Panicked selling of Portuguese government debt drove the European Central Bank to intervene in the secondary bond markets yesterday, alleviating strain and putting a temporary floor under the euro. Later in the session, the euro moved up against the yen but exhibited surprisingly little movement against the other crosses after Japanese Finance Minister Yoshihiko Noda said that his country would use some of its foreign exchange reserves to buy European debt.
A Portuguese bailout mounted via the European Financial Stability Facility has become a near certainty in the market's eyes. A rescue of Spain is the next possibility on the horizon, but the country's relative fiscal strength makes such an outcome slightly less probable. Belgium is rapidly moving toward crisis, with its government paralyzed, debt levels topping 100% of gross domestic product, and bond yields on a steady upward march.
The coming trading cycle should see another spike in volatility in the euro, in advance of the Portuguese debt auction. Spain and Italy are also due to sell securities on Thursday. Amid the uncertainty, many traders with large short positions will trim their exposures, while others will seek to place new bets on the currency's direction –leading to choppy trading conditions. Sharp reversals are common in this sort of environment, making it a good time to consider placing limit orders.
Aussie Falls on Flooding
The Australian dollar weakened against all of its major rivals as floodwaters threatened Brisbane, the country's third largest city. The currency is now sitting just above the .98 barrier against the US dollar, after topping 1.0225 only two weeks ago.
According to numbers released yesterday, November's trade surplus contracted as coal shipments declined in value and imports rose. Exports contribute roughly 20% of Australia's gross domestic product. Traders expect a further contraction in the weeks ahead as flooding damages mining and transportation infrastructure across Queensland state. Depending on the extent and duration of the economic damage, weakness in the Aussie may not last long, as there is little indication that this unfortunate event will substantially affect longer term growth prospects.
Interest Rate Momentum Sustaining Canadian Dollar
Canada's dollar regained ground after slipping earlier in the trading cycle, trading near the .9930 mark once more as commodities provided support and domestic bond yields continued to march higher. Traders are steadily moving benchmark interest rate hike expectations forward as conditions in the country's largest export market improve and domestic lending continues to grow.
A third of Canada's gross domestic product is generated through exports, approximately 73% of which go directly to the United States. US growth forecasts from the major banks and government bodies have been aggressively upgraded in recent months, raising hopes that Canada's exports will gear up accordingly.
Deputy Governor of the Bank of Canada Agathe Côté was the latest in a line of policymakers to warn about consumer debt risk, highlighting the 170% growth in home equity loans over the last ten years as a particular area of concern in a speech yesterday. Home equity loans tend to be indexed to floating interest rates, making them particularly sensitive when rates rise sharply – an echo of the adjustable rate mortgages that caused so much havoc in the US economy two years ago.
The central bank raised benchmark rates in an effort to slow lending last year, and clearly remains motivated to put the brakes on further debt increases. Whether the Bank will hike rates in the face of a strong dollar and uncertain export conditions remains to be seen, but rising yield differentials are providing support for the currency at the moment. This is reminiscent of the dynamic seen early last year, which bolstered the exchange rate for almost six months before interest rates were actually increased.
Inflation Back?
After meetings in Switzerland, the traditionally inflation sensitive European Central Bank President Jean-Claude Trichet put the subject back on policymaker agendas, saying: "This is no time for complacency and the solid anchoring of inflation expectations is considered something that is important by all of us". Trichet is remembered for hiking rates the last time that prices were rising sharply just prior to the financial crisis. He called for central bankers to maintain vigilance, saying "We have to deliver price stability and need to be credible in this delivery".
While prices are not moving as quickly as they did in 2008, inflation indicators are steadily ticking up around the planet, as economies improve and commodity prices rally. Central banks created massive amounts of new money in the wake of the financial crisis, and much of this liquidity has sloshed into the real economy over time. As Warren Buffett said in 2009; "Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcome after-effects. Their precise nature is anyone's guess, though one likely consequence is an onslaught of inflation".
Prices have skyrocketed in much of the emerging world, and annualised increases are already well above central bank comfort levels in the United Kingdom and Europe. At the same time, deflationary conditions remain entrenched in the United States and Japan.
History suggests that relatively high inflation rates tend to cause exchange rates to depreciate. When prices rise more quickly, a country's goods become less competitive and export revenues fall. Demand for the currency drops as fewer foreign buyers purchase it, and domestic consumers sell it to buy foreign goods.
As always, markets act on expectations. High inflation expectations often lead to downward adjustments in exchange rates as traders act in anticipation of future conditions.
The seventies and eighties were marked by wide variations in inflation rates, which drove extensive dislocations in foreign exchange rates. It is difficult to know whether the modern central banking system will successfully calibrate stable inflation paths in the years ahead, but it is very likely that price expectations will once again become a large influence on global currency markets. Something to keep an eye on – particularly for corporate treasurers with dual, correlated exposures to interest rates and currencies.
Happy trading!
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