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The long summer ahead
Publication date: 10 July 2012
Author: Simon Smith, FxPro
Tagged with: Simon Smith
Although the euro managed to crawl higher during Monday, the signs are that we are in for a long summer period. Eurozone finance ministers have been meeting this week and have agreed the next steps of Spain’s bank recapitalisation, with an initial EUR 30bln to be lent by the end of this month. There is also talk that the loans will not land on the Spanish government’s balance sheet. This is a development worth watching, given that the euro’s (inverse) correlation with peripheral bond spreads has been increasing of late, one reason why the euro has been pushed to a 2yr low vs. the dollar at the same time that Spanish bonds have seen yields up at 7%. Meanwhile, the German constitutional court today holds a hearing on the possible delay to German ratification of the ESM rescue fund. One thing’s for sure, nothing’s easy in the governance of the single currency.
The not so soggy pound. In a subdued overnight session sterling has softened slightly, with both housing and retail data showing a softer tone. The latest British Retail Consortium data has shown like-for-like sales on the high-street nudging a touch higher to 1.4% (from 1.3%). This series is volatile but both the 6mth and 12mth averages are sitting at zero. Meanwhile, the latest data from surveyors shows the RICS house price index at a 9mth low at -22. Both suggest that domestic conditions remain fragile at best. Despite the more subdued activity overnight, sterling has been holding up relatively well. At just above 1.55 vs. the dollar, cable is not too far below the average for the year to date of 1.5765. Against the euro, sterling continues to advance, with EUR/GBP falling to 0.79 yesterday morning, its lowest level since October 2008. At the end of 2008, the euro almost reached parity with the pound. As we have been intimating for some time, the pound has been a beneficiary of capital flows from those investors fleeing Europe. High net worth investors from all parts of the eurozone have been diverting some of their wealth into both London property and UK gilts. Sovereign wealth funds likewise have shifted some of their euro-currency allocation into the likes of the pound, as well as the greenback, the Japanese yen and the Australian dollar. The consistency of these flows out of the euro into the pound evident over the first half of the year is unlikely to end anytime soon. As such, we can reasonably expect that the pound will continue to make steady progress against the single currency in the months ahead. We could see 0.75 reached before year-end.
New records for EUR/JPY. Although volatile, one of the best currency trades since 2008 has been short EUR/JPY. After reaching 170 in the summer of ‘08, this currency cross has collapsed, and in recent weeks has consistently traded under the 100 level. The downtrend in EUR/JPY has been so powerful that it has not traded above the 200d moving average in the past four years, and has only traded above the 100d moving average twice (and then only briefly). For those with patience and commitment, it has been a very fruitful trade. Now just below 98, EUR/JPY shorts will be eyeing the record low of just below 90 reached in October 2000. Few would bet against this level being tested. The single currency has endured three particularly intense selling periods over the past year, and judging by the price action of recent days, it appears that a fourth episode may just be underway. Most of Europe is in recession, at a time when governments are imposing sustained fiscal austerity and European policy-makers are still attempting to find lasting solutions to the sovereign debt and banking crisis. Meanwhile in Japan, the economy is growing again after last year’s tragic earthquake and tsunami. Prospects for the second half of this year still look respectable despite the fact that the currency is over-valued and demand for exports has waned. Like the US dollar, it is the Japanese yen that benefits most whenever global risk appetite diminishes. Although EUR/JPY has been a preferred way to bet on a declining euro for many traders, it should come with an important health warning. Europe’s fundamentals may appear awful right now but Japan’s are none too special either. National debt is astronomical at over 200% of GDP; the government is incredibly reliant on domestic saving to fund itself; tax revenue covers only one half of government spending; and the trade sector has consistently been in deficit since last year’s disastrous events. Right now, with Europe heading into a slow-motion financial implosion, Japan’s shortcomings have been pushed into the background. Eventually, however, they will come forward and attract sustained opprobrium. The direction of travel still favours a lower EUR/JPY, but the risk in this trade is definitely growing. As such, tighter stops than usual are required.
Beijing’s easier determination. Although China’s policy brigade has been very busy over the past month or so, we can expect much more from it in the months ahead. Yesterday, Premier Wen Jiabao suggested that downward pressure on the economy was “relatively large” and that attempts by the government to fine-tune policy would intensify. His remarks followed the revelation that inflation dropped to just 2.2% last month, well below the official target of 4.0%. Overnight data has also shown a relatively sharp slow-down in the pace of import growth, rising 6.3% vs. an average of 15% over the past six months. Chinese officials are apparently increasingly worried about the global backdrop. At the same time, policy-makers are looking into fundamental structural changes to the tax regime.
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