In our commentary on Friday we noted that there's be fireworks if the euro breached $1.2700 against the dollar. While much of the United States celebrated Presidents' Day a new report from Moody's highlighted an ugly exposure of European banks to Eastern European companies and governments. The analysis concluded that this exposure, which has resulted in defaults and losses, is likely to lead to a further wave of banking downgrades in the region. As a result the euro slipped beneath $1.2600 Tuesday, while equity markets around the world are just waking up to the reality that a stimulus package and any sense of resolution for the toxicity of American balance sheets is being swamped by a broad deterioration in the health of the global economy.
It matters not that the breakage of financial companies' balance sheets started in Florida and California through ill-principled mortgage lending. What matters today is the result, which is that the structure of bank lending decisions has faltered around the world in a case of too much risk-taking. As we have been saying for some time, the Eurozone is likely in a worse position than the United States and failure at the top to abandon monetary policy is likely to harm the status of its currency.
It is unlikely that the euro will make it through the week without printing below the October low at $1.2330 as investors collectively work out that, no matter how bad the U.S. economy looks, Europe is behind – how far, we can't say. The jump in risk aversion as illustrated by the decline in equities over the last 48 hours serves as a timely reminder that the dollar and not the euro is the world's reserve currency.
Currency traders are bidding up the dollar on all fronts today. Against the Japanese yen the dollar has gathered its senses from a low point at ¥87.12 recorded on January 21, to ¥91.98 this morning. The seemingly endless slew of negative Japanese economic news continues to pile up. For its sins the yen remains a global safe haven unit, perhaps as a consequence of its status as a carry-trade victim. But the efficiency of the Japanese economy is lost in a world void of consumption. In addition the rising water mark of its currency leaves domestic companies drowning in inventory and job-losses.
Against the commodity currencies, the dollar has gained. We have to see this move as the start of a second flushing of those who dared make a recovery trade. Australian officials note that there has been so much of a stimulative effort made to get the economy back on track that perhaps enough is enough. The reality is that Australia's distance from the United States and its reliance on other Asian economies has partially sheltered its domestic economy from the harsh reality that's now sinking its teeth into the backside of Europe. While interest rates carry a positive value down under, there is scope for further relaxation, which currency investors deem a lead balloon these days. The Aussie dollar has lost a cent this morning and buys 63.82 U.S. cents.
G7 ministers failed to address the second-round currency effects of what's happening in Britain or Japan over the weekend. We can only conclude that round one is far from over and given the apparent lack of resolution there that currency strains are simply not on the agenda right now. The G7 ministers have more than enough on their plates right now.
Implied currency option volatility is edging higher with that on the euro back above 20%. Things are certainly hotting up on the forex front.
