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EUR/USD brushes the 1.6 mark

Wed, Jul 23 2008, 12:24 GMT
by Erste Bank Bond Research Team

Erste Bank der oesterreichischen Sparkassen AG

• Franc moving sideways – short-lived negative correlation with stock markets
• Yen hits low vs. euro

US dollar

In the past few weeks, events on financial markets have been driven by frightening newsflows from the US financial sector. Speculations regarding the write-offs and/or amounts needed by the two mortgage lenders Freddie Mac and Fannie Mae caused unrest in the markets. The two institutions hold or guarantee loans totaling USD 5000bn, which is more than one-third of US GDP. Additionally, a smaller bank, IndyMac, was forced to file for bankruptcy.

Finally, the situation became so bad that Secretary of the Treasury Paulson proposed taking government measures. The measures included enlarging the line of credit granted by the Treasury to Freddie Mac and Fannie Mae as well as the right of the government to buy shares of the two institutions. At present, these proposals are being discussed in the US Congress. Whether these options will actually have to be implemented is unclear. However, what is decisive is that the announcement of possible measures has already stabilized the markets. Still, concrete measures by the government will be needed ultimately for these two institutions, because the sustained loss of confidence in the two “giants” would hardly be digestible by financial markets. The loss of confidence up to now can be seen, among other things, in the weakness of the USD. Even though the EUR/USD is still within the bandwidth of the past few months and recently bounced off the 1.6 mark, the countermovement was so moderate that it may very well be interpreted as persistent skepticism towards the US dollar. In this environment, new lows of the USD versus the EUR are quite possible. Thus, the EUR/USD could surpass the mark of 1.6 more strongly than up to now. We believe that such a movement would only be short-lived, because we expect the support package to be passed by lawmakers and any further downslide of the USD from its current level would call the central bankers onto the scene, and lastly, the upcoming economic data from Euroland will be anything but good news. Therefore, we are not changing our forecast for now, even though the downside risks for the USD have increased.

Swiss franc

After a short phase of firming, the franc has shifted into a countermovement and thus remained in a channel of between 1.605 and 1.62 EURCHF. In the last weakening, a negative correlation with the stock market was observed, because it seemed as if carry trades were experiencing a revival.

Several factors were probably behind the significant rise of global stock markets for the first time since May last week. On Tuesday, Fed chief Bernanke gave a speech that stopped the US financial crisis from rekindling. Moreover, the oil price declined, which sent a strong positive signal to the market. Finally, the “naked” short selling of 19 stocks was banned (including Fannie Mae and Freddie Mac) on US stock markets. Short selling means that borrowed stocks are sold and returned at the end of the lending period. If the price of a stock is lower at the end of the period than at the beginning, the short seller earns a profit. In the past few months, this was one of the most popular methods for making profits also on falling markets. However, the problem was that stocks were often not really borrowed, and several short sellers used the same stocks as underlying for their short sale trades. This creates a leverage effect and can accelerate price losses.

For the franc, the latest recovery of the stock markets meant that more loans were taken out in order to invest in the more profitable stock markets abroad, which led to a weakening of the Swiss franc. The question of whether the uptrend on the stock markets will be sustainable will play an important role in further developments, and this is a risk factor because if the stock markets plunge again, a firming of the franc is relatively likely. At the same time – as long as this does not materialize – we expect a continued sideways movement over the short to medium term.

Yen

The yen seemed to have briefly appreciated, but now reached a new low vs. the euro again. The last movement was caused by the strong uptrend on the stock markets (see above) just like in the case of the Swiss franc. This uptrend is causing carry trades to be financed in yen again, and thus, the yen is correlating negatively with stock markets more and more. Just like for the franc, in this case as well any renewed turmoil on the stock markets could entail a firming of the yen. What is remarkable though is that EURJPY for the first time reached levels outside of the channel between 150 and 169. Should this movement be repeated and EURJPY possibly even break through 170, this would be decisive for the further movement of the yen, because in this case, a further weakening of the yen might lie ahead.

By contrast, since mid-June, there have been signs of a start of a trend reversal versus the US dollar and the yen is moving on a slight upwards channel, but this seems to be a USD weakness rather than the yen’s strength. Should this movement continue, an exchange rate of 102 USDJPY by September would not at all be unrealistic. Nonetheless, what we have experienced in the past is that the yen does like to break through trend channels.

Thus, we believe that the yen should show a tendency to firm vs. the USD, but versus the Euro in the short run, it has potential in both directions.

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Published on  Wed, Jul 23 2008, 12:30 GMT