Forex markets: the meetings of the Fed and ECB could prove crucial in guiding the main market trends in August

Lug 27, 2012

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Next week could prove to be crucial, as the Fed and ECB meetings will guide August trends. The interventions expected from the Fed should help brighten market sentiment, …..

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resulting in a slight retracement of the dollar, after its rise in July. If the ECB does not disappoint the expectations it has created in the past few days, a drop of the euro below EUR/USD 1.20 could be avoided. If the euro area crisis is taken on more “appropriately”, the market will be willing to show greater confidence in the single currency, and the resulting easing in risk aversion would allow the yen to start depreciating.

After the developments seen in the week ending today, the meetings of the Fed and ECB – next Wednesday and Thursday – could prove crucial in guiding the main market trends in August.
USD (nominal effective exchange rate) – The deterioration of the picture in the euro area, also as a result of the crisis, has been one of the main factors behind the strengthening of the dollar this month in trade-weighted terms. Given the new measures expected from the Fed at the end of the FOMC meeting of 1st August – and on condition of the ECB not disappointing the expectations it has generated on the market in the past few days (see below) – the dollar could start to ease back, at least in part.

This should not be read as signalling weakness for the dollar, as it will in fact be an effect of an improvement in sentiment, prompted by (1) brighter prospects for the US economy, thanks to the Fed’s actions, and (2) fewer concerns over the euro area crisis if the ECB and the other European institutions do not dwell too long on what they need to do.

EUR – After having slipped to a whisker away from our downside target at EUR/USD 1.2000, this week the euro unexpectedly, but legitimately, recovered, rising back up – during its upswing – to 1.23. The recovery was triggered by a set of statements made by ECB officials, which boosted confidence in the European authorities’ intention/ability to intervene appropriately to tackle the crisis. The key statements were made by Draghi, who exactly one week ahead of the ECB meeting of 2 August, said that the ECB (1) will do whatever it takes, within its mandate, to preserve the euro, and that (2) “it will be enough”, i.e. it will work.

Therefore, we confirm our short-term projection of 1.20 (see table), as (1) if the ECB delivers on its commitment, and (2) if the other national and supranational authorities take on swiftly and effectively the crucial issues of the euro area crisis, the euro could be spared a plunge to below EUR/USD 1.2000, starting a gradual consolidation process. Lacking these conditions, on the other hand, the exchange rate would stay exposed to the risk of a drop below 1.2000, with potential downside containable to within 1.15, and the main downside target at 1.1877 (the low hit in June 2010, during the first Greek crisis). Therefore, the developments of the crisis will be crucial, essentially in terms of the actions taken by the institutions, to which the markets seem to be reacting coherently, as proven by the euro’s reaction movements in the past few days.

GBP – On Thursday the Bank of England will also meet. However, as it already acted in July by expanding the APF, we believe this time around it will leave monetary policy conditions unchanged. However, it should be said that 2Q GDP data published this week were much poorer than expected (-0.7% q/q, marking the third contraction in a row), although this was largely due to one-off factors (festivities for the Queen’s Jubilee, bad weather, closing of North Sea oil platforms). Also – contrary to the situation in the euro area – in the United Kingdom the Treasury and the central bank have drawn up a rather composite growth stimulus programme, the Funding for Lending Scheme (FLS), which was opened in July. At least temporarily, therefore, the BoE should not find itself alone with the task of supporting the British economy.

Next week, the BoE’s inaction, as opposed to expectations for moves by both the Fed and the ECB, could temporarily weaken sterling both against the dollar and the euro. A drop against the dollar, however, should be read as an opportunity to re-enter in view of a gradual consolidation and subsequent strengthening of the pound. A decline against the euro, on the other hand, could offer an opportunity to bet on a matching of recent lows for the EUR/GBP, in the 0.77 area or just below, during institutional “hiatus” phases on the front of the euro area crisis, and given the more exhaustive and timely anti-crisis scheme launched by the British authorities.

JPY – Timely and implicitly coordinated action taken in the euro area against the crisis would be the most effective factor in stopping the appreciation of the yen, which only strengthened in July, again abandoning the USD/JPY 80 mark and stabilising at around USD/JPY 78.00. The domestic authorities have expressed more than veiled concern over the protracted strengthening of the exchange rate, which risks compromising the recovery of the economy. Finance Minister Azumi has said that following the publication of GDP data (due out on 13 August), the government will consider the opportunity of introducing new fiscal stimulus. The resilience of the yen could also start to be eroded next week by expectations for the Fed’s decision on occasion of the FOMC. The resulting improvement in the outlook for the US economy – on condition of the ECB not disappointing on the other side of the Atlantic – should help reduce risk aversion, which has long been one of the most supportive factors for the Japanese currency.

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