Market Volatility Explained

The beginning of 2011 has thrown up a series of major market-moving events and we thought it’d be useful to take a closer look at the extent to which localised unrest and disasters can send shockwaves through the currency markets, and why. After all, how many of you would expect that the Norwegian Kroner will directly benefit from social uprisings in Bahrain? (Norway is a major oil producer, Middle Eastern tensions push oil prices up, Norway profits.)

Whilst the currency markets are more volatile than, for example the equity markets, in calmer times even currency movements can be relatively predictable. When the market spotlight is focused on economic fundamentals, data announcements have a direct impact and exchange rates are more faithful to trends. In early 2011, we saw sentiment governed by interest rate speculation and sterling benefited accordingly whilst the greenback suffered.

However, such factors are of little relevance to investors during times of uncertainty. Most recently the Japanese crisis, but before this the natural disasters in Australia and New Zealand, and unrest throughout the Middle East and North Africa, place traditional economic factors on the backburner. Long-term investors flee to the safety of currencies such as the Swiss franc, the US dollar and the Japanese yen. Short-term investors, or “speculators,” react so quickly to events that their movement is as unpredictable as the freak occurrences on which they base their currency “bets.”

Using the Swiss franc as an example, market volatility surrounding natural disasters is clearly visible in the context of the Japanese earthquake/tsunami/nuclear crisis, and is clearly visible. The “swissie” climbed 6 cents against the Australian dollar from 1.06 to 1.12 in the space of 3 days, having hovered around the 1.06 mark for the preceding three weeks. Investors abandon calculated risks on currencies such as the aussie, euro and sterling, and revert back to safety in such uncertain times leading to sharp appreciation of “safer” currencies such as the Swiss franc.

We can be confident that these times of heightened volatility will prove temporary. As events stabilise in states such as Bahrain and Japan the market’s will begin to calm down and factors such as interest rate differentials and growth potential will return to focus, bringing with them more predictable currency investments. However, amid soaring debt levels in eurozone peripheral countries, there may yet be another crisis round the corner unless the EU can reach a firm agreement at their Summit meeting next week.

Richard Driver
Analyst – Caxton FX


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Eurozone crisis still bubbling under the surface

The crisis in Japan is understandably dominating the headlines in the financial markets as the impact on the global economy is contemplated. Aside from this, the state of emergency in Bahrain is also providing reason for the markets to remain in a heightened state of nervousness. The country’s debt rating has been cut to BBB by Moody's and there remains the possibility of an Iranian militarily intervention if the protests escalate.

Although it’s not dictating market direction at present, bubbling under the surface (and surely soon to come back under the spotlight) remains the eurozone debt crisis.

After last weekend’s EU Summit, the markets responded positively to news that EU leaders agreed to expand the European Financial Stability Fund to €440bn euros, which will now have greater capacity to cope with further euro-area bailouts. But Trichet’s comments this week suggest that the markets may have got overexcited about the weekend’s early progress. Trichet dismissed the agreement as “insufficient” and it’s quite clear that in order to reach the “comprehensive package” there are some serious obstacles to be overcome. It remains to be seen whether the agreement can actually pass through the European Parliament and whether the populations of large eurozone countries, such as Germany and Austria, can be convinced to increase their financial commitments.

Portugal’s credit rating was downgraded by Moody’s yesterday, and the euro suffered accordingly. A Portuguese bailout seems on the cards and a Greek default is certainly probable in the coming months. Any perceptions of a new safe-haven currency in the form of the euro – as was seen in City AM this morning - are wholly misguided; the downside risks to the euro in coming months clearly outweigh its upside potential.

Richard Driver
Analyst – Caxton FX

For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

And its the Swiss Franc coming up on the outside...

Whilst Japan continues to dominate the headlines we have seen the yen and dollar strengthen as the markets chase the solace of safe-haven currencies. However, there is one very well-performing currency that may have crept under your radar- the Swiss franc, A.K.A the Swissie. Due to Switzerland’s economic, political and fiscal stability, the franc represents the third major safe-haven currency. Indeed the swissie has today climbed to its highest point against the US dollar in at least 40 years and is rallying against all its major counterparts, which illustrates its increasing popularity in these times of extreme market uncertainty.
However, just as the Japanese government is determined not to let the yen appreciate too strongly, the Swiss National Bank (SNB) has showed willingness to intervene. The bank intervened last year when it considered the swissie to be overvalued, and it could do the same again if the soaring currency threatens the country’s economic growth, having stated last December that it would “take measures necessary to ensure price stability.”

The Swiss government are concerned about maintaining the strength of its export sector, but a closer look reveals that despite currency appreciation, its trade surplus actually widened last month. In addition, last year’s intervention was broadly unsuccessful (as intervening often is) and cost the SNB $25bn. In light of this, and amid a healthy economy, it seems unlikely that the SNB will act any time soon, though one has to wonder how far they will allow their currency to appreciate. This will surely come to the point if Swiss growth were to slow down and safe-haven appeal remain strong.

Against sterling, the swiss franc has gained 5% over the last month with the rate currently at 1.47. But there is certainly room for further gains with the rate still some way from the 1.44 levels seen at the end of 2010.

In other news, investors looking for higher yields might, ironically, look to Quantitative Easing, racing at Cheltenham Festival on Thursday, people say he has a licence to print money...

Richard Driver
Analyst – Caxton FX
For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

Japan announces a major round of quantitative easing: how will the yen fare in response?

Reacting to the devastating impact of the earthquake that struck on Friday, the Japanese central bank has announced its intention to pump a record ¥15tn into the economy ($183bn). This follows the reaction of the Reserve Bank of New Zealand to the earthquake that struck Christchurch, which opted to cut rates by 0.50%. With Japanese interest rates currently at next to nothing (<0.10%), the Bank of Japan clearly can’t follow suit, and has therefore opted to loosen monetary policy through flooding the money markets and buying government bonds.

The two countries’ approaches are alternative ways of achieving the same basic goals - to give consumers ‘a break’ in amid social upheaval and to provide support to fragile economic growth.

The so-called policy of quantitative easing that Japan has announced this morning invariably has the effect of weakening the economy’s national currency. The US Federal Reserve’s ‘QE II’ program has been responsible for the dollar’s woeful underperformance over the past year or so. Money-printing increases supply, thus weakening the currency as demand eases.

Accordingly, the yen declined against 13 of its 16 major counterparts as markets reacted to the news. However, just as the New Zealand Dollar did in the immediate aftermath of its rate cut last week, the yen has rebounded relatively strongly. There is a sense that New Zealand’s economy may eventually benefit from Christchurch’s disaster, with its construction sector in particular expected to enjoy strong growth. The same was thought of the Japanese construction sector but the apparent devastation suffered in the country’s north-eastern region seems set to provide a genuine setback to the Japanese economy in 2011. The country has suffered major damage to its infrastructure- most notably its roads and highways, factories and nuclear plants.

Fundamentally, we can be pretty confident of one thing- the yen will not strengthen this year. The Japanese government has this morning said as much. It threatened intervention to curb any sudden yen appreciation, asserting that it “will take decisive steps if necessary” (indeed the BOJ acted on their threat in September last year, though the impact was fleeting). So anyone hoping for a yen appreciation to mirror the aftermath of Japan’s last major earthquake in 1995 will be disappointed.

Behind the government statement is the concern that Japan is an export-dependent country which relies on weaker exchange rates particularly in times of low-growth. When a government makes this sort of statement, market appetite for the related currency is understandably dampened.

Will the yen decline? Well, the scale of the disaster is continually being revised up, and in light of this morning’s government statement, the yen could be set to weaken despite a thus far robust post-quake performance. In addition, we see risk appetite increasing over the course of 2011 and anticipate that funds held in yen will be redirected to higher-yielding, riskier currencies.

Richard Driver
Analyst – Caxton FX


For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

Tsunami hits Japan- how have the currency markets responded?

Japan has suffered from one its most powerful earthquakes for a century, unleashing a devastating tsunami across its northern coast. Today’s events follow last month’s earthquake in New Zealand, and January’s flooding in Australia. Japan represents the world’s third largest economy and the effects of this disaster are being felt throughout the global financial world.

The immediate response to the quake saw the Japanese yen fall across the board. This is understandable; it comes only two days after Japan announced that its economy slipped back into contraction last quarter. However, the market’s slightly longer-term response to the quake is somewhat counter-intuitive.

Since its initial dip, the yen has rebounded very strongly against all its counterparts as the markets. Why? The yen is one of the world’s few safe-haven currencies, which investors turn to in times of uncertainty. The earthquake may have occurred in Japan, but the global financial markets are intertwined and the widespread concern that has been triggered has seen the yen appreciate impressively. Market appetite for safety had already been heightened this week amid soaring oil prices, turmoil in the Middle East and North Africa, and eurozone debt concerns – this earthquake merely confirms this recent investor mindset. Accordingly, other safe-haven currencies such as the US dollar and the Swiss Franc have today strengthened against riskier assets such as the euro and sterling.

So will the yen continue to benefit from the earthquake? This will not be clear until the extent of the damage to the Japanese economy is ascertained. If Japan’s last major earthquake in 1995 is anything to go by, then the yen will continue to appreciate impressively. But the yen has heavily underperformed this year and with Japanese interest rates low and growth prospects poor, it will take prolonged risk aversion for this downwards trend to be reversed.

In other Caxton FX-related news, it was excellent to see fellow analyst Duncan Higgins quoted by Reuters today on his UK rate rise forecast.

Richard Driver
Analyst – Caxton FX


For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

UK interest rates left unchanged - expect a rise in June

It is no secret that central bank interest rates represent the main driver of the foreign exchange market at present. So why isn’t today’s monthly UK interest rate announcement an exciting one? Well, because we knew that the 0.5% rate would be maintained, as it has been every month for the past two years.
UK inflationary pressures are soaring at double the BoE’s target and given the ECB’s recent hawkish indication of an April rate hike, there has been growing demand for the MPC to take similar action to tighten policy. However, the BoE is wary of destabilising the economic recovery at this stage and we don’t see rates changing until June. Nor should they; we really need to wait until June to know what impact the UK’s austerity measures will have on British growth.

However, it will be interesting to see what the minutes of the MPC reveal. At last month’s MPC meeting, resident hawks Andrew Sentance and Martin Weale recruited Spencer Dale to their cause, but remained outnumbered by 6:3. We may see a fourth vote added in favour of a rate rise this month, but we still don’t envisage the BoE raising rates before June - by which time there should be firmer evidence that economic conditions are improving.

Given that the MPC was expected to maintain rates, we have seen a somewhat surprising drop in value for sterling, falling by over a cent against the dollar to its lowest point in almost a fortnight. However, the focus for the market will now turn on the EU summit this weekend, where officials will attempt to work towards an agreement on the eurozone’s fiscal troubles. After a week where the euro has suffered somewhat against its major counterparts on the back of flare-ups in Greece, Portugal and now Spain, the single currency would benefit hugely from some progress on the peripheral debt issue.

Richard Driver
Analyst – Caxton FX
For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

The Tobin Tax: Will they, Won’t they?

Yesterday, the European Parliament (EP) voted to pass the Tobin Tax, otherwise known as the Robin Hood Tax. The tax proposal represents a 0.05% levy on all financial transaction passing through the EU and it is estimated that it will raise €200bn annually. Whilst the EP may have backed the proposals, the measure will not come into force until it is passed by national legislatures. Herein lies the main obstacle...

Is it a good idea? Well in theory it’s certainly a nice idea. Banks would barely notice the impact of the levy and it would reduce exchange rate volatility caused by short-termism, but the fund could also be used to ease global poverty and the effects of climate change. 

However, although the tax is appealing the pitfalls are glaring. The tax is likely to have the damaging effect of reducing liquidity in the FX markets as speculative investors would turn elsewhere. The EU wants to press ahead with EU-wide coordination of the levy if a worldwide tax proves too difficult to attain (as surely it will). However, in light of this the tax would simply be unenforceable as EU financial centres would be a far less attractive place for banks to do business. Inevitably major institutions would relocate en-masse to more tax-friendly centres, taking with them a vital source of income for the EU. 

Nonetheless, France and Germany are right behind the tax, and accuse the UK of “dragging its feet” on the issue. London is the global financial centre of the world and Britain’s economy is heavily reliant on the financial services industry. Banks relocating is a heated enough debate as it is so can we blame George Osborne & Co for balking at the prospect of adding yet another tax?  

It seems highly likely that, despite the renewed energy the EU is putting behind it, the Tobin Tax will not gain the widespread approval that such a measure requires. Whilst so-called “banker bashing” is an excellent way for political leaders to bolster their own popularity, the Tobin Tax reeks of over-ambition and impracticality. And as for “banker bashing,” don’t be fooled by the label of “Robin Hood Tax,” the burden that the tax will impose on the banks will, as ever, simply be passed on to the consumer, so be careful what you wish for…

Richard Driver

Analyst – Caxton FX

For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

Will the eurozone debt crisis flare up once more via Portugal? And what will it mean for the euro?

Eurozone leaders are meeting this weekend in a prelude to the main EU summit in a fortnight’s time, where they will attempt to work towards an expanded bailout fund to deal with the region’s debt problems. As ever, the market expects little progress.

Addressing the key issue, it’s less a question of whether Portugal will need to accept a bailout and more of a question of when. The likelihood is that this will be sooner rather than later as the longer Portugal delays the inevitable, the more expensive it will become. The ailing country’s 10-year bond yields reached euro-era highs yesterday at 7.55%, which is simply not sustainable. Portugal opposes turning to the EU and IMF for help, but similar bond yield trends triggered bailouts for Greece and Ireland last year, and if Portugal sticks to its stubborn line then monetary assistance may be forced upon it by April.

As if things weren’t bad enough for poor old Portugal, Trichet has recently indicated that the ECB will raise interest rates to fight inflation (as discussed in the last blog), which will only increase borrowing costs for a country that remains in recession. So, what choice does Portugal have?

Interestingly, the market has moved the spotlight back onto Greece this week, in light of Greece’s recent credit downgrade. However, the markets are fickle and the Portuguese problem will be back in the headlines before long.

The impact that a Portuguese bailout or a Greek default will have on the euro is not as clear as might be imagined. A trend appears to have emerged of fading market sensitivity to eurozone debt crises over the past year; Greece shocked investors, Ireland less so, and more recently the euro has strengthened across the board despite these imminent periphery issues. On the other hand, investors may lose patience with the eurozone’s inability to find a long-term solution. Clearly a firm agreement on the bailout fund at the end of this month would do much to set investors minds at ease.

For the time being, the single currency seems set to continue to benefit from its new “front-of-the-queue” status with regard to raising interest rates. However, once this arrives (consensus is that this will be in April), focus will then shift to the effect that this rate rise could have on countries like Portugal, and their impending funding issues. Accordingly, a long-term euro uptrend is far less secure than its monthly outlook and sterling could yet revisit the winning ways it enjoyed early this year, especially following its own rate hike (potentially May/June), which is bound to entice investors.

 
Richard Driver
 
Analyst – Caxton FX


For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

Inflation response: ECB vs MPC

With the eurozone’s headline inflation running at 2.4% (y/y), the surprisingly hawkish comments from ECB President Trichet shocked the market by indicating that the ECB is likely to raise interest rates by 0.25% (from 1%) in April. UK inflation sits at 4.0% and will in all likelihood have increased beyond this point when the latest figure is released next week. However, in contrast to the ECB the BoE remains reluctant to raise interest rates, with the market pricing in a move by May at the very earliest. Both central banks have an inflation target of 2.0%, so what can explain this divergent approach?

Well, as the 0.6% GDP contraction in the final quarter of 2010 showed, the UK’s recovery is by no means guaranteed, with the dangers of stagflation and a double dip recession never far from focus. UK unemployment remains very high (nearly 8%) and the effects of the UK government’s austerity measures are yet to be truly felt by already tight household budgets. An interest rate hike is only likely to exacerbate these issues and the dovish majority within the MPC take the view that temporary factors are responsible for high UK inflation (such as VAT, oil prices and past sterling weakness). These factors are expected to fade over the longer to leave inflation on target. In truth, the UK’s recovery is on somewhat shakier ground than the eurozone’s (when taken as a whole) but the BoE risks losing credibility on tackling inflation.

The ECB’s more hawkish response is due to a stricter commitment to price stability, rather than the MPC’s approach of balancing this remit with stimulating economic growth. This can perhaps be put down to a more optimistic outlook from the ECB on eurozone and indeed global economic growth.

However, whether or not the ECB’s impending rate rise is prudent, remains to be seen. The move is not without its serious risks to ongoing eurozone periphery debt levels and bond yields - unemployment rates and budget deficits in states like Greece and Portugal vastly overshadow the UK’s. Much faith is being placed on German economic growth to drag the periphery out of recession but the rate rise could yet prove to be self-harming for the eurozone.

And finally, what implications does the ECB’s April rate rise have on the likelihood of a similarly early move from the BoE? That the ECB is convinced of the need to tighten monetary policy may persuade some of the more dovish MPC members to join Sentance’s growing hawkish faction (currently out-numbered by 6:3). However, the eurozone is the UK’s biggest export partner, and if an ECB rate hike slows demand for UK products then this could take much of the heat out of the British economy, which in itself could ease inflationary pressures

Fundamentally, the deciding factor for the MPC is likely to be the UK’s GDP performance in the first quarter of 2011 and if it does bounce back strongly, the MPC will find it difficult to resist tightening policy.

Richard Driver

Analyst – Caxton FX


For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

Sterling heading lower following ECB fireworks

So, a comparatively quiet non-farm payroll Friday draws a hectic week to a close, lending us the opportunity to take stock of a major shift in market sentiment and to look ahead to next week’s activity. Thursday’s disappointing UK services sector figures were overshadowed by events in Europe. In response to eurozone inflationary pressures, ECB President Trichet’s groundbreaking remarks on the likelihood of a rate hike within the next month placed the euro firmly on the front foot against all its counterparts.


With the ECB now well ahead of the BoE in terms of rate hike expectations, sterling looks set to weaken to levels potentially as low as 1.1360 against the euro in the coming weeks and months, though it should remain stable against a broadly weaker US dollar. With the single currency reaching a one-month high against sterling today, investors have clearly (and understandably) responded very positively to Trichet’s hawkish tones. However, perhaps greater caution would be sensible as a rate hike could yet prove highly damaging for the eurozone’s periphery members, where bond yields and unemployment remain harmfully high and growth remains elusive. The prospect for higher rates offers investors a greater return and has lifted euro demand, but, if they cause deepening debt crises in the PIIGS, the prospects for the European economic recovery, and therefore the euro, will suffer considerably.

Taking a longer term view, the market at this stage is only pricing in a single rate hike from the ECB this year (April) in order to bring eurozone inflation back to target (2.0%), however, markets are pricing in up to three UK rate rises this year, which could give sterling the edge in later months.

After this week’s excitement, we are likely to see something of a lull next week with few major data releases or announcements due. Following the heightened volatility that has epitomised the past few sessions, it will be interesting to see whether a broader trend of euro strength is consolidated. The market’s sole focus will on Thursday’s Bank of England rate statement, where investors will watch for any clues of an unlikely replication of the ECB’s hawkish response to inflation. Whilst UK inflation is at a far more alarming level than that of the eurozone (4.0% vs 2.4%), the majority of the MPC voters seem determined to maintain their ‘wait-and-see’ approach with regard to the effects of austerity measures on the UK’s stubbornly fragile recovery. No change to the 0.5% UK interest rate is therefore widely expected. That said, no one was seriously entertaining the idea that a rate rise from the ECB would be brought forward by five months this week!

In the US, today’s Non-Farm employment results for February met positive expectations and further evidenced the promising signs of economic recovery that we’re seeing on the other side of the Atlantic. Nonetheless, a radical improvement, which remains highly unlikely, will be necessary before the Federal Reserve decides to change course from its strong commitment to keep rates at record lows. It is this factor which limits sterling’s downside risks against the dollar and provides hope of a long-term continuation of this year’s gradual GBP/USD strengthening.

Richard Driver

Analyst – Caxton FX


For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.