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M$PC Currency Update: What to expect next week

After a sharp sell-off at the end of last week, markets consolidated ahead of the end of the month and the end of the quarter. While there was some tempered optimism in the early part of the week, with risk-correlated assets making a much-need correction, higher yielding currencies resumed their decline by Thursday. Given the relatively lower volume present during North American trading hours on Thursday, which saw markets slightly higher, a dropped was expected sooner-than-later, considering there has been a consistent lack of conviction behind moves higher.

Heading into the next week of trading, the start of October and the fourth quarter will unlikely offer any reprieve of recent trends. Despite the passage of a bill in the German parliament that expands the country’s contribution to the European Financial Stability Facility, a move that should have bolstered confidence (it did not), market participants will continue to worry about the situation in Greece. It is no longer a question of “if” Greece will default, it is now a matter of “when” and “how.” The expanded EFSF should ring-fence write-downs onset by a Greek default, but the ramifications could cause a cascading effect of contagion across Italian and Spanish bond markets. Furthermore, in FX markets, a further flock from the ‘sick’ Euro into the ‘healthier’ Japanese Yen and U.S. Dollar would ensue.

While this is the expected outcome in the medium-term, the beginning of the new quarter presents another possible watershed moment in the FX markets. The first occurred last week, when Federal Reserve Chairman Ben Bernanke announced that no quantitative easing would be pursued, but rather a shift in the composition of assets on the Fed’s balance sheet. In the hours following that decision, the U.S. Dollar rallied sharply, with the higher yielding currencies, such as the Australian Dollar and New Zealand Dollar, depreciating sharply. Likewise, the European Central Bank rate decision is due Thursday at 11:45 GMT / 07:45 EST. In recent weeks, interest rate expectations have plummeted for the Euro, and as recently as Monday markets were pricing in an eighty-eight percent chance of a 50-basis point rate cut. Today’s inflation data out of the Euro-zone suggests that a rate cut would be ill-advised, but lowering borrowing costs across the Euro-zone is of greater importance at this point of the crisis. Ultimately, no matter what decision the European Central Bank makes is going to weigh on the sentiment.

In one outcome, we could see the ECB hold rates at their current level, a move that would keep borrowing costs high for the periphery countries. Pundits have pointed towards the recently elevated rates as a reason why Greece has had trouble in the bond market, as well as a reason why Italy and Spain may soon see their debt go stale as it is deemed undesirable by investors. On the other hand, a rate cut would be a white flag of sorts: acknowledging the strains on the market and the necessity for lower rates could scare investors. Certainly, loosening conditions could be perceived as bullish for equity markets in the short-term (as they have historically), but the Euro would be viewed as substantially weaker, given its actual lower yield. In either case, risk-aversion will remain the theme, and market participants will continue to err on the side of caution by finding haven in the Dollar and Yen.