Whipsaws on Yuan Flexibility

June - 20 - 2010 Author: Christine Allen Respond

In a day full of volatility, most currency pairs wound up reversing course as traders reevaluated the bullish effects of the Chinese pledge to allow flexibility in the setting of the Yuan’s exchange rate. Price action today was decidedly mixed. On one hand, we had dollar strength against the euro, pound, yen, and loonie. However, at the end of the day, the aussie and kiwi managed to prevail. Their gains transpired on the fact that they stand to benefit most from the Chinese announcement. While the Federal Reserve rate decision will be one of the major event risks of the week, it will likely be signs as to whether or not the Chinese will make good on their claim to allow Yuan appreciation to drive currency markets.

Traders Ask How Far and How Fast

A Saturday decision by Chinese authorities to allow more flexibility in their currency’s exchange rate set markets ablaze in Monday trading. The return to a “managed floating exchange rate” was engineered to fend off global frustrations that an undervalued Yuan was giving China an unfair trade advantage. However, the initial jubilation that sent risk currencies rallying evaporated steadily throughout the day. As Treasury Secretary Geithner said, “the test will be how far and how fast they let the currency appreciate.” The emphasis on a ‘gradual approach’ to any revaluation did not send the specific message that traders wanted to hear. Nevertheless, such a move stands to produce benefits both within and outside Chinese borders. One of the primary considerations relating to the decision is to lead a transformation from an economy driven by exports to one driven by consumer spending. A stronger currency does this in two ways. First, it makes Chinese exports more expensive relative to competitors on the global stage, allowing smaller Asian nations an opportunity to compete. Secondly, it affords Chinese consumers more purchasing power, and therefore stands to ramp up imports as international goods become cheaper. This type of economic change is not something that happens overnight, but it could gradually lessen China’s exposure to troubles emanating overseas. Another benefit may be the fact that a stronger Yuan could act to lessen the pace of inflation by making imported goods cheaper. While the move definitely has its roots in the economic advantages, it is just as much based on political maneuvering. Traders worry that comments to allow flexibility in the exchange rate is more of an attempt to avoid assault at this weekend’s G-20 meetings rather than to promote a meaningful move to shift the economy on to a more sustainable path. Only time will tell what China’s true intentions are with their currency, but this is a step in the right direction.

2 Months Later, Fed Contemplates Options

The Federal Reserve will begin a two-day monetary policy meeting tomorrow, but with uncomfortably low inflation and little proof of a sustainable jobs recovery, it is unlikely that the Fed will be able to say anything other than their classic ‘extended period’ pledge. In the two month stretch since their last meeting, the Fed has watched markets return to a pattern that more closely resembled the disastrous days of the credit crisis than that of the gleeful months since the bottom. Since their last meeting, the S&P stumbled by about 6% while volatility surged to levels not seen since early-2009. Among disappointing economic data, the biggest blow was Non-Farm Payrolls which not only missed expectations but was driven higher mostly due to hiring for temporary government census jobs. Even though manufacturing has held up, the economy is simply too fragile to expect any unwinding on the part of the Fed.

EUR: TOUGH WORDS ON FISCAL GOVERNANCE

The euro lost ground after ECB head Jean-Claude Trichet spoke about punishing non-compliant member nations and beefing up budgetary oversight and surveillance. Trichet proposed a new agency, which would be “the equivalent of a fiscal federation,” to have the power to impose a “wider spectrum of financial sanctions” against Eurozone nations who let their budget deficits grow uncontrollably. Those sanctions could include “more stringent reporting requirements or even a limitation or suspension of voting rights.” The central banker posed an even more radical suggestion in dealing with fiscal negligence in that the European Commission could “reflect on changing the treaty” if his reforms are not acceptable under current laws. Trichet’s comments come amidst a push to compel nations to more responsibly manage their economies to prevent another Greek-like scenario. In a speech reminiscent of an ECB interest rate decision, Trichet reflected on comments suggesting that the bond purchasing program, which he adamantly denies as being the equivalent of quantitative easing, would stoke inflation, saying that such concerns are “entirely unfounded.” According to Trichet “inflation expectations appear to be remarkably well anchored in line with the definition of price stability,” thus, interest rates are set appropriately. Tomorrow’s IFO Survey and Consumer Confidence should really shed some light on how damaging the European crisis has been on sentiment.

GBP: SETTING BUDGET IS FINE BALANCING ACT

The pound gave way to the dollar after a healthy early-day rally evaporated. George Osborne, Chancellor of the Exchequer, spoke out today ahead of his emergency budget announcement scheduled for tomorrow. The chancellor said that his plans are forceful enough to “put beyond doubt” that fiscal goals will be realized. Osborne hints that a “general rule of thumb” in gauging the forthcoming budget is that it will comprise 80% in spending cuts and 20% in tax hikes. He says that welfare spending has “simply gotten out of control in recent years,” and needs to be reined in. Above all, notes Osborne, “the greatest risk to the British economy is the sovereign debt risk.” The new coalition government faces a fine balancing act in setting the budget, in that cuts have to be harsh enough to appease rating agencies, but not too harsh as to spread fear that the nation will sink back into a recession. Unfortunately, critics are already surfacing that believe the latter. Former Bank of England policy maker Blanchflower says that if the austerity plans take hold, Britain is “certainly going into a double-dip recession.” Ahead of the fiscal cleansing, new signs emerged that point to a strengthening housing market. Rightmove Home Prices rose to 5.0% from last year, closing in on the peak that was hit in mid-2008. The report also indicated that asking prices rose to a record and the time that properties spend on the market plunged from 83 to 58 days.

AUD: TO BENEFIT FROM STRONGER YUAN

Much of the earlier euphoric moves in the commodity currencies have diminished as the stack of questions that remain about China’s decision managed to temper the risk-taking spirit. As previously mentioned, the commodity dollars’ rally has been driven by the fact that they stand to benefit most from any appreciation in the Yuan because the added purchasing power should create additional demand for commodities. This situation may turn out to be strongest for Australia, who has quickly come to rely upon China as their number one trade partner. After all, trade between the nations has jettisoned 15.1%, with “no signs of slowing,” says the Australian Trade Minister. The tie may become stronger still as the nations recently signed off on several new accords aimed at expanding trade at an estimated value of $8.8 billion. Today’s progress signals that China and Australia have taken a step in the right direction toward developing a free trade agreement, one that stands to benefit the resource rich Australia immensely. In Canada, the BoC released their Financial System review, showing that the bank notes that the majority of major risks have increased. Those added risks, says the bank, includes factors such as excessive household debt and increasing difficulties of banks to access capital. Once again, the bank is painting a picture that indicates it is in no rush to move on rates. Tomorrow’s Consumer Price Index stands to serve as a big clue as to the BoC’s next move.

JPY: RISING YUAN GOOD FOR STOCKS

The yen dropped against all major currencies after reacting to news this weekend that China will free the Yuan’s peg to the dollar, allowing the currency to appreciate. The NIKKEI rose almost 2.5%-a 1-month high. As seen in today’s price action, stock markets viewed the Yuan news as a big positive since it will not only improve Japan’s export competiveness, but may heighten trade with China due to their improved purchasing power. The impact on the yen is a little more ambiguous, since the benefits to the economy will likely clash with the pick-up in risk tolerance. On a separate note, Fitch ratings stated the obvious today in that “the next two months is quite an important period,” in assessing how committed the Japanese government will be toward cutting debts. Japan is under heavy pressure, in that if its attempts at fiscal austerity do not appease rating agencies, they may face a crippling downgrade. In terms of data, the All Industry Activity Index rose at the fastest pace in three months, but missed expectations.

EUR/CAD: Currency in Play for Next 24 Hours

The EUR/CAD will be our currency pair in play for the next 24 hours. From the Euro-zone, we have German IFO Business Climate expectations at 4:00 ET or 8:00 GMT. In Canada, we expect Consumer Price Index figures at 7:00 ET or 11:00 GMT.

For the sixth straight day, EUR/CAD is trading in the Range-Trading Zone, which we determined using Bollinger Bands. The nearest level of support for the pair is at the major 1.2449 low, which it hit earlier this month. Near-term Resistance is at 1.2723, the pair’s 20-Day Simple Moving Average. Since December of 2009, the pair has made many failed attempts at breaking its strong downtrend. If these levels are breached, we could see major movement in either direction.

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