Prepare For The Worst

Another critical week confronts global financial markets with a plethora of earnings reports due from America’s corporate heavyweights and Fed Chairman Bernanke delivering his semi-annual testimony on the economy and monetary policy before the Senate Banking Committee later today.

Bernanke's Guidance
Although the Fed decided to extend Operation Twist last month declaring it was ready to “take further action as appropriate”, Bernanke is likely to be confronted with some hostile questioning from members of the Committee on why the Fed has not done more. With just two weeks until the next FOMC meeting, Bernanke may pre-empt too much criticism by emphasising that the Federal Reserve is ready to do what is necessary while also highlighting that America is being hobbled by Europe’s financial crisis.

IMF Guidance
Some of the weekend headlines in the financial press do not augur well for the coming week, with speculation intensifying that the American economy may already have lurched back into recession. The IMF is due to release its latest forecasts for global growth later today; no doubt its projections for growth will be revised downwards. Meanwhile, the marked slowing in the pace of growth in China is also attracting justifiable attention -- the Shanghai Composite has fallen a further 1.4% overnight, a decline of more than 12% in just over two months. In forex markets, the dollar lost some ground both on Friday and again overnight. Some short-covering in the euro ahead of today’s Bernanke speech saw the single currency run up to 1.2283 in Asia, although it has since dipped back to 1.2230. The yen remains well-bid, as does the pound with EUR/GBP now near 0.7850.    

A More Competitive Europe
After the mini-euphoria that followed the EU Summit at the end of last month, the first couple of weeks of July have been pretty awful for the single currency. Safe-haven currencies such as the dollar, the Japanese yen and the Canadian dollar have recorded gains of roughly 4% so far this month, while even high-beta currencies such as the Aussie have registered an advance of close to 4%. If we scroll back further, the euro’s losses are even more dramatic. Since the end of the first quarter, the yen has jumped against the euro by 14.5%, the dollar by 9% and, against the pound, by 6%. Some of the major Asian currencies have also surged against the euro over this time period -- the won, the Singapore dollar and the Taiwanese dollar are all up by 8% since the end of March. Amidst the understandable negativity toward the single currency, it is worth recognising that the euro is now much more competitive. Since late 2009, the real trade-weighted index has dropped by more than 18% to its lowest level in almost a decade. For those producers in Europe who were already competitive at a much higher exchange rate, this decline is now starting to represent a real boon. Indeed, what is clearly happening in Europe is that there is a very powerful internal devaluation from the likes of Spain, Portugal, Italy, Greece and Ireland, and an equally critical external devaluation via the nominal exchange rate. As such, through a dramatic realignment of relative labour costs, much needed structural reforms in the labour market, fiscal consolidation and a significant currency depreciation, the necessary adjustments to make Europe more competitive over the longer term are well underway.

Yen Dynamics
The stand-out currency last week was the yen, with EUR/JPY threatening to break below the 2012 lows. In contrast, USD/JPY has been confined to a relatively tight 79-80 range for nearly all of the month-to-date, suggesting that the dollar and yen are becoming more aligned as investors err towards safe-havens and away from taking on risk. In markets, the summer lull may have come early, even though the global hub of FX trading (the UK) is seeing rain on a daily basis. However, the fact that the yen outperformed last week fits with what we’ve seen in interest rates and stock markets.  The two-tear rate spread (U.S. minus Japan) has moved in the yen’s favour as both U.S. yields have moved lower and yen rates higher. Meanwhile, there are also signs that the yen is becoming more sensitive to stock movements, with the correlation between USD/JPY and emerging Asia stocks (MSCI) rising (on one-month rolling basis). This correlation was in negative territory for nearly half of last year, but only fleetingly so this year, dipping to -0.30 in May, vs. the current 0.28. As such, the weaker tone to equities in general offered more support to the yen last week and this greater correlation underpins why it has done relatively well. 
 
Simon Smith, Chief Economist
Michael Derks, Chief Strategist
 
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