Dollar gains evaporate on Friday after massive Japanese earthquake
14/Mar/2011 • Currency Updates•
A week of lacklustre trading and generalized euro weakness ended with a bout of severe volatility on Friday as news of the massive Japanese earthquake and the following tsunami hit the tapes and televisions worldwide carried dramatic images of destruction. Surprisingly, the dollar failed to rally and actually sold off heavily against the Japanese yen on the news. While initially it rallied heavily against most other G10 currencies, the flight-to-quality bid was short lived, as equities throughout Friday shrugged off the earthquake news and the full-fledged civil war in Libya and staged a decent end-of-day rally, while the dollar finished about unchanged for the week. Commodities however sold off sharply, down 4% for the week.
After markets closed on Friday we also received news that European leaders have made what appears to be significant progress in revamping the bailout mechanism for troubled sovereigns. While details have yet to emerge, this should be a short-term positive for the common currency, although the large probability of further tape bombs regarding Japan, the Middle East and Europe itself that we expect next week makes it more difficult than usual to make predictions on short-term market moves.
The Bank of England decided to leave both the purchase target and the level of rates unchanged. As is usually the case when no change is made to monetary policy, no statement was released, so we will have to wait until the publication of the meetings to find out whether more members have joined the hawkish camp. Aside from the BoE, it was a fairly light week in terms of macroeconomic releases. Sterling traded almost tick by tick with the euro, except for late Friday, when news of the progress being made in the European bailout framework buoyed the common currency but not sterling, which ended down 0.6% against the euro and 1.1% against the greenback.
In spite of continued strength in economic releases in core Europe (industrial production in Germany continues to outmatch expectations), the common currency struggled throughout most of the week. No doubt fears of disappointment in the agreement to expand and improve the bailout facility weighed on the markets, as did the stretched long positioning in the common currency by speculators. After spending most of the week drifting down against the dollar, the euro got some support late Friday from the news that the European summit was making much more progress than expected. The key points were agreement had been reached involved increasing the EFSF’s effective lending capacity to €440bn, and permitting it to buy bonds directly from bailed out sovereign and a cut in lending rates to Greece by 1% and lengthening of the repayment schedule from 3 to 7 years, in return for an ambitious privatisation program. No such easing was given to Ireland, as the Irish Government refused to bring its ultra-low corporate tax rate in line with the European norm.
Clearly, this level of agreement this early in the discussion is a notable positive for the common currency. We do not, however, have a bullish stance on the euro due to the crowdedness of the short dollar trade; the already high level of the euro; and the lack of any progress in resolving the Spanish zombie banks and restoring credit flows in that country.
Macroeconomic news flow has turned somewhat softer over the last few weeks. This week, consumer confidence measures gave nasty downward surprises, and constitute the first indication that the spike in oil prices is starting to impact non-oil producing countries. The trade deficit also came out worse than expected. The combination of oil spikes, tighter-than-expected fiscal adjustment and a drag from net trade brought most observers to lower their near term projections for US economic growth. None of this had much impact on the dollar, however, which traded most of the week as a flight-from-risk asset, moving in roughly inverse proportion to equities. Given the enormous uncertainty surrounding world events (Middle East unrest, now joined by the Japanese earthquake and the agreement being hammered out in Europe), together with the record short USD positioning among traders, we maintain a positive stance with respect to the dollar for the coming weeks.
The Japanese yen traded in a low volatility, idiosyncratic manner all week until the earthquake hit. After a brief flurry of selling, JPY started rallying against the dollar and continued to do so until late in the Friday trading session. The rationale appeared to be that the damage will actually force purchases of yen, as Japanese entities collect on their insurance policies with international insurers and repatriate foreign holdings to pay for reconstruction. The generalized flight to safety which traditionally buoys the yen also did not hurt the Japanese currency. As the estimates of the scale of the disaster climb, we cannot but remain sceptical of the reasons given for yen strength and maintain our bearish stance against JPY.