FX: Safe Havens Back in Vogue and Italian Bloodbath

TODAY'S BIGGEST PERCENTAGE MOVERS

• pips

  %

• AUD/USD

  -237

  -2.26

• EUR/USD

  -284

  -2.05

• AUD/JPY

  -165

  -2.05

THE STORIES IN THE CURRENCY MARKET

• FX: SAFE HAVENS BACK IN VOGUE

• EUR: ITALIAN BLOODBATH

• GBP: HITS EIGHT MONTH HIGH AGAINST THE EUR

• AUD: 3 REASONS WHY AUD WAS HIT THE HARDEST

• NZD: OIL AND GOLD UNCHANGED

• CAD: HOUSE PRICES RISE

• JPY: TRADE AND SENTIMENT IMPROVES

EXPECTATIONS FOR UPCOMING FED MEETINGS

** PERCENTAGES MAY NOT ADD UP TO 100% BECAUSE OF THE PROBABILITY OF LARGER OR SMALLER MOVES BEYOND THOSE SHOWN ON THIS TABLE

FX: SAFE HAVENS BACK IN VOGUE

With U.S. equities falling more than 3 percent and high yielding currencies selling off across the board, safe havens such as the U.S. dollar and the Japanese Yen are back in vogue. The news stream over the past 24 hours made everyone forget about the positive implications of Berlusconi’s planned resignation. Rapidly rising Italian bond yields, weaker Chinese economic data along with warnings of even slower growth in the U.S. and Europe spooked investors out of holding any type of risky asset. And when investors are nervous, they always turn to the U.S. dollar and Japanese Yen. Despite high levels of debt, stagnant growth, very little room to move on monetary policy and sovereign debt ratings lower than AAA, there is voracious demand for dollars and yen and the main reason is deleveraging. When the markets are volatile and uncertainty is high, cash is king. In a world where the dollar is the main reserve currency, being in cash means being in dollars, where liquidity is the highest. In addition, with extremely low yields, the dollar and yen have been very attractive funding currencies and when deleveraging occurs, investors sell their risky assets and use those funds to square up their short dollar and yen positions. There has been many times over the past year that investors have questioned whether the dollar and Japanese Yen deserve to remain safe havens. The Japanese Yen has been threatened by government intervention but the U.S. dollar has and will continue to remain a harbinger of safety as we have seen today. Safe havens are back in vogue and as long as the headlines out of Europe continue to give investors reasons to be nervous, the U.S. dollar will rise.

Once again, no U.S. economic data was released this morning and Federal Reserve officials skirted talk about monetary policy. Fed Chairman Ben Bernanke gave a speech at a small business conference where he did not make any mention of his plan on interest rates and asset purchases. Like other central bankers around the world, he is certainly watching the developments in Europe closely because a large body water is not enough to protect the U.S. from Italy’s ripples. U.S. banks do not own a lot of European bank debt but they own quite a bit of credit default swaps. According to the latest report from the Bank of International Settlements, the CDS holdings of U.S. banks are almost 3 times the size of their direct lending to Greece, Portugal, Ireland, Spain and Italy. To prevent a default that would trigger a credit event and hence massive payments on these swaps, the Federal Reserve may have to join forces with their European counterparts to stabilize the market and bring European yields back down from the stratosphere. If they do not, IMF head Lagarde’s warning that the world could face a “lost decade” could come true. Meanwhile this morning’s Chinese economic reports provided very little help to the markets. As our colleague Boris Schlossberg report, “Chinese inflation moderated significantly printing at 5.5% from 6.1% the month prior. Industrial Production was also lower at 13.2% vs. 13.3% eyed while Retail Sales dropped to 17.2% from 17.7% the month prior. This was the lowest reading in consumer demand in three months but the falloff was not particularly sharp suggesting that so far China is able to engineer a soft landing. Market consensus in the wake of the data indicated that the PBOC is unlikely to ease monetary policy into the end of the year given the relatively robust demand.” U.S. trade numbers are scheduled for release tomorrow along with jobless claims.

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EUR: ITALIAN BLOODBATH

Financial markets are a mess this morning with currencies and equities trading sharply lower. The euro started weakening at the start of the European session and has not given up since then. Unless European policymakers sweep in like a white knight (which is highly unlikely) over the next 12 hours, the EUR/USD could poised for further losses. The volatility in the market has sparked rumors that the ECB will be holding an emergency meeting - although this hasn't been confirmed, European officials wouldn't be doing their jobs if they weren't calling each other frantically. As the third largest country in the Eurozone, it will be 10 times more difficult for Europe to bail out Italy than Greece and at its current size, the EFSF does not have the capacity to support the Italian debt market. For this reason, if Italy is forced to default on its loans, the impact on the euro would be far more significant impact than the carnage created by Greece. By now, everyone knows that Italian bond yields have moved into uncharted territory since the launch of the euro with 10 year yields rising more than 50bp to 7.20 percent. Reality is setting in with investors realizing that it won't be long before Italy is forced to extend its hand out for financial support. The latest tensions in the market was sparked by European Clearing House LCH's decision to raise its margin requirements on BTPs, causing investors to dump Italian bonds left and right. Expect European officials to scramble to look for ways to stabilize the markets. It may be too late for Italy to restore confidence but if European policymakers do not step in with some type of response, we could be looking at months of less credit, balance sheet deleveraging and uncertainty which will not bode well for currencies. With no major Eurozone economic reports on the calendar tomorrow, keep an eye on the headlines and on the 1.35 level in the EUR/USD.

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GBP: HITS EIGHT MONTH HIGH AGAINST THE EUR

The British pound may have weakened against the U.S. dollar but it rose to an 8 month high versus the euro. Considering that the uncertainty is coming from the third largest country in the Eurozone, it is not a surprise to see sterling outperform the euro now that the Berlusconi resignation relief rally has fizzled. Economic data out of the U.K. was very weak but the macro and not micro story is the main driver of currency flows. With that in mind however, investors should still be concerned about the large surprise in the U.K.’s trade balance. The U.K. trade deficit widened to its largest level ever due to a 3.8 percent increase in imports (exports rose only 0.2 percent). A large part of the change was caused by a surge in imports of art and antiques which are most likely temporarily and means that the trade deficit could revert back to more normal levels next month. Nonetheless at –GBP 9.814 billion, the trade deficit will contribute negatively to GDP in the third quarter. Taking a look back at the retail sales reports, consumer spending will not make up for the difference which means the economy could have contracted in the third quarter. This prospect will not sit well with Bank of England policymakers who will be convening to discuss and decide on monetary policy tomorrow. After raising their asset purchase program last month, the Monetary Policy Committee may not be ready to pull the trigger again so quickly even though the volatility in the financial market and the trend of U.K. data could necessitate more stimulus. If the BoE stands pat, the rate announcement should be a nonevent for the British pound.

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AUD: 3 REASONS WHY AUD WAS HIT THE HARDEST

The commodity currencies were hit hard by the turn in risk appetite with the Australian dollar taking the brunt of the selling. The Aussie lost nearly 2 percent of its value against the greenback while the loonie (CAD) fell less than 1 percent. The reason why the Australian dollar has suffered the most is because of 3 main factors. First, even with the recent interest rate cut by the Reserve Bank of Australia, the A$ is still the highest yielding G20 currency. For that reason, many investors kept their funds parked in the Aussie but when they become nervous, deleveraging starts to occur and the Australian dollar suffers the most because it is less liquid than some of other major currencies and has more one directional flow. Secondly, the RBA is only the central bank among the 3 commodity producing countries to have lowered rates in the past few months. Although they did not provide much clue on the possibility of additional easing, their decision to pull the trigger earlier this month suggests that they could be proactive about lowering rates again in the future. Finally of the 3 countries, Australia also does the most trade with China and last night’s weaker Chinese economic reports has the most direct impact on Australia’s economy. Better than expected Australian housing market data didn’t help – even though home loans rose at a faster pace in September, investment lending growth slowed. The New Zealand and Canadian dollars on the other hand may have sold off more aggressively if not for stronger economic reports. In New Zealand, consumer spending rose 1.5 percent last month, more than double the past month’s gains. In Canada, house prices also rose 0.2 percent in September compared to 0.1 percent growth in August. New Zealand business PMI numbers will be released this evening followed by Australia’s employment report and Canada’s trade balance. Job growth in Australia is expected to have slowed last month with the unemployment rate forecasted to tick up to 5.3 from 5.2 percent. If the jobless rate increases, it could add pressure on the Australian dollar and drive the currency pair back towards parity.

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JPY: TRADE AND SENTIMENT IMPROVES

The sell-off in global equities drove investors back into the arms of the dollar and the Japanese Yen. As much as the Bank of Japan has tried to fight yen strength, in times of distress, investors are still bidding up the low yielding currency. USD/JPY has held steady but the U.S. is not Japan’s only trade partner and for that reason, the Yen’s appreciation against other currencies will also frustrate policymakers. In fact, a senior currency official from the Ministry of Finance said last night that “we have to think about the impact not only from Europe’s economic conditions, but also the EUR/JPY exchange rate.” The latest Japanese economic reports were mixed. The country’s trade deficit shrank by 21 percent in the month of September, which was less than expected. Although this was the seventh straight month of contraction, the pace has slowed which reflects a rebound in activity following the March earthquake. The trade balance also returned to surplus in September but the data can be volatile which means that weaker global growth and a strong currency may still have weighed on trade activity this month. The Eco Watchers survey, which measures the sentiment of taxi drivers, waiters and other blue collar workers improved slightly, reflecting an increase in optimism. The Japanese economy has a long road ahead to recovery and for the time being, we remain on watch for additional intervention from the central bank because more support will be needed.

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AUD/USD: Currency in Play for Next 24 Hours

The AUD/USD will be our currency pair in play for the next 24 hours with the Australian employment report scheduled for release at 7:30PM ET or 00:30 GMT. This will be followed by the U.S. trade balance and jobless claims reports at 8:30 AM ET or 13:30 GMT.

The sharp sell-off in the AUD/USD today has renewed the downtrend in the currency pair according to our Bollinger Bands. The currency pair has broken below 1.02, which was a key support level. The next area of support will not be until parity (1.0). Should the currency pair regain its legs, it will need to rise back above the first standard deviation Bollinger band and the 50-day SM,A which converge at 1.0220. A break above that level could lead to a stronger rally towards 1.0430.

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