Euro Will Be Vulnerable to Further Selling Pressure

EUR/USD

The Euro pushed to a high just above 1.3350 against the dollar in Europe on Friday and was then subjected to the same pattern as in previous days with sharp losses during the New York session.

The German economic data remained favourable with an increase in the IFO business confidence index to 109.9 for December from 109.3, the highest reading since 1991. The positive elements for the Euro were again overshadowed by structural vulnerabilities. Rating Agency Moody’s cut Ireland’s credit rating by a very substantial 5 notches to Baa1 from Aa2, maintaining a severe lack of confidence in the Irish economy and increasing fears over the regional contagion risk. Markets will remain convinced that Portugal will need a support package from the EU early in 2011 which would then put the focus on Spain.

There was also evidence that the European banks were facing an increased cost of securing dollar funding in the inter-bank market and the Euro will be vulnerable to further selling pressure if these pressures intensify over the next few days.

There were no major US economic data releases on Friday and data over the forthcoming week may have a limited impact with markets focussing on year-end liquidity and technical issues. The Euro retreated to lows just below 1.3150 on Friday and remained firmly on the defensive in Asian trading on Monday.

Yen

The dollar was unable to move back above 84.20 against the yen on Friday and was confined to relatively narrow ranges with support emerging below 83.80. The US currency continued to gain some degree of support on yield ground even though there was a rally in US Treasury bond prices during the day.

There were fresh tensions surrounding Korea on Monday with South Korea confirming that military drills including live firing would go ahead as planned despite warnings from North Korea that this could lead to a declaration of war. The tensions had some impact in curbing yen demand, although this was limited by the fact that underlying risk appetite also deteriorated as Asian equity markets declined.

There will be some unease over potential capital repatriation from Euro-zone countries which could magnify year-end yen volatility, especially with low liquidity.

Sterling

Sterling was unable to move back above 1.5650 against the dollar on Friday and dipped sharply in US trading with lows below 1.5480. Although the US currency was generally strong, there was also independent Sterling vulnerability as domestic doubts had a negative impact. 

There was a warning from Lloyds banking group that it would need to increase its bad-loan provisions related to Irish banks  for 2011. These comments revised fears that the UK banking sector as a whole would be damaged by weaknesses within the Euro-zone and also maintained fears over a negative contagion impact on the UK.

There were also persistent fears over an economic slowdown within the UK early in 2011 and there will also be fears that adverse weather conditions will dampen retail spending in the crucial pre-Christmas period. Policy uncertainty remains a key factor with doubts that the Bank of England will be in a position to tighten policy in order to contain inflation expectations. Sterling edged back above 1.55 on Monday, but the performance remained unconvincing

Swiss franc

The dollar found support below 0.96 against the franc on Friday and advanced to highs around 0.9720, primarily due to the wider advance against European currencies. The franc retained a firm grip against the Euro and tested record highs near 1.2720.

There has been no major change in sentiment towards the Euro-zone and the Swiss currency is continuing to gain defensive support from an underlying lack of confidence in the Euro. Markets will be on alert for National Bank action as any intervention would have a magnified impact when liquidity is lower over the next two weeks.

Australian dollar

The Australian dollar was unable to move back above 0.9920 against the US currency on Friday and retreated to lows just below 0.9850, but did prove to be broadly resilient. There was a general shift towards risk aversion, especially given tensions in Korea and this did have a negative impact on the Australian dollar. There were also further analyst reports pointing to the currency’s over-valuation from a medium-term perspective.

There are only limited domestic economic indicators due in the near term and the currency is likely to be buffeted by international moves, especially with liquidity declining over the next few days.