*** Currency Market Analysis 22-08-2011 ***

[The Machine]

Currency traders are cautiously stepping back into the markets this morning, but a pervasive sense of fear is weighing on many minds. Both the euro and the dollar are up slightly against the other majors, but have seen their gains limited by continued tension in European debt markets and a sluggish US economy.

Wary of central bank intervention, traders are keeping the Japanese yen and the Swiss franc rangebound near recent highs.

Weighed down by weak economic expectations and the prospect of Libyan peace, West Texas Intermediate is trading just above the $82 barrier, while gold continues to set new highs near the $1,900 mark.

Loonie's Flight Diverted

The Canadian dollar is holding ground just below the 99 cent mark this morning, after a four-week decline against the US dollar. If it were not for parity's psychological significance, the Canadian dollar would likely be trading on an even weaker basis.

Weakening economic expectations in the United States have delivered a one-two punch, damaging Canadian growth and interest rate forecasts. The Bank of Canada still expects to see a domestically-driven rebound later this fall, but it has cut growth expectations significantly over the past few months. As a result, interest rate hikes have been taken off the table.

On the other hand, Canadian policymakers have a considerable amount of flexibility relative to their international counterparts. From a fiscal perspective, Finance Minister Flaherty has more room to manoeuvre than the majority of his peers, and the Bank of Canada also has room to cut rates if the need arises. This means that the Loonie should continue to receive a modicum of support from international investors for some time to come.

However, as has long been the case, the Canadian dollar remains highly vulnerable to changes in the international environment. It is becoming increasingly clear that the slowdown in Europe and the United States will affect other areas of the global economy, including the emerging markets.

Since the mid-90s, the Loonie has maintained a stronger correlation with commodity prices than with economic growth itself. This is causing a dramatic realignment in commodity demand expectations, driving the crude oil price within spitting distance of the $80 mark – after losing almost $20 a barrel over the past two months. If this decline continues, a push back through par cannot be ruled out. Either way, tighten your seatbelts – the ride is going to be bumpy.

Jackson Hole in One

This week, traders across the full range of asset classes will be focussed on the Federal Reserve Chairman’s words at the Jackson Hole Economic Symposium in Wyoming on Friday. Judging by the extreme suppression of yields seen in the Treasury market over the last month, it is clear that many investors expect Mr. Bernanke to hint at a third round of quantitative easing.

Undoubtedly, Bernanke will attempt to talk the markets off the ledge, pointing to stability in the American economy and outlining some of the policy tools that his central bank has at its disposal. However, investors looking for a third round of large-scale asset purchases are likely to be disappointed.

Three things stand in the Fed’s way.

The first is the fact that this approach has been tried before. The Fed's “shock and awe” approach no longer shocks, nor awes. After observing the effects of the last two attempts, investors are likely to drive asset prices up in the short term, before reverting to fundamentally-driven trading patterns in the longer term.

Secondly, providing additional liquidity is extremely risky. The financial system is already awash with cheap money, and this money is beginning to leak into the real economy. Even as activity slows, prices are rising – meaning that 70s-style stagflation has become a very real threat.

Additional monetary stimulus may kick-start growth, but it may also kick inflation into higher gear and damage the real economy in the process.

Thirdly, the markets are already doing the central bank’s work on its behalf. Treasury yields are at shockingly low levels; in effect, funding rates cannot go much lower. This means that the Fed’s actions would have a limited impact on borrowing costs, particularly on the short end of the curve.

Thus, it seems that the Fed will use other tools. For example, it can lower the interest rate on bank reserves in an attempt to encourage lending, or simply tell the markets that it will not begin trimming its balance sheet for another two years. This would have the effect of anchoring expectations and assuring investors of the status quo.

Those looking for another injection of cheap liquidity may express their disappointment by pushing short yields and the dollar upward. In the event that this touches off a new spike in market volatility, trading opportunities will be created on both sides of many currency pairs. Speak with your trading teams in the days ahead about how to use strategically placed market orders and structured options to harness these opportunities – and have a great week!

By Karl Schamotta, Senior Market Strategist

[El Rey]

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