by Don Alexander, MBA
Associate, RSD Solutions Inc.
The G10 foreign exchange market is likely to enter a more challenging environment as problems in Spain are starting to refocus investor attention on the underlying structural problems in Europe and continued deterioration of the financial condition of European banks. The ECB has not given any indication of injecting further liquidity into the banking system if the situation in Spain deteriorates and/or spreads to other countries. Leading indicators in many advanced countries are starting to show weakness suggesting that growth for Q2 and Q3 could be lower than earlier estimates. In this environment, investors and corporations may want to re-evaluate their foreign exchange exposure as the global economy enters a more risk-averse, slower growth environment.
Meanwhile, policy-makers and central banks are becoming cautious about major policy changes. The US deficit continues to overhang the Presidential election as major parties refuse to compromise over spending cuts and tax reform. A potential showdown on raising the debt ceiling could provide temporary market uncertainty. In Europe, a number of countries are reconsidering fiscal austerity as the economic costs could cause a shift in the political landscape.
Elsewhere, central banks remain cautious about providing further liquidity over concerns about central bank balance sheet size and asset quality. The ECB has not provided any indication of adding further liquidity, but may be forced to if Spanish banks have further problems. While central banks in Japan and Australia are active in adding liquidity, most G10 central banks are content to keep policy steady.
In an environment of slowing global growth indicators together with the reduced prospect of a monetary policy response could make the euro more vulnerable. Currently, any tightening of global liquidity conditions suggests a negative impact on the high-risk currencies, especially the euro. The spotlight remains on the peripheral Europe, especially after Spain’s rating downgrade, the collapse of the government in the Netherlands and the shift in political sentiment in France. Fiscal problems at the periphery of Europe could be quickly transmitted to core countries, also adding to political uncertainty. In this environment of stagnating growth and ongoing structural problems could keep the euro under pressure well into 2013.
In Japan, the continued support from the central bank and some signs of a rebound in growth should provide a base of support for the yen. The yen will have support from better economic prospects in Asia. In contrast, weaker growth prospects in the UK may cause temporary sterling weakness. Recent weaker UK data has taken some of the steam out sterling and could test the BoE’s willingness to hold policy steady.
In other major currencies, the Aussie could experience some weakness as the key support points of stronger growth and favorable terms-of-trade are showing signs of deterioration. Already, the RBA has started to ease policy in expectation of further economic weakness. In contrast, the hawkish stance by the BOC, favorable fundamentals and steady growth prospects should keep the loonie well-supported against major currencies.
If the global economy shifts towards a slower growth and more risk-averse environment, the euro could come under further downward pressure. This may include some modest pressure on sterling and the Aussie dollar. Have you examined your foreign currency exposure?
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