Friday August 10, 2007 - 16:00:38 GMT
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Forex Market News - FX Briefing - Increased liquidity demand in financial markets
FX Briefing 10 August 2007
Â· Subprime crisis claims further victims
Â· Markets ignore Fed warning of inflation risks and price in rate cuts
Â· High liquidity demand forces ECB to inject additional funds into the market
Increased liquidity demand in financial markets
Despite the volatility in the forex markets, exchange rates remained much the same across the week as a whole. After disappointing US labour market data, expectations of a US rate cut grew and weakened the dollar. At the beginning of the week, EUR-USD climbed to 1.3840; USD-JPY slipped to 117.19, a 5-month low.
The US currency initially recovered again. After the labour market data, the markets had priced in rate cuts of 50 basis points by the end of the year; but they apparently got cold feet before the FOMC meeting: both the Fed and the ECB had previously described the development in the credit markets as an appropriate normalization of risk assessment, which hardly suggested that they were about to cut interest rates. Equity markets stabilized, which also contributed to the dollarâ€™s recovery.
In its statement, the Fed did indeed admit that downside risks to growth had increased somewhat due to heightened volatility in financial markets and tighter credit conditions. Nevertheless, it expressed confidence that the economy would continue to expand at a moderate pace. Inflation risks still remain its predominant concern.
At first market participants were encouraged by the Fedâ€™s unperturbed stance. Equity markets continued to develop favourably, and, judging by the iTraxx for instance, credit risk jitters eased somewhat. On the forex markets, some market participants took advantage of this to re-invest in carry trades. It was rumoured that eastern European market players had stocked up on EUR-JPY on a large scale; the now famous Japanese small investors with margin accounts are reported to have been buying too. During this phase, EURJPY rose to over 165; USD-JPY approached 120.
However, attempts to return to normal then failed as lots of fresh signs of trouble emerged. On Thursday morning, BNP Paribas announced that it had frozen three funds temporarily, because lack of liquidity in ABS/CDO securities was making it impossible to calculate their fair value. There were further reports of funds being frozen and huge outflows of capital. A small Dutch bank admitted to significant losses, and rumours of a meeting of bank representatives and Bundesbank authorities, also caused concern. This, however, turned out to be solely IKB-related.
In this environment, news that liquidity in the interbank market had started to dry up and that the ECB was launching a quick tender, dropped like a bomb. In the morning, interbank rates had risen to over 4.60% (the previous day the EONIA had been around 4.09%); the ECB reacted by launching a one-day quick tender at 4%, pledging to meet 100% of all requests. In the end, the ECB allocated â‚¬95bn of liquidity to the money market â€“ more than after the terrorist attacks in September 2001.
The liquidity shortage on the money market was not limited to the eurozone, but was also reflected in the US dollar and the pound sterling, as dollar and the yen. Although central banks everywhere pumped additional funds into the market, prices at the moment are still reflecting the liquidity shortfall. On Friday morning, the dollar interbank rate was at around 6% (fed funds target rate 5.25%); the pound was 6.5% (bank rate 5.75%). It was only in the eurozone, where the central bank provided the market with another â‚¬61bn, that rates returned to their normal level during the morning.
The reasons for the sudden tension on the money market are not quite clear. The fact that banks tend to hold larger amounts of liquid assets, in order not to be caught out when markets are jittery, like now, is certainly playing a decisive role; at the same time, credit conditions are tightening. It is also possible that some banks might be in need of considerable refinancing because of loans granted or underwriting commitments.
The forex market reacted predictably by closing carry trades. The yen strengthened, EUR-JPY dropped below 161 temporarily, and USD-JPY fell below 118. The euro slipped to below 1.37 against the dollar. It is striking that, although the root of the subprime crisis is in the US, when the situation comes to a head, the euro weakens against the dollar.
At the moment there are several reasons for this: firstly, recent headlines are giving the (probably wrong) impression that the subprime crisis is having a bigger impact on Europe than on the USA itself. The ECBâ€™s massive intervention on the money market also supports this theory. Secondly, heightened risk aversion is making dollar oriented investors reduce their currency exposure. This in turn is supporting the dollar. And thirdly, at present currency speculation seems to be focused on EUR-JPY or EUR-GBP; when fear grows, euros are traded for yen. This drags EURUSD down too.
However, this is not likely to turn into a trend in the dollarâ€™s favour: the US economy is fundamentally weakened, but dependent on capital inflows; and interest rate cuts on the scale the markets are expecting are hardly likely to provide an incentive for investing in the dollar. We see rates of around 1.3650 as a buying opportunity.
Stephan Rieke +49 69 718-4114
+49 69 718-3642
Foreign Exchange Trading
+49 69 718-2695
Matthias Grabbe / Klaus NÃ¤fken
+49 69 718-2688
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