Fear and Fear of the Recession - Forex Update, 5th August 2011

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by: fxsolutions
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Date: Wed, 24 Aug 2011 Time: 6:57 AM
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Joseph Trevisani is Chief Market Analyst at FX Solutions (http://www.fxsolutions.com/). An expert in Forex trading, he frequently provides foreign exchange traders with an overview of currency movements and the news set to influence it. On 5th August 2011, he takes an overview of the fear currently making waves across European and beyond.

"World equities are pricing in slower economic growth and a possible recession. There are many signs that a recession is close, and if it materializes Chinese economic growth will not suffice to keep it at bay.

But markets are also very fearful of a second financial crisis from the overload of European sovereign debt on a weak and inadequately capitalized continental banking system. Italy and Spain cannot sustain the refinancing rates imposed by the credit markets. Either the rates come down or those countries will have to be bailed out as well. There is no such thing as an isolated financial system crisis. The first cracks in banking confidence appeared Friday with reports that American money market funds are reducing their exposure to French banks. The memories of three years ago are still fresh; that is how it began that fall.

Jean Claude Trichet's warning rate hike gambit to European Monetary Union (EMU) politicians to solve the debt crisis has failed. Although the ECB will not hike rates until moderate economic growth resumes and the debt crisis is over its attempt to avoid the main responsibility for the crisis ended on Friday when the central bank agreed to buy Italian and Spanish bonds if Italy promises economic reforms.

The ECB ceased buying sovereign bonds four months ago but was forced back into the market by the rout in Italian and Spanish bonds, which threatened the ability of the EMU's third and fourth largest economies to borrow effectively in the private credit markets. So far the promised purchases are conditional on Italian government action. The ECB has not yet bought Italian and Spanish debt but just the report of the agreement on Friday afternoon was enough to reverse losses in the equities and the euro.

The potential downgrade of American debt by Standard & Poor's was a secondary story. Moody's and Fitch have already affirmed the top grade of for US debt. But even if S&P does drop the American rating it will not affect the dollar and Treasury safe haven status. Investors and traders have already judged the quality of US debt, driving Treasury prices to near records over the past few weeks. In an imperfect world the US and dollar assets are still the safest bet. The Bank of Japan's two interventions in defense of the dollar are a holding action. The policy will fail as market pressure on risk assets continues

The euro and the dollar are still range bound but that will change to the dollar's benefit as risk aversion flows to the dollar increase.

The EMU debt crisis continues to spread. The advent of the central bank in Italian and Spanish debt markets cannot end the crisis even if it can bring rates down. Any rate improvement is essentially false. If the ECB becomes the buyer of choice and last resort it can only maintain lower rates as long as it is in the market. A soon as it leaves rates will jump higher as they portray the real judgment of private investors. An ECB bond program could quickly become an open ended support of two economies whose combined debt is estimated by Bloomberg to be 2.2 trillion euros ($3.1 trillion). That would be debt monetization of the highest order.

This is not yet a repeat of the fall of 2008 but the market reaction to economic and financial weakness is the same as it was three years ago; buy the dollar and dollar assets and the Swiss Franc."

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