In most years, interest rates are the main drivers of the forex market. That paradigm was upset last year as historically low interest rates around the world created a market that was driven by events and central bank actions, and often saw some currencies strengthening by default. More recently, commodity prices also have become a factor (see "Top forex fundamentals").
Many of the forex moves in 2010 were triggered by major events such as the sovereign debt crisis in Europe and the announcement of a second round of quantitative easing (QE2) from the U.S. Federal Reserve. "Ever since our late, great financial crisis, we’ve pretty much been trading in an event-driven FX world," says Joseph Trevisani, chief market analyst at FX Solutions. "There are periods where that lessens, usually when there hasn’t been any event to drive it, but if you look at the big moves over the last two years, that’s it."
While world events are continuing to shape the forex market, as seen in market reactions to the Libyan crisis, they are diminishing in importance. According to Trevisani, it is because the markets are getting used to experiencing crises. "In effect, it’s because we keep having so many events. You can’t keep getting excited when we’ve seen it already three or four times before," he says. "The barriers have gotten increasingly higher to get a move out of the FX world these days."
As events are having a diminishing impact on forex trading, central bank decisions again are taking center stage in trade decisions. At the heart of central bank decisions is the impact of inflation on economies and the ways banks are choosing to handle that inflation.
A dichotomy is arising between two of the largest central banks — the U.S. Federal Reserve and the European Central Bank (ECB). "We’ve got this sort of clarity appearing in the world of forex whereby it is becoming almost accepted from the rhetoric of the ECB that they are going to shift from an era of easy money to the hawkish side of the fence," says Andrew Wilkinson, senior market analyst at Interactive Brokers. "The Federal Reserve keeps stating the opposite as the ECB insofar as it does not see a need to remold monetary policy. It doesn’t feel the economy is in good enough shape yet, as indicated by signals coming from the labor market."
The result is two central banks focusing on different sets of data. In Europe, inflation has become the focus, especially following historic rises in many commodities. "The strength of the rebound, especially in the heartland of Europe, has been quite stunning over the last 18 months. It’s almost to the point that you wouldn’t know there had been such a severe financial crisis. The legacy here is the sovereign debt crisis," Wilkinson says.
That sovereign debt crisis is creating a tale of two states within the European Union (EU). On one hand, Germany and France are doing very well, particularly Germany because of its export structure. On the other hand, peripheral nations still are struggling to bring spiraling debt problems under control.
Kathy Lien, director of currency research at GFT, says a new round of banking stress tests that are being planned could highlight the problem. "The first round of stress tests they had last year was aimed at restoring investor confidence, but this stress test is aimed at weeding out the weak links. There could be a number of banks that will fail the stress test and that could bring back the sovereign debt problem," she says.
Be that as it may, Trevisani expects the European Union to move forward with austerity measures. "The damage to the peripheral countries happening now and what will occur in the future because of austerity measures is trumped by Germany," he says. "Even though austerity budgeting will be bad for Spain, Portugal, Greece, Ireland and probably Italy, the euro still can rise on the strength of the German economy."
The Governing Council of the ECB left interest rates unchanged at their latest meeting on March 3, leaving rates at the same level since May 2009. Speculation has been growing that they will raise rates in the near future. Following the March meeting, ECB President Jean-Claude Trichet said a rate increase could be seen as early as the April meeting and that "strong vigilance" is needed. The move is expected despite Eurozone unemployment over 9% (see "Worse off").
The Federal Reserve is taking a very different approach to monetary policy. While the February employment report showed unemployment dropped to 8.9%, there has been very little talk about ending QE2 early, much less raising interest rates (see "No change in sight").
The big distinction is the role of unemployment. The ECB enjoys a much simpler role in that it exists mainly to encourage price stability. "The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term," the ECB website says. The Federal Reserve has a more involved mission that has evolved over time and now includes a mandate to pursue full employment.
"Bernanke’s constant reference point for the health of the economy seems to be the labor market," Wilkinson says. "No matter how much business confidence revives or how much manufacturing activity resumes, it’s all redundant to him until we see meaningful gains in employment."
As a result of the difference, the two central banks are pursuing very different monetary policies and will have very different impact on their currencies. "It shows that one part of the world is dealing with growing inflationary pressures whereas the Federal Reserve, because of the high level of unemployment and the high abundance of spare capacity, doesn’t see inflation as a problem," Lien says. "Everyone is realizing the Federal Reserve will be trailing other central banks and will be behind the curve."
Trichet and the ECB have made it clear that inflation is their biggest concern and have indicated a readiness to raise interest rates to combat it. Sovereign debt problems may resurface as a result and dampen potential gains in the euro. "Sovereign debt problems are going to keep a lid on an explosion in the euro," says Darin Newsom, senior analyst at Telvent DTN. "It seems like every time we start to show these signs that the euro is undervalued, these things are tending to pop up again."
Lien sees economic data being a more likely indicator for the euro. "The latest sentiment indicators still show businesses and consumers are relatively optimistic. That provides enough of a backdrop for the ECB to tighten monetary policy and that should be positive for the euro."
Lien warns there could be downward pressure on the euro if a number of banks fail the stress test, though.
Most analysts expect to see upward momentum for the euro through the second quarter. Wilkinson sees a trading range in the EUR/USD developing from $1.33–$1.43 and favors the upside. Trevisani expects a range of $1.34–$1.42, and Lien expects $1.38–$1.42. Newsom projects downward pressure from sovereign debt issues and sees a range of $1.34–$1.41.
The Bank of England (BoE) has been grappling with many of the same inflationary concerns as the ECB. In February, Mervyn King, governor of the Monetary Policy Committee (MPC), wrote a letter to the British chancellor to explain that inflation was at 4%. The governor is required to write an open letter to the chancellor anytime inflation moves away from target by more than 1%. In the letter, King explained that inflation was above target because of a rise in the value added tax (VAT), fall of the sterling in late 2007 and 2008, and increased commodity prices, particularly energy.
Trevisani says the BoE’s monetary policy is supportive of the pound. "Their austerity measures are the type of fiscal policy that currency traders tend to like. It supports the gilts, will prevent rates from falling and [they’re being transparent]. That will keep the currency strong."
Lien expects a rate hike by this summer from the BoE. She sees a lot of upside potential and sees the GBP/USD in a range of $1.61–$1.65 through the second quarter. Other analysts weren’t quite so bullish. Trevisani expects the range of $1.55–$1.62 to continue; Newsom sees a upside target of $1.64 but could fall back to $1.58 and Wilkinson forecasts a range of $1.55–$1.65, but favors the downside on economic weakness going forward.
Yen treading water
The yen strengthened throughout much of 2010 as investors sought a safe haven away from European sovereign debt problems. Even an intervention by the Bank of Japan to weaken the currency in September failed to do so for very long.
Inflation is not a concern in Japan as their consumer price index is staying close to 0%. "What’s weighing on the yen most is the political stalemate with Prime Minister Naoto Kan’s ambitions to rejuvenate the economy likely to run into opposition from fellow lawmakers who don’t want to grant him the power to spend more," Wilkinson says.
The result has been a consolidating trading range in the USD/JPY. Wilkinson expects a trading range of ¥79–¥89, favoring the dollar; Trevisani sees a range of ¥81.50–¥84.25 developing; Lien expects ¥80.50–¥83. Newsom expects the dollar to strengthen from a technical standpoint and sees it moving to ¥86–¥88.
The Reserve Bank of Australia (RBA) and the Bank of Canada (BoC) are two of the few reserve banks in the world that raised interest rates in 2010. The RBA raised rates four times last year and the BoC did so three times. Both the Australian and Canadian dollars benefited from rising commodity costs in 2010.
Australia has benefited from increased demand from China that has persisted despite Chinese attempts to curb inflation. "About the only thing Australia doesn’t have that China needs is oil. Just about everything else for the manufacturing industries in China comes from Australia," Trevisani says. "It is a very important relationship."
Lien does not expect to see further rate changes from the RBA soon because it already raised rates last year. She expects the AUD/USD to trade on either side of par at $0.99–$1.02. Trevisani sees slightly lower at $0.98–$1.015, and Wilkinson sees $0.98–$1.03. Newsom says the pair could go either way and has upside potential to $1.05 but could fall to $0.97.
The Canadian dollar has benefited from rising oil prices and the BoC’s willingness to raise rates. "The U.S. dollar isn’t going anywhere and crude has been making gains. We have a pretty strong uptrend going in the market and it looks like the USD/CAD wants to extend the rally it’s been on," Newsom says.
Oil prices will continue to be the thing to watch for the direction of the loonie, analysts say. Wilkinson expects the USD/CAD to trade on either side of parity. Trevisani sees that range being C$0.975–C$0.995, and Lien expects C$0.97–C$1.00. Newsom sees C$0.97 as a key level and says it could move to C$0.90 if it breaks through, but support at C$1.06 if it is unable.
While forex markets are beginning to return to a more normal fundamental picture, all analysts say major events can change these forecasts quickly. "It’s still an event-driven world; still a black swan world," Trevisani says.