A quiet week before the holidays

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After last week’s taper-related turbulence, a quiet week beckons in the foreign exchange markets. With major holidays landing mid-week and very few economic data releases in the docket, liquidity conditions are extremely thin. Equity markets are edging up, and commodity prices are seeing some buying activity, but fears of an interbank credit squeeze in China are limiting broader gains.

The greenback is trading with a slightly heavier bias and 10-year Treasury yields are falling as asset managers take profits off the table. Although the dollar rally does appear to be in an overstretched condition, differentials are likely to continue supporting the dollar. On Friday, the US government dramatically revised its estimate of third quarter growth, suggesting that the economy expanded by more than 4.1%, rather than the 2.3% originally calculated. In an interview on the weekend, Managing Director Christine Lagarde said that the International Monetary Fund was raising its forecast for 2014 growth, up from the 2.6% reported in October.

Among the majors, sterling is gleaming the brightest, up against the dollar and the euro after a slew of data points suggested that the UK’s economic recovery continues to gain traction. Further appreciation is becoming less likely however, with the Bank of England warning that the currency’s strength poses “additional risks to the balance of growth and the recovery” – meaning that interest rate increases are  not on the immediate horizon.

Interbank lending markets in China are seizing up, with seven-day repo rates jumping to nearly 10% over the weekend, forcing the central bank to inject additional liquidity. Chinese policymakers are attempting to slow the flow of credit into the economy, but are struggling to calibrate rebalancing measures – making many global investors nervous about the future of the world’s second largest market.

This concern is weighing on the commodity-linked units, and trading in the Canadian dollar is colder than an Ontario ice storm. This morning’s gross domestic product report may warm things up a little, but investors are likely to continue favouring the US dollar ahead of next year.

As we enter year end trading, the legendary investor John Templeton’s words comes to mind – “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria”.

Few could describe today’s market environment as anything less than optimistic. After last week’s confirmation that the Fed would keep monetary conditions extremely accommodative into 2015, skepticism is in short supply – and financial headlines are looking as if the writers at Hallmark might have had a hand in producing them. As such, we would suggest that participants begin watching for signs that sentiment is nearing euphoric territory. Mania doesn’t yet appear to accompany the rally we’ve seen in the dollar, but risks are growing as equity markets push further into nosebleed territory without experiencing a correction. Hedgers on both sides of the market should be putting strategies in place to cope with (or to capitalize upon) an unexpected shift early in the New Year.

Further reading:

EUR/USD Dec. 23 – Little Movement to Start Week

Settling for year end

Get the 5 most predictable currency pairs

About Author

Director, FX Strategy and Structured Products at Cambridge Mercantile Group.

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