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Faced with a daunting trip over the next couple of weeks down a road littered with potential landmines, the single currency soared on Friday ahead of the Fed Chairman’s Jackson Hole address (see below). After sliding below 1.25 early, the euro discovered plenty of buying interest from the Middle East on the way to a 2mth high of 1.2638.

Against the dollar, the euro is now sitting on the 100d moving average; those of a bullish disposition will hope that the strong buying seen from sovereign wealth funds in the last couple of weeks continues in the near-term. As the vanguard for the declining dollar, the single currency outperformed other majors such as the Japanese yen, the Aussie and the pound. EUR/AUD for instance, a trade we have liked for some time, continues to excel, now 1.2250.

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It was as though traders and investors suddenly could see that not just the US, but also Europe, Britain, Japan and probably China, will be contemplating some seriously stimulatory monetary policy action before too long, which must help risk assets. For his part, the Fed Chairman failed to really add in any material way to the last set of FOMC Minutes, other than voice “grave concern” over the state of the labour market and to assert that high unemployment might “wreak structural damage” on the economy. He also suggested that the economy faced “daunting economic challenges” and described the situation as “far from satisfactory”. Although he did not commit to more QE, he was certainly sympathetic. Another program of asset purchases from the Fed looks very likely within a short space of time, quite possibly at the next FOMC meeting.

Commentary

A busy week. After the summer lull, there are plenty of events to get traders excited this week, starting later this morning with a deluge of PMI data out of Europe. The RBA meets this evening, and after the poor retail sales figures released overnight, it is entirely plausible that it will vote to cut rates again. The troika return to Athens on Wednesday, while on Thursday both the ECB and the BoE meet to decide on monetary policy. Mario Draghi will be impatient to reveal details of the ECB’s new sovereign debt-purchase plan; in addition, the Governing Council may decide to lower the refi rate by 25bp to 0.50%. The BoE’s MPC will be considering its options but is likely to decide to leave the base rate at 0.5% and the asset purchase target at GBP 375bn. On Friday, US non-farm payrolls for August are expected to show a rise of 125K, after a 163K increase in July – such an outcome is unlikely to placate the Fed, which regards employment growth as anaemic and will likely decide to implement more QE when it meets on September 13th.

The Aussie and plunging iron ore prices. Vast forests have been chopped down over recent weeks to accommodate the dialogue on the collapse of iron ore prices and the potential consequences for the Aussie dollar. For the most part, much of the commentary has warned that plunging Chinese steel demand spells big trouble for the currency, at a time when traders are already extremely long the AUD. Suddenly, we are being deluged with Armageddon-like forecasts for the Aussie – some are suggesting we could see 60c within a couple of years! Although we have also been writing extensively about the Aussie’s downside potential recently, at the same time we have tried to be very careful to provide a balanced assessment. In the first instance, the price action last month has consistently warned against the traditional short sharp dive that has been a hallmark of the Aussie over the past year. In May this year, as well as September and November 2011, the AUD lost roughly 10% of its value. In contrast, August was tame – sure, the AUD fell to 1.0240 overnight after some soft retail sales figures, but this represents a loss of merely 3% from the high recorded three weeks ago. All things considered, it might be wise not to be swept away by the tide of bearishness that seems to have overwhelmed many Aussie dollar commentators. With America, Europe, Britain and Japan all contemplating substantial  quantitative easing to help their ailing economies, the Australian central bank stands as one of the last bastions of monetary orthodoxy for those investors who are uncomfortable with central banks resorting to the printing press to finance government largesse. Sovereign wealth funds and central banks themselves continue to see the virtues of the AUD, notwithstanding the risks that a sustained global economic slowdown might represent for the currency. Also, it is entirely plausible that iron ore prices will rebound quickly once Chinese steel mills have run down their excess inventory. According to Brazil’s Vale SA, the second largest mining company in the world, these inventories have been shaved aggressively in recent weeks, and some steel mills will soon be forced to buy aggressively for the winter. Aussie bears need to tread warily.

Japan catches cold. Friday’s barrage of Japanese data made clear that the economy is suffering much like other major advanced nation. Industrial production was much weaker than expected, falling by 1.2% in the month of July; shipments are on the slide, and inventories are growing, confirmation that demand has softened. Moreover, further declines in output are expected, with industrial production forecast to fall another 3.3% in the month of September alone. More worrying is that deflation appears to be deepening – consumer prices fell by 0.4% YoY in July, a long way short of the BoJ’s official inflation target of 1.0%. Furthermore, the government announced overnight that it would miss deficit-reduction targets, despite the introduction of a phased-in rise in sales tax. Complicating matters for the government is that the parliament has still not passed a bill authorising deficit-financing. If this piece of legislation continues to be delayed then automatic spending cuts will come into force, accentuating the economy’s vulnerability. Forecasts for growth in Japan over the second half of this year have been revised down – some commentators now fear that the economy may in fact slip back into recession. As always, it is the BoJ that is being called upon to ride to the rescue, notwithstanding the extraordinary injection of monetary amphetamine already prescribed. Making its task even harder has been the strength of the currency and the sharp slowing of the global economy. Moreover, the BoJ surely recognises, like so many other central banks, that simply printing money ad nauseam is now rendered virtually impotent as a solution to deflation and stagnant growth. That said it cannot be long before the BoJ finds it impossible to resist accelerating the pace of the printing presses.

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