Japanese Yen Surges as US Treasury Scraps Plans to Buy Troubled Assets

Yesterday I mentioned that “risk trends remain the primary driver of the financial markets, which is likely to continue benefiting low yielding currencies like the yen and dollar, while high-yielding currencies like the Australian dollar and New Zealand dollar may be prone to the sharpest declines.” This was indeed the case on Wednesday after US Treasury Secretary Henry Paulson said that the government would not purchase illiquid mortgage-related assets under the Troubled Assets Relief Program (TARP). Ironically enough, the first aim of the program listed by Assistant Secretary of the Treasury for Financial Stability Neel Kashkari on October 14 was to identify “which troubled assets to purchase, from whom to buy them and which purchase mechanism will best meet our policy objectives.” Instead, Mr. Paulson suggested that the government intended to use the funds to shore up the capital positions of financial institutions, mitigate mortgage foreclosures, and improve the availability of consumer credit. Overall, the news was disappointing to the markets, as evidenced by the sharp drop in US stocks and surge in the Japanese yen, and it seems like investors aren’t too confident that banks will be able to weather the persistent financial crisis without another party taking illiquid mortgage-related assets off their books. Given the inverse correlation between the Japanese yen and the DJIA, the low-yielding currency could surge even higher if the DJIA breaks below the recent lows and the psychologically important 8,000 level.

US Dollar Gains on Risk Aversion, Second Only to the Japanese Yen

The US dollar rose versus most of the majors - with the exception of the Japanese yen - as concerns about the health of the financial markets triggered an increase in demand for safe haven assets and a further unwinding of carry trades. As mentioned in our write-up about the Japanese yen, US Treasury Secretary Henry Paulson said that the government would not purchase illiquid mortgage-related assets under the Troubled Assets Relief Program (TARP), spurring fears that banks won’t be able to weather the persistent financial crisis without another party taking troubled assets off their books. Meanwhile, the Bloomberg Professional Global Confidence Index rose slightly to 6.6 in November but still remains near the October low of 4, which was worst reading since the survey began a year ago. Indeed, the market turmoil and fears about a broad global economic recession is taking a heavy toll on sentiment, which helps to explain why stocks have fallen so rapidly and why the US dollar has surged. As a result, it may be more beneficial to keep an eye on risk trends and data from regions like the Euro-zone and UK, as US data has not had a reliable impact on the greenback lately.

British Pound Falls Nearly 3% Below 1.50 as Bank of England Signals Significant Rate Cuts, Won’t Rule Out ZIRP

The British pound plummeted below 1.50 versus the US dollar for the first time since 2002 on Wednesday following the Bank of England's quarterly Inflation Report, in which they revised both their growth and inflation forecasts significantly lower. The BOE’s forecasts predict that the UK economy will contract through 2009 and CPI will fall “well below” the government's 2 percent target and could even fall negative, signaling deflation, unless it cuts rates further. Subsequently, Credit Suisse overnight index swaps have shifted to almost fully price in a 50bp rate cut by the BOE during their next meeting on December 4, but this could shift even further in coming weeks as BOE Governor Mervyn King said that interest rates could fall much lower from current levels, and declined to rule out cutting rates to zero. GBP/USD ended the day by consolidating above 1.49, but with lingering risk aversion and bearish interest rate expectations unlikely to fade anytime soon, the pair could easily break below this level. The next major region of support looms at 1.4680/1.4700.

Euro: Why Didn’t EUR/USD Plunge Like GBP/USD on Wednesday?

The euro ended the day relatively mixed across the majors, as the currency slipped against the US dollar and surged versus the British pound. What happened? One of the sharpest moves in the forex markets today was the drop in the British pound following the BOE’s quarterly Inflation Report, which translated into a massive rally for the EUR/GBP pair. In fact, EUR/GBP reached its highest level since the inception of the euro at 0.8413. As a result, the moves of this currency cross helped to alleviate some of the bearish pressures on EUR/USD. Nevertheless, the trend for EUR/USD remains to the downside and at the time of writing the pair looked to be making a successful break below 1.2450, leaving price likely to target the 10/28 low of 1.2328 next. Looking ahead to the next 24 hours, the release of the European Central Bank’s monthly report could create quite a bit of volatility for the euro as the central bank is likely to have an extremely bearish outlook for the Euro-zone’s economies and downward revisions for inflation. Credit Suisse overnight index swaps are already fully pricing in a 50bp rate cut by the ECB at their next meeting in December, but could move to price in more aggressive reductions following the release of the monthly report, which could easily trigger further declines for EUR/USD.

Terri Belkas is a Currency Strategist at FXCM.