Currency Markets Brace for Volatility Amid Conflicted Risk Trends

Key Overnight Developments

• China Sets Yuan Reference Rate at Highest Since July 2005
• Asian Shares Slump Amid Renewed Euro Zone Bank Concerns

Critical Levels



The Euro slid as much as 0.2 percent against the US Dollar amid resurfacing concerns about the Euro Zone banking sector (see below). The British Pound was little changed on the session ahead of the opening bell in London. We remain flat EURUSD and GBPUSD.

Asia Session Highlights



The US Dollar came under selling pressure after the People’s Bank of China (PBOC) set the daily Chinese Yuan reference rate at 6.7980 to the greenback, up 0.43 percent from the previous day to mark the largest increase since July 2005. Losses were short-lived however as the knee-jerk selloff gave way to the realization that the fixing matched yesterday’s spot close, seemingly reinforcing the central bank’s pledge emphasize market supply and demand in setting exchange rate policy. The Yuan promptly retreated, retracing as much as 62 percent of yesterday’s advance on speculation that a more market-oriented posture will translate into greater two-way volatility in the country’s exchange rate rather than a strictly stronger Chinese unit. As we discussed in detail yesterday, we expect China’s exchange rate reform to boost the US Dollar over the medium to long term.

Asian stocks fell for the first in nine sessions after Fitch Ratings downgraded BNP Paribas, France’s largest bank, while Moody’s said Spanish banks face “substantial strain” from mounting credit losses. The MSCI Asia Pacific regional benchmark index fell 0.3 percent.

Euro Session: What to Expect



Germany’s IFO Survey of business confidence is set to show sentiment soured for the second consecutive month in June. The forward-looking Expectations gauge is expected to decline to 102.7, down a full point from May to mark the largest drawdown in 18 months. The outcome seems hardly surprising considering the likely implications of the EU debt crisis. Indeed, financing gaping deficits will drive up borrowing costs and weigh on output as firms find it more expensive to expand capacity while consumers shy away from big-ticket purchases typically made on credit.

On balance, risk sentiment is likely to remain the top catalyst driving currency markets, but the overall landscape looks uneven and highly uncertain as a multitude of factors jockey for position in the spotlight. Indeed, traders will need to resolve renewed concerns about the Euro Zone banking sector (see above) and the unveiling of the UK “emergency” budget – an austerity-focused mix of spending cuts and taxes likely to weigh on growth and keep the BOE in dovish territory for the foreseeable future – as well as continue to digest the shift in Chinese exchange-rate policy, all ahead of tomorrow’s Federal Reserve interest rate decision. On balance, continued volatility seems like the only well-founded conclusion to be reached at present.

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