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Euro Suffers Unlikely Post-Cyprus Fallout

Euro Suffers Unlikely Post-Cyprus Fallout

Kathy Lien, Technical Strategist

Despite the Cyprus bailout announcement, the euro still fell to fresh year-to-date lows, causing traders to seek shelter in unlikely safe havens like commodity currencies and even the Japanese yen.

Without question, the Cyprus bailout deal should have been good for the Eurozone and the shared currency, and while Cyprus was able to avoid imminent default and secure emergency liquidity, both currencies and equities fell sharply.

To the confusion of many investors, besides an initial rally during the Asian and early-European trading sessions, the markets received zero relief from the news. For the rest of the day, investors sold the euro, taking the currency to its lowest level against the US dollar (USD) this year.

We can't attribute the selloff to one specific factor, and that is perhaps the most worrisome aspect of the move. It’s clear that investors aren't convinced that the bailout indicates a welcomed end to the Eurozone's problems.

Cypriot banks reopen Tuesday (though some will be closed until Thursday), and there could still be a run on the banking sector. Part of the recent selloff was attributed to the Dutch Finance Minister's comment that Cyprus is a template for bank restructurings. He quickly denied making such a comment, though EURUSD never recovered because regardless of how unique the problems are for Cyprus, the restructuring of the nation’s banks sets a precedent that could be revisited in future bailouts.

Finally, concerns about what to expect going forward for the Eurozone also added to the pressure on the currency.

We are in the midst of a new phase of potential weakness for Germany, the Eurozone's largest economy. Last week, we learned that manufacturing and service sector growth slowed significantly this month, thus causing business confidence to decline.

Later this week, consumer confidence numbers are due for release along with retail sales and unemployment data. In February, concerns about Italy hampered economic activity and confidence in the Eurozone. (See the economic calendar here.)

This month, we have Cyprus to blame, and as a result, we expect the weakness in sentiment and economic data to remain soft for the time being. Though Cyprus is overshadowing Italy at this point, the Italian electoral deadlock is still creating uncertainty for the region.

See related: Euro Crisis Averted, but New Problems Await

Ultimately, the main reason why EURUSD dropped to fresh lows after the Cyprus deal is because the deal does not eliminate the near-term risks for Europe. The 1.2880 level was the main support for the currency pair, and now that it has been broken, the next level of support is the November low of 1.2660.

Dollar Rally Fizzles with Event Risk Upcoming

Early enthusiasm in the US markets fizzled quickly on Monday once European stocks turned negative. The S&P 500 climbed to a fresh five-year high before ending the day lower. It was a mixed day for the US dollar, which traded sharply higher against European currencies but lower against the Japanese yen (JPY) and commodity currencies.

The only US economic data released Monday were secondary reports that yielded very little reaction in the dollar. Both the Chicago and Dallas Fed districts reported stronger manufacturing activity, which should bode well for the broader Chicago PMI report expected later this week.

Also, Fed Chairman Ben Bernanke and Federal Open Market Committee (FOMC) voter William Dudley spoke about the economy and monetary policy. Bernanke did not make any fresh comments, instead saying that easing by advanced economies have helped global growth and noting that inflation is generally contained.

Dudley, on the other hand, was not as reserved. He called on the Fed to keep monetary policy "very accommodative" because they are falling "well short" of employment and inflation goals. He expects growth to be very sluggish in the first half of the year and for the recent rebound to lose momentum. As one of the most dovish members of the FOMC, Dudley's pessimistic comments are in line with his general views.

A number of US economic reports are due for release Tuesday, including durable goods, the S&P/Case-Shiller housing price index, consumer confidence, and new home sales. We believe consumer confidence will be the most important release on the economic calendar, and unfortunately, based on the sharp decline in sentiment reported by the University of Michigan, we are wary of a disappointment that could compound losses in the USDJPY pair.

British Pound Hits New Recent Highs Against Euro

Even the British pound (GBP) fell victim to risk aversion, as sterling traded lower against the US dollar and Japanese yen. The pound still managed to tack on gains against the euro because of the uncertainty stemming from the region.

Economic data was mixed, with house prices growing 0.3% in the month of March and loans for home purchases declining in February. Bank of England (BoE) Governor Mervyn King spoke at the same conference as Bernanke, and unlike his US counterpart, King sounded more cautious, saying that the "banking crisis, the euro-area crisis, and the fiscal crisis" are far from over and could have more twists and turns before finally ending.

We are not surprised to hear King's pessimism, though we wonder how much it really matters when the monetary policy committee as a whole feels that the risk of higher inflation offsets the risk of weaker growth.

The Confederation of British Industry's sales report will be released Tuesday morning. A sharp rebound is expected, which would be consistent with the improvements seen in the rest of the economy. It could also support gains in the GBPUSD.

Commodity Currencies Make Surprising Safe Havens

It is fascinating to see commodity currencies among the biggest beneficiaries of risk aversion because that is so rarely the case. Usually, the Australian (AUD), Canadian (CAD), and New Zealand (NZD) dollars are hit hard in those cases, but they are holding up extremely well this time, perhaps because Europe is the source of the uncertainty and investors are looking at commodity-producing countries as areas of relative safety.

No economic reports were released from any of the three commodity countries on Monday, but New Zealand trade numbers are on the calendar, which will be followed by comments from Reserve Bank of Australia (RBA) Governor Glenn Stevens. The upcoming comments shouldn't pose much threat to the AUD, however, because of Stevens’ “glass-half-full” view of the economy.

In New Zealand, stronger manufacturing activity points to stronger trade, which could be positive for the NZD.

A Strong Case for a Stronger Yen

The Japanese yen traded higher against all major currencies, which should not surprise anyone who has read our special report “3 Reasons for Near-Term USD/JPY Losses.” Japanese companies have a history of repatriating money from their subsidiaries abroad to window dress their balance sheets in the last two weeks of March, and this has traditionally been positive for the yen. Recent yen strength suggests that repatriation has already begun and could continue in the coming week.

Repatriation flows alone won't cause a massive rally in the yen, but it could be enough to drive USDJPY down to 94. While there is little question the Bank of Japan (BoJ) will increase asset purchases next month, considering the amount of speculation and positioning that has built up in anticipation of additional easing, the new central bank may need to over-deliver in order to avoid disappointment.

We still expect USDJPY to hit 100, but we do not preclude a pullback to 92 before that happens, especially if the markets remain risk-averse.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.