A “Volatility Explosion” No Debt Crisis Can Stop

DailyFX

While the ongoing debt fiasco in Cyprus and conclusion of the most recent Fed meeting dominate headlines, two particular conditions are shaping up that might cause a “volatility explosion” in the British pound.

In Tuesday trading, the markets remained focused on the headlines out of Cyprus, which not only determined every pip move in the euro, but also the moves of most major currencies. We’ll discuss this in greater detail later, but in a nutshell, the Cypriot Parliament rejected the proposed levy on bank deposits. In response, the euro sold off aggressively as investors flocked into safe-haven currencies, with the US dollar (USD) and Japanese yen (JPY) being the biggest beneficiaries.

See related: 3 Safe Harbors from the Cyprus Debt Fiasco

While the Federal Reserve's monetary policy meeting concludes on Wednesday with the Federal Open Market Committee (FOMC) rate announcement and latest Fed forecasts (2pm ET) and a press conference from Fed Chairman Ben Bernanke (2:30pm ET), we are not expecting much from the central bank. Asset purchases and interest rates are expected to remain unchanged, leaving the market's focus on the FOMC statement, the forecasts, and Bernanke's comments.

Economic data has improved since the last meeting with retail sales jumping 1.1% and non-farm payrolls doubling, but concerns about the impact of the sequester and deterioration in more recent economic reports also raises red flags about the outlook for the US economy. As a result, Bernanke, the mild-mannered dove, may opt for cautious optimism, which may not be good for the US dollar.

There has been recent speculation that the Fed could begin tapering asset purchases, and there's no doubt in our minds that Bernanke will be asked about the Fed’s exit strategy by reporters at the press conference. Traders should also beware that the FOMC statement, Fed forecasts, and Bernanke's comments could send mixed messages. That has happened before, and can—or more likely will—happen again.

In this case, the FOMC statement could recognize recent improvements in economic data and contain a more optimistic tone, but economic projections and Bernanke's comments could be more cautious. Previously, the Fed Chairman said the sequester could reduce GDP growth by 0.5%.

In the end, confusion, ambiguous answers, and caution won't lend much support to the greenback, but it may not hurt it either as long as Cyprus continues to dominate the headlines, giving investors greater reason to seek safety in the greenback.

See also: 4 Market Drivers Trumped by Tiny Cyprus

Euro Drops to Three-Month Lows after Cyprus Rejects Levy

The euro dropped to fresh three-month lows against the US dollar as the fiasco in Cyprus continues to unfold. As we anticipated, the deposit levy was shot down in Parliament, and the next step is now for the Cypriot government to start discussions about alternative ways to raise revenue. This does not mean that a tax on deposits is completely scrapped, however. That will rear its ugly head again, only with a different tone.

According to The Wall Street Journal, the Cypriot Finance Minister, who previously denied rumors of resignation, plans to propose a deal that would impose a 20%-30% levy on Russian deposits in return for equity in Cyprus's future national gas company and some additional strategic benefits in the sector. Russian investors could even be given control of the board of directors at Cyprus' banks. We have no idea about how receptive Russia would be to this type of deal, particularly since a 20%-30% tax is a steep amount that will undoubtedly incite internal anger.

As we mentioned in yesterday's note, this is a terribly difficult situation for Cyprus and the euro. Without a levy, Cyprus risks not receiving its much-needed bailout from the European Union. If the levy is imposed, however, it would be a blow to confidence in Europe's banking sector and to the government. Regardless, this has reawakened fear of contagion which could cause capital flight out of European banks and slower LTRO repayments even though the European Central Bank (ECB) has pledged to provide liquidity if the bank levy is approved.

Elsewhere in the Eurozone, German investor confidence increased slightly in the month of March with the ZEW survey rising to 48.5 from 48.2. Unfortunately, overall Eurozone economic sentiment deteriorated significantly with the region's ZEW survey plunging to 33.4 from 42.4. German producer prices and Eurozone current account numbers are due for release on Wednesday, but like those prior, these releases will also take a back seat to the ongoing debt developments in Cyprus.

GBP: 2 Upcoming Catalysts for a “Volatility Explosion”

The British pound (GBP) was trading cautiously ahead of Wednesday's busy economic calendar. Individually, each of the day’s economic reports has the power to trigger big moves in the GBP, but collectively, an explosion in volatility is almost assured, especially after the recent consolidation in the GBPUSD. Between the Bank of England (BoE) minutes, the country's employment numbers and the 2013 budget, we are potentially looking at a very active day for the currency pair.

Based on the trend of recent economic reports and the PMI numbers, the BoE minutes and employment data could be negative for sterling. At the February meeting, the monetary policy committee (MPC) voted 6 to 3 to keep quantitative easing (QE) unchanged with BoE Governor MervynKing joining members Fisher and Miles in favoring more QE. While the majority still voted to keep policy steady in March, one more member could have sided with the minority as talk of a triple-dip recession gains momentum. If we are right, the GBPUSD will collapse.

Jobless claims could also fall less than anticipated, or worse, increase based on earlier reports that the manufacturing sector saw staffing levels reduced at the quickest pace in 40 months. However, the UK employment numbers will take a back seat to the BoE minutes and the UK budget.

Chancellor GeorgeOsborne is expected to release a tighter fiscal budget with possible initiatives to help credit flows. The BoE's inflation target could also be reviewed, and more flexibility in the central bank's inflation target would be negative for the British pound. If the inflation target is not reviewed, however, the budget could lend support to the GBP, but only if the BoE hasn't grown more dovish.

Canadian Manufacturing Drops Fourth Months Out of Five

The Canadian (CAD), Australian (AUD), and New Zealand dollars (NZD) all extended their losses against the greenback amidst weaker economic data and continued risk aversion. In Canada, wholesale sales growth rose 0.3%, which was less than expected, while manufacturing sales dropped 0.2%. This was the second consecutive decline in manufacturing sales and marked the fourth time in five months that demand contracted.

For the Bank of Canada (BoC), the latest economic reports reinforce their increasingly cautious monetary policy stance. We are particularly worried about the sluggish growth in wholesale sales because it tends to have a strong correlation with the broader retail sales index. The USDCAD has soared and appears to be on its way for a test of 1.03.

No economic data was released from New Zealand, but last night's Reserve Bank of Australia (RBA) minutes provided zero support for AUDUSD. While the RBA left interest rates unchanged this month, the minutes revealed a continued bias to ease. The central bank said, "While further reductions may be required, on the information currently to hand, it was appropriate to hold rates steady."

Still, this bias did not weigh too heavily on the AUD thanks to optimistic comments from RBA Deputy Governor Lowe, who said, "The high exchange rate and increased household savings are the very same factors that have been critical to Australia's good macroeconomic performance."

With no support from the RBA minutes, the AUDUSD failed at the critical 1.04 level. New Zealand current account numbers will be released Tuesday evening, and we expect the deficit to narrow. This will be followed by leading indicators from Australia.

Bank of Japan (BoJ) Welcomes Governor Kuroda

The last day of Bank of Japan (BoJ) Governor Masaaki Shirakawa's term proved to be positive for Japanese equities and the yen. In his own words, it has been a "turbulent" five years at the BoJ. Not only did Shirakawa have to battle the global financial crisis, but he was unable to make significant headway in the government's decade-long battle with deflation.

That task will now fall on new Governor Haruhiko Kuroda, who officially takes over as BoJ Governor on Wednesday. It is no secret that he is a dove whose policies are aligned with Prime Minister Shinzo Abe. He has international experience, having served as the head of Asia's Development Bank, and he also has experience with currencies. Abe has brought in three new Monetary Policy Committee members with the goal of easing policy. Kuroda made it clear last week that he will be looking to increase bond purchases, and more specifically, he favors unlimited quantitative easing. He has said previously that a "self-imposed rule limiting the scale of buying isn't something adopted by other central banks." We should soon get a sense of where he and the new BoJ members stand with their first press conference scheduled for Thursday.

In the meantime, recent Japanese economic reports were encouraging. While leading and coincident indicators were revised downwards, nationwide department store sales, and more specifically, Tokyo department store sales, both soared. This increase in demand in Tokyo suggests that the economy is finally moving in the right direction after two consecutive months of lower spending. The country's trade balance is due for release on Tuesday evening, and the deficit is expected to shrink as the weak yen continues to support the export sector.

By Kathy Lien of BK Asset Management

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