It is an exceedingly quiet morning in the foreign exchange market with currencies trading not far from Friday's levels. Considering that most of FX volume goes through London, the holidays on Monday and Tuesday has led to a dramatic decline in trading activity and volatility. Asian stock markets plunged overnight but these catch up moves had very little impact on risk appetite as the U.S. dollar and Japanese Yen hold steady or trade slightly lower against its peers. While trading should be quiet in the front of the week, volatility should pick up significantly as the week progresses with 4 central bank meetings on the calendar. June will be a very busy month due to the number of high profile meetings and European event risk - dealing with Europe's sovereign crisis will be unavoidable. The EUR/USD became deeply oversold in May and the question of whether it stabilizes here or continues lower will largely depend on what the recent radio silence from European policymakers mean. Have they been working around the clock on ways to end the crisis or have they thrown in the towel?
Based on various news reports this weekend, it appears that European officials have not given up completely. G20 leaders are meeting at the end of the month and it is largely expected that they will announce greater fiscal consolidation measures. The market wants Eurobonds but a central commission to manage European finances and extended power for the European Commission, European Parliament and European Court of Justice are the most we've heard so far. According to Spiegel, a German newspaper, Finance Minister Schaeuble urged Spain to secure money from the EFSF to recapitalize Spanish banks, a step that Ireland took more than a year ago. Unsurprisingly, Spain rejected the idea because they still believe that they can raise money in the capital markets. In light of this, Thursday's Spanish bond auction will be a particularly important test of investor confidence.
In the near term, the outlook of the euro will depend on how ready and willing the European Central Bank's is to providing stimulus to the European economy. They have made it clear that they want the solution to come from Europe's leaders but the recent deterioration in economic data and slide in asset prices makes easier monetary policy inevitable. As a result, the ECB will be faced with 2 choices this week - continue to turn a blind eye and wait for the Greek elections and G20 meeting, which will be very negative for EUR or hint that help is on its way in the form of an expanded LTRO, rate cut or unsterilized asset purchases. While easier monetary policy is normally negative for the EUR, the prospect of monetary support could actually lift risk appetite. At this point, everyone who wants to short euros are already short which means that the extent of further losses ahead of the ECB meeting could be limited . However unless and until we have progress on the fiscal or monetary front, the EUR/USD will remain under pressure.
Where is the Line in the Sand for Japan?
Meanwhile the Japanese Yen continues to test the patience of policymakers. USD/JPY is struggling to hold onto its gains, prompting continued verbal intervention out of Japan. Last night, BoJ Governor Shirakawa said he is carefully watching the impact of the Yen's gains on the economy and will make the utmost efforts to beat deflation. In terms of the Yen, everyone is focused on the possibility of intervention. The last two times the Bank of Japan came into the foreign exchange market and sold Yen was late last year when USD/JPY fell below 76 in November and when it dropped below 77 in August. On Friday, a spike in USD/JPY after non-farm payrolls prompted speculation of intervention but this has been unconfirmed. The Bank of Japan is checking rates, which is a common scare tactic but if the spike was BoJ intervention, we would have seen a 250-300 pip move in USD/JPY, not a 100 pip move. Nonetheless, it is clear that Japan's central bank could come into the market at anytime. The effectiveness is questionable but if the Yen continues to rise, the Ministry of Finance can't sit on the sidelines and do nothing but watch trade imbalances grow, deflation exacerbate and growth slow. With 78 in USD/JPY already tested and taken, the Bank of Japan's line in the sand should be at 77.