Fears Surrounding the European Banking Sector

EUR/USD

The Euro found support below 1.36 against the dollar on Tuesday and rallied firmly to the 1.37 area as the failure to break support levels triggered some short covering. Following a second conference call with the IMF-led troika, the Greek finance Ministry again reported that satisfying progress had been made and that the IMF mission would return to Greece next week to continue negotiations.

Reports of a referendum on Euro membership was denied by the government and there was still evidence of serious divisions within the cabinet and this will make it extremely difficult to actually impose further austerity measures even if they are agreed. Underlying confidence remained extremely fragile, especially with further concerns surrounding the Italian economy.

There were also further fears surrounding the European banking sector following reports that Chinese banks had withdrawn credit lines while dollar Libor rates continued to increase slowly.

The German ZEW business confidence index weakened to -43.3 for September from -37.6 previously, although this was slightly better than expected and there was also some cautious optimism from the ZEW institute that conditions might be stabilising.

The decline in US housing starts did not have a major impact as it was offset by a rise in permits and market attention was also focussed elsewhere. There was caution ahead of the Federal Reserve FOMC meeting on Wednesday. There are expectations of ‘operation twist' whereby the Fed will look to keep longer-term interest rates down by purchasing longer-dated maturities. There was also be some speculation of more substantial action in the form of additional quantitative easing.

Fed uncertainty curbed dollar buying to some extent and the Euro was able to regain the 1.37 level. The US currency still gained some net support from a withdrawal of funds from emerging markets.

Yen

The dollar hit resistance close to 76.70 against the yen on Tuesday and there was a spike in volatility during the Asians session on Wednesday as a dip to the 76.10 area was following by a brief move to 76.60.  There was speculation over Bank of Japan intervention with the dollar close to record lows, although the bank did not appear to be in the market.

The yen maintained a generally strong tone as the Euro was unable to recover much from 10-year lows. Underlying risk appetite remained weaker with a particular focus on the Euro-zone which continued to drive defensive yen demand.

The latest Japanese trade report was weaker than expected with a larger than expected deficit as imports increased. Although this will increase optimism that the economy may be able to recover more quickly than expected, there will also be fears surrounding the export outlook and additional pressure to prevent a further loss of competitiveness.

Sterling

Sterling found support on dips to the 1.5660 area against the dollar on Tuesday and secured modest net gains with a recovery from 8-month lows and a move back above 1.57 as the dollar dipped from its best levels.

The latest Nationwide consumer confidence index edged slightly lower to 48 for September from 49 as spending caution prevailed.

The IMF lowered its growth forecasts for the next two years which had some negative impact n confidence, especially as there will be a negative impact on government finances.  The 2011 estimate was cut to 1.1% and, more damagingly, the 20012, forecast was cut to 1.6% from 2.3% previously. There was also further market discussion surrounding the FT assessment that the structural budget position was weaker than expected.

The Bank of England minutes will also be watched closely on Wednesday amid speculation that the MPC will have moved closer to additional quantitative easing.

Swiss franc

The Euro rallied strongly against the franc on Tuesday with a peak above the 1.2250 level while the dollar also peaked above 0.89 after finding support below 0.88. Some recovery in Euro sentiment curbed franc demand, although renewed speculation surrounding franc policies was the dominant market focus.

There were market rumours that the National Bank would announce an adjustment in its minimum level against the Euro to 1.25 from 1.20 at present. Predictably, the central bank refused to make any comment on the rumours. The franc regained some ground late in the European session, but was subjected to renewed selling pressure in Asian trading on Wednesday as rumours returned.

Australian dollar

The Australian dollar rallied in European trading on Tuesday as solid buying support below 1.02 helped trigger a short-covering rally to just above 1.03. Global equity markets generally had a slightly firmer tone which also helped cushion the currency from further selling

There was still a lack of confidence in the global economy and risk appetite was extremely fragile which dampened Australian dollar buying support. There were further doubts surrounding the domestic economy with particular doubts on the housing sector and there was tough resistance close to the 1.03 area.