Concerns Surrounding the Banking Sector

EUR/USD

The Euro continued to drift weaker in European trading on Friday in subdued trading conditions.

There were concerns surrounding the banking sector with reports that the Dexia would need further refinancing quickly which maintained serious underlying concerns surrounding the relationship between the banks and sovereign debt.

There were further underlying concerns surrounding the economic outlook with expectations of a generally weak set of second-quarter GDP readings. As well general vulnerability, there were concerns that divergence between the core and peripheral economies would intensify. In this context, there were also fears surrounding the underlying Italian outlook. There are growing political pressures on Prime Minister Monti as the economy continues to contract.

The Euro dipped to lows below the 1.2250 level against the US currency at the US open. There was, however, a sharp recovery during the US session with a peak back above the 1.23 level before some stabilisation as trading volumes dwindled. There were no major fundamental factors to boost the Euro as positioning dominated although there were some reports that a ban on a short selling of bonds could be considered did contribute to gains for the Euro.

Trading volumes will remain generally low in the short term which will maintain the threat of erratic trading. Political developments will be watched very closely in the short term, especially with German Chancellor Merkel due to return from holiday which will ensure a strong focus on potential German opposition to Euro-zone bond buying plans.

There will be further speculation that the US Federal Reserve will move to additional quantitative easing and San Francisco Fed President Williams state that the time was now right for action.

The latest IMM data recorded little underlying trend in positioning with a small decline in net Euro shorts and the Euro hit resistance close to 1.23 in Asia on Monday.

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Yen

The dollar was unable to regain the 78.50 level against the yen on Friday and retreated to lows just below 78.20 as the US currency lost widespread support.

There was speculation that agreement to increase the sales tax would undermine domestic demand and would also lead to further easing by the Bank of Japan. There was also still a reluctance to buy the yen aggressively, especially as risk appetite was generally firmer.

The second-quarter GDP data was weaker than expected with a 0.3% gain for the quarter compared with expectations of 0.6% as consumer spending remained weak and the data maintained pressure for the further Bank of Japan action as the dollar found support in the 78.20 area.

Sterling

Sterling remained under selling pressure in Europe on Friday and dipped to test support in the 1.5570 region on two occasions.

There were further concerns surrounding the UK fundamental outlook, especially with unease over the prospect for domestic demand and exports following a downbeat Bank of England inflation report and weak exports in the latest trade report.

Positioning dominated in US trading on Friday and the UK currency rallied strongly to a peak near 1.57 as Sterling retained a strong tone against the Euro.

The extent of safe-haven demand will continue to be an important short-term factor and trends in UK gilt yields will continue to be watched very closely over the forthcoming week. Sterling drifted weaker towards 1.5650 in Asian trading on Monday in subdued trading conditions.

Swiss franc

The dollar was unable to push above the 0.98 level against the franc on Friday and dipped sharply during New York trading with a decline to lows just below the 0.9750 level. The Euro maintained a heavy tone against the Swiss currency as it tested support below the 1.2010 level which suggested that there had been a renewed increase in pressure on the Swiss National Bank to intervene.

Comments from central bank officials will continue to be monitored closely in the short term, especially if the Euro is subjected to wider selling pressure.

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Australian dollar

The Australian dollar found support in the 1.05 level against the US currency on Friday and pushed to a high in the 1.0575 region during New York trading.

The currency drew support from a solid tone in equity markets as well as a generally weaker US currency. There was still some residual concerns surrounding the Asian economic outlook and in this context support was dependent on hopes of expectations of further support measures and the currency edged lower in Asian trading on Monday.

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