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Despite rather mixed data, stocks held onto their gains, while commodity and forex markets also showed mild risk appetite. Perhaps it was just a typical end of month drift on light data? If so, then get ready for a wild ride next week, which looks like one of the most packed scheduled event weeks of the year.
USD Weakness From Expected Coming Stimulus
Behind virtually every major trend outside of global equities last week was the weakening USD in expectation of new US stimulus. Highs in commodities and various risk currencies are all have a strong link to a weakening US Dollar against which commodities are priced and other currencies are most heavily traded.
Primary forces behind the USD’s continued weakness include:
-Resilient risk appetite, as US consumer confidence, jobs, a news helped the EURUSD break over the 1.3500 resistance zone. Now, 1.4000 is in sight.
-Market belief that coming US stimulus is a more immediate threat to the USD than the worsening Greek, Irish, and Spanish banking and sovereign debt situation is for the EUR. Forces behind this sentiment include:
--Dovish comments from the Boston Fed's Rosengren and the NY Fed's Dudley helped fuel the growing conviction that a new round of stimulus is coming. Even news of slowing German and EZ growth Friday didn’t stop the EUR’s climb vs. the USD
--Ireland’s announcement that the final cost of winding down Anglo Irish Bank will exceed €30bn removed some uncertainty, with 10-year yields on Irish bonds have eased from record highs. Although this hikes Ireland’s total budget deficit to over 30%, the government is fully funded into next year, making Ireland a serious but not immediate concern.
--Underestimating Spanish Weakness? See below.
Seeds For Reversal?
We don’t see the USD reversing until something grabs attention away from potential new US stimulus. This focus has allowed the EUR to stay strong despite banking trouble and national austerity strikes that in earlier months would have shaken markets. A new normal for the EUR?
The most likely events to shift focus off of US stimulus include:
-Short term USD oversold, EUR overbought positioning
-The past week’s month and quarter end USD selling that included Japanese exporters’ repatriating USD profits (selling Dollars and buying Yen) is now over.
-US Fundamentals Beat Expectations: US Earnings season, monthly jobs reports coming next week. With the USD so depressed it is ripe for a bounce on any beating of expectations. Consensus is for a good earnings season, and that could be the spark needed, especially if EU data continues to show slowing growth to levels already seen in the US.
-The ever-present risk of a new outbreak of EU crisis anxiety. Likely near term hotspots include:
-- Ireland: Though markets have calmed on the Ireland situation, it in fact remains a work in progress. Hedge fund investors have threatened to force Anglo-Irish bank into default, and Ireland has threatened to suspend market activity that threatens its financial stability.
-- Spain: Markets may not have priced in the risk from Spain. Yields on 10 year Irish government bonds are about 6.3%, whereas for Spain they are only 4.1%. However:
----While markets focus on Spain’s national budget deficit of around 11.2% of GDP, debts of Spain’s regional governments are of a similar magnitude.
----While Spain’s big international banks appear to be in decent shape, less is known about the extent of bad debts from Spain’s property bubble on the books of  local lenders (‘cajas’). The estimated 2 million unsold homes in Spain represent a lot of potential bad debt. The uncertainty has shut them out of international capital markets.
----Spain has a 20% unemployment rate and stagnant growth.
----Spanish GDP is about 10% of the EZ’s, making it a bigger problem than Ireland or Greece if its bonds come under speculative assault.
Of course, Greece and Portugal could are always there as well.
Gold Hits New Highs Over $1300/oz on USD, EUR Weakness Fears
Gold is primarily a currency hedge. With both of the most widely held currencies facing likely loss of value, gold remains the chief beneficiary.
-The USD is undermined by the belief that more stimulus is coming and that this will ultimately be inflationary.
-The EUR suffers from concern that it too will ultimately be undermined by more stimulus. EURUSD strength has been a function of USD weakness, not EUR strength.
Since the beginning of August, gold prices are up over 10% while the dollar index has fallen by only 2 percent. This suggests that the rise of gold continues to be more of a reflection of anxiety about the EUR, given slowing Euro-zone growth and the likelihood of further forms of bailouts ahead.
Noteworthy But Not Market Moving
1.       EU Banking Sector Fears Fail To Stem EUR Strength
The EUR was again the strongest currency of the week despite news of:
-Rising costs for winding down Anglo-Irish bank, possible restructure of its debt (and threatened lawsuits from injured parties
-Moodys downgrade of Spain’s credit rating
-Capital outflows from Greek banks threatening further credit rating downgrades
-Concerns that Basel III capital requirements will strain EU banks
-Tensions in Portuguese debt markets
Why? The most likely explanation is that markets believe the USD faces more immediate threats from new stimulus measures than the EUR does from its own likely coming additional stimulus and/or bailouts.
2.       “Currency War” / “Race To The Bottom” Talk Fills the Blogosphere
With Japan intervening to lower the JPY, and Washington lawmakers threatening tariff’s on China goods, (despite such a move’s dubious legality under international free trade laws) there was much written on how currency devaluation is one of the means remaining for nations to manipulate trade balances.
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