The meltdown in the forex market on Friday is a reminder of why you shouldn’t be sleeping at the wheel in the month of August – either stay away or be prepared for big moves in the financial markets. Summer vacations in Europe and the U.S. means lower liquidity that can compound movements in currencies. In the first 10 trading days of August, the U.S. Dollar Index hit 1-year highs, driving EUR/USD to its lowest level since July 2017.
Turkey has its own troubles but it is not just a local risk. Like many other countries around the world they are at odds with the Trump administration and have been hit with U.S. sanctions. And the fear is that in the month of August when liquidity is lower, emerging market troubles could spillover to the rest of the world. The Eurozone is particularly exposed – the European Central Bank is worried about non-hedged exposure of European banks to Turkish companies and if Turkish banks fail, there’s no question that it will affect markets around the world.
For the first time in over a year EUR/USD is trading below 1.15. The single currency has been trending lower since the beginning of the second quarter and has come close to testing this support level on numerous occasions. The meltdown in Turkey was the straw that broke the camel’s back, opening the door to the deeper slide towards 1.12. There wasn’t much Eurozone data released over the past week but the few reports we had were far from impressive as factory orders and industrial production in Germany tumbled. The calendar heats up in the week ahead with Q2 GDP, CPI and ZEW scheduled for release. However all that will take a backseat to Turkey’s troubles. Banco Bilboa Vizcaya Argentaria, UniCredit and BNP Paribas have the greatest exposure to Turkish debt and many of their loans are unhedged. According to data from the Bank of International Settlements, Spanish lenders are the most exposed followed by Italian and French banks. Over the last year the Lira has lost 33% of its value and its cost of servicing its debt has risen to the highest level in 9 years. If Turkey’s economy crumbles more migrants could be headed to the EU, making Turkey a political and economic crisis for the region. From a fundamental and technical perspective, the euro is vulnerable to additional losses.
Meanwhile the U.S. dollar is rising because investors are flocking into the safety of the greenback. While the stronger dollar is a growing problem for countries around the world, so far it hasn’t taken a significant toll on the U.S. economy. A strong currency is supposed to hurt exports, drive inflation lower, cause businesses to curtail hiring but so far we haven’t seen any evidence of that. Inflation growth is still strong with year over year core CPI growth rising to its highest level since 2008 last month. Job growth is healthy, wages are on the rise and consumer confidence is steady. The only place we’ve seen an impact is corporate earnings. Retail sales, which is the only piece of market moving data on the U.S. calendar next week should be slightly weaker but strong enough to allow the Fed to raise interest rates.
All 3 of the commodity currencies traded lower on Friday. NZD/USD extended its post RBNZ slide while AUD/USD finally broke its 2 month long range to trade at its lowest level in 19 months. The first leg of the move happened after RBNZ and Turkey triggered the second. Australian fundamentals aren’t terrible but as a high beta currency, AUD has and could continue to sell-off on risk aversion but when the turn happens, it could be one of the first to benefit. The RBA minutes were relatively positive.
USD/CAD on the other hand remained relatively rangebound. The blowup in Turkey, wild swings in oil, release of key Canadian economic reports and the diplomatic rift between Canada and Saudi Arabia failed to have a significant impact on the currency. This is because of the divergent effects on the loonie. On the one hand, political tensions, oil prices and Turkey’s problems is negative for CAD (and positive for USD/CAD) but the unexpectedly strong employment report reinforces expectations for a rate hike by the Bank of Canada this year. Not only was job growth in July the strongest this year but the gain in services employment was the largest on record. The unemployment rate also declined to match its 40 year low. Rate hikes in the current environment could become rare making the Canadian dollar more attractive compared to other major currencies.
Sterling weakness has been one of the most consistent trends in the forex market this month. GBP/USD fell every day this past week despite stronger trade, industrial production and Q2 GDP data. Investors are growing more concerned about the risk of a no-deal Brexit, worried about UK bank exposure to Turkish debt and more certain that the turmoil in the financial markets will keep monetary policy unchanged for the rest of the year. The UK government has 7 months to strike a deal with the European Union or risk damaging morale and delaying business investments by extending negotiations. With a number of important economic reports on the calendar, sterling will remain in focus in the week ahead. The latest employment, inflation and consumer spending numbers are scheduled for release and given the extent of GBP/USD’s decline this month, if any of them surprise to the upside, we could see a furious short squeeze.