The dollar had a volatile day on Monday after China announced reform of its exchange rate mechanism and risk appetite increased temporarily. Initially equities rallied as the move was seen as positive for trade relations between the US and China after recent quarrels over Chinese exports which were viewed as being kept unfairly cheap. But the markets rapidly cooled as one by-product of the reforms which had been overlooked came to light. Under the old system China was forced to use its massive trade surplus to buy US treasury bonds to diversify its holdings into other currencies and avoid inflation. This had the effect of keeping yields artificially low and therefore borrowing cheap, but now the remnimbi has been un-pegged the Chinese may not need to do this anymore. Yields on Treasury bills increased marginally on the news. If the cost of borrowing increases by too much, however, the economy may slow and deflation may set in and recessionary housing patterns could return as buyers find themselves priced out of the market and struggling owners find their mortgage costs rising. The dollar fell initially but gained latter in the day, posting gains against the euro to $1.2317 and also against the yen to ¥91.10.

   The euro fell on Monday despite early gains, after Fitch downgraded BNP Paribas, France’s largest bank and sparked fears about the stability of Europe’s banking system. The 16-country currency had sunk from above $1.24 Monday as the post-depegging euphoria waned and its long-term debt rating was cut from AA to AA- . Analysts commenting on the common currency's rebound have said it is partially a product of market players covering negative bets but that it might not portend a sustained improvement. Long term, most commentators are still pessimistic about the Euro, seeing parity against the dollar as a distinct possibility in 2011. They argue that the austerity measures being implemented in many European countries may create a ‘significant deflationary shock’ as growth slows and that this will weaken the common currency further. However, the upside will be more competitive exports and this may be particularly highlighted after the de-pegging of the remnimbi and the prospect of China becoming a more important export target even for European products. The Euro fell against the yen to ¥112.16 and against the pound to £0.8341.

   The pound fell by the close on Monday after making new highs on the back of a global demand for risk sparked by the de-pegging of the remnimbi. Gains, however, were quickly given up as the markets came to realise the sting in the tail of de-pegging could be higher borrowing costs for everyone. On the economic news front the emergency budget report will be published today outlining how the government intends to bring the economy back on track. Sterling ended the day down to $1.4755 against the greenback and fell to ¥134.40 against the yen.

   The yen rose against most currencies as China’s trading neighbours saw their currencies appreciate after the reform of the Remnimbi which should increase the export potential for those countries which trade the most with China like Japan and Australia. Japanese retail figures were also mildly positive with nationwide department store sales posting a lower decrease than last month and the all industry activity index showing muted gains. Downgrading fears persist, however, as Japan’s debt to GDP ratio remains the worst in the western word. The government plans to implement an increase in sales tax to try to deal with the deficit but many commentators say it may be too late to stop a ratings downgrade. And whilst some analysts have seen an improvement in Japan’s macro-economy the facts remain that the BOJ has just instituted another round of quantitative easing which cannot be a positive sign at all. For doomsayers looking for another crisis on the cards Japan may be the one to watch as a ratings downgrade would send much bigger shockwaves through the financial system than Greece did. The yen ended the session up against the euro at ¥112.16 and up against the pound to ¥134.40.

Analysis prepared by:

Joaquin Monfort
Forex4you analyst