The Euro: Europe's Political Wildcard

The euro traded sharply higher against the U.S. dollar Monday, ignoring the risks of renewed political troubles in Italy. This week, an Italian Senate subcommittee will debate whether former Prime Minister Silvio Berlusconi should be stripped of his Senate seat. The reason why this issue is being so closely watched that it was discussed at the G20 Summit is because Italy is the third largest economy in the euro zone and if a tiny country like Cyprus can threaten the region's stability, then Italy is a much bigger problem. Berlusconi has threatened to withdraw his party's support for the current government if he is pushed out of the Senate and unfortunately his People of Freedom Party is a critical link in Prime Minister Enrico Letta's coalition government. An expulsion could collapse the less than one-year old government, force them into snap elections and destabilize the economy. Political uncertainty is never good for a country and in the case of Italy a fresh political crisis could drive Italian bond yields sharply higher and the euro lower.

Under Italian law, a public official cannot serve in the government if he or she has been convicted a crime carrying a sentence of two years or more. Berlusconi was sentenced to a four-year prison term on tax fraud that has been reduced to a single year because of prison overcrowding and he is given the choice to serve the time in jail, under house arrest or through community service. The former Prime Minister doesn't want to serve any sentence at all and wants to remain in the government because he would otherwise lose certain legal protections. The Italian Senate is faced with a very tough choice that could pose a major risk to the fragile recovery in the euro zone. Fresh signs of weakness in Germany should also raise concerns about the economic outlook for the region. As a result, we look at the recovery in the EUR with caution especially against the crosses since the EUR/USD itself is rallying because of dollar weakness.

Dollar: All Eyes On Syria
With no U.S. economic reports released Monday, the dollar traded lower against all of the major currencies with the exception of the Japanese Yen. The retail sales report is the only piece of U.S. data worth watching this week and unfortunately it is not due for release until Friday. In the meantime Syria will dominate the headlines and currency flows as the U.S. Senate prepares to vote on a limited military strike this week. President Obama will be struggling to win Congressional support for intervention in Syria and at this moment it's a very tough call because the majority of the Senate and House are still undecided. Democrats have control of the Senate and if they reject the move, it would be a major loss for the President. For the financial markets, a strike on Syria would do more harm than good. If the Senate approves military action this week, we can expect an increase in volatility that could lift oil prices, drag stocks lower, pressure high beta currencies and spark a safe haven bid for the U.S. dollar. If the Senate rejects the action, we could see a relief rally in stocks and a continued sell-off in the dollar. When military operations began in Libya on March 19, 2011, oil prices began a move from $100 to $113 a barrel. The U.S. dollar also rose in reaction to the strike but the gains in the greenback were short-lived and we expect a similarly knee jerk reaction in currencies in the event of military intervention in Syria. Reduced expectations for Fed tapering could also lead to the adjustments of long dollar positions. While we believe that the central bank could take advantage of the decline in yields and make a symbolical change in asset purchases, the outcome of their decision should be negative for the dollar and positive for bonds. Friday's non-farm payrolls report puts the chance of Fed tapering in September versus December at 50-50 but even if monetary policy is changed this month, the move would be downplayed by a dovish FOMC statement. This week's retail sales report is not expected to provide much help to the greenback - consumer spending should have increased in the month of August, but the momentum in spending will be weak.

AUD: More Signs Of Stabilization In China
The Australian, New Zealand and Canadian dollars extended their gains against the greenback on the heels of better than expected Chinese data. While growth in the U.S. has been uneven, there has been a persistent sign of stabilization in China that lent support to the commodity currencies. Last night China reported its highest trade surplus this year and there's a reasonable chance that the industrial production and retail sales figures due later this week will also surprise to the upside. The General Administration of Customs in Beijing said that China's trade surplus rose to $28.5 billion in the month of August from $17.82 billion. Exports in particular rose 7.2% compared to an estimate of 5.5% but imports dropped to 7% from 10.9%. Over the past month, we have seen evidence of improving manufacturing activity around the world and China is benefitting from the uptick in demand. Inflationary pressures are also under control with CPI growth slowing in August and producer prices falling which combined with stronger Chinese trade activity should provide relief to investors. In a week with a light economic calendar in the U.S., the focus for the front of the week will be Chinese data. If Monday night's industrial production figures show continued strength, it could provide underlying support for global equities and commodity currencies. Australian business confidence and New Zealand credit-card spending numbers were also scheduled for release Monday evening and, given the recent uptick in Chinese economic activity, we would not be surprised to see stronger confidence.

Expect Additional Pressure On EUR/GBP
After experiencing steep losses last week, the British pound continues to trade near six-month highs against the euro and U.S. dollar. While no U.K. economic reports were released overnight, the recent pickup in manufacturing, service and construction sector activity bolstered the outlook for the economy and demand for sterling. Employment numbers are not scheduled for release until Wednesday and we expect the currency to remain bid between now and then especially considering the political risks in the euro zone. From both an economic and political perspective, the U.K. should be a more attractive area of investment for the financial community than the euro zone in the near term, which we feel should be negative for EUR/GBP. With this in mind, 0.8400 is a significant support level for the pair that needs to be broken for an additional push down to 0.82. The RICS house price was scheduled for release Monday evening and it was expected to hit a new multi-year high as government initiatives continue to bolster property demand. Good data could extend the British pound's gains.

Good News From Japan Lifts Nikkei And Yen Crosses
The Japanese Yen traded lower against all of the major currencies on solid expected economic and Japan's successful bid for the 2020 Summer Olympics. The Nikkei rose nearly 2.5% overnight in celebration as businesses look forward to increased economic activity in preparation for the event. While 2020 is a long time from now, it is just the type of good news Japan needs at this early juncture in their recovery. Last night's economic reports should not stand in the way of the consumption tax in Japan. Second quarter GDP growth was revised up to 0.9% from 0.6%, which boosted annualized GDP growth to 3.8% from 2.6%. The current account balance also increased from Y336.3 billion to Y577.3 billion in the month of July. However more stimulus is needed if Prime Minister Abe wants to increase the VAT tax AND keep the recovery on track because there are also pockets of weakness in Japan's economy. The current account deficit ballooned in July and confidence deteriorated according to the Consumer Confidence index and the Eco Watchers Survey. Looking ahead, we expect more detail on the government's outlook with the BoJ August minutes scheduled for release and Economy Minister Amari set to speak at a Conference. While some of the Yen crosses are trading near the top of their recent range, the daily reversal candle in USD/JPY points to a potential drop below 98.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.