European currencies win out as Japan and US woes bite

The dollar fell to a two-month low against the British pound, and also fell against the Swiss franc, as fears over the US stance on Iraq continued to benefit the Swissie’s safe-haven reputation.

Tumbling equities both in Japan and the US also had a hand in the moves, which helped the euro rise to a one-month high close to parity with the US dollar.

In Japan, the Nikkei 225 stock index closed at its lowest level since 1983, as investors sold banking equities heavily amid fears that the Japanese government’s efforts to rid the banking sector of bad loans could result in bankruptcies.

In the last week of September, foreign investors sold ¥425 billion of Japanese stocks -- the second biggest net sale since statistics began in April 2001, and a worrying prospect for yen bulls.

"Sentiment towards Japan remains negative," said Karen Pringle, senior currency strategist at ANZ Investment Bank in London. "The measures announced by the Bank of Japan have not convinced the market, and although the economy is getting less weak, there is no reason to get into Japanese assets."

US equities recovered towards the end of the week, but further losses may be on the horizon with the onset of the corporate earnings season in the US.

If major firms downgrade earnings or fail to achieve targets, another round of US equity selling may be in order, triggering a weaker dollar. The US relies on foreign direct investment to finance its current account deficit, and an equity sell-off generally impacts the dollar as overseas investors direct flows elsewhere.

"Earnings reports have driven US equities, and negative surprises weigh heavily and affect the dollar," ANZ’s Pringle told FX Week. "This week’s earnings will be important for the dollar."

So far, Bank of New York warned that it would not achieve its third-quarter earnings projections, while US pharmaceutical firm Schering Plough cut its earnings estimate by 20%. One plus for corporate firms in the US is that they will not lose out on sales of their products or services in Europe. Previously, some US firms had found that the euro’s downward slide had shaved up to 20% off their sales earnings in Europe when converted back into dollars.

However, with the euro sitting near parity with the US dollar in recent months, euro-related exchange rate risk has greatly diminished.

The ongoing debate over potential military action is also currently wielding an influence over the dollar’s fortunes. The UK and US governments are lobbying the United Nations to pass a new resolution that would require total Iraqi compliance with weapons inspectors. Failure to do so would allow military force to be used against Iraq.

"Fears over the Middle East continue to remain an influence on the market -- there is a war premium attached to the dollar," said an FX trader at a US bank in London. "It is not clear what the solution will be, but the market doesn’t like uncertainty."

That uncertainty is also affecting US institutional players. "US investors are confused about what to do," said ANZ’s Pringle. "Portfolio managers have no clear direction."

Fearful that the US dollar could weaken further on the back of US equity weakness and a war premium, institutional investors, particularly in Asia, are turning to the eurozone in the interim, traders said.

However, economic data continues to paint a bleak picture of the eurozone’s prospects for economic recovery. Data on the service sector issued last week showed that business activity contracted. The business activity index for September slipped to 49.1 in September (a reading below 50 indicates contraction) from 50.8 in August.

"The euro is winning by default," said the London trader. "That is partly reflected in the fact that no-one seems to be able to make the case for a stronger euro." Indeed, a stronger euro could hamper already fragile growth prospects in the eurozone by increasing inflationary pressures and forcing the European Central Bank’s hand on interest rates.

The head of German research institute Ifo last week called for an interest rate cut to bolster the German economy. Hans Werner Sinn said the risk of deflation in Germany must be taken seriously.

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