21 January, 2013
Dollar Climbs to a Six-Month High, EUR/USD Soon to Break
On one hand, the S&P 500 – a benchmark for risk appetite trends – closed this past week at its highest level in five years. On the other, we have the Dow Jones FXCM Dollar Index (ticker = USDollar) – the world’s reserve currency and thereby a primary safe haven – closing Friday at its highest level in six months. That is a contrast in fundamental outcomes that leads us to one of two conclusions: that risk trends are completely disengaged; or the market is running under unique factors and not properly reflection the risk-reward potential moving forward. I think that we are seeing a mix of both factors.
When we look more closely at two of the market’s favored barometers of risk appetite trends – the benchmark equity indexes and yen crosses – we recognize unique drivers behind both. For the stock market, capital rotation through the beginning of the year is still playing a considerable role in capital appreciation. Funds are still slowly reentering the market following the temporary Fiscal Cliff deal; but far more influential is the interest from banks (flush with central bank stimulus cash) finding their way into these higher yielding assets. As for the yen crosses, the carry trade interest they represent normally follows the ebb and flow of risk appetite. Yet, yield differentials are still at historic lows and the extreme low in implied volatility (risk) for the FX market has itself risen to four months highs. Rather than reflect a demand for the interest rate returns on these pairs, we are seeing a flight of capital away from Japanese assets as the country moves closer to an unlimited stimulus regime.
Both of these issues will continue to play out moving forward. For capital markets running on borrowed time, the countdown to the combination of the debt ceiling limit (mid-February to March), the sequester – or automatic spending cuts – deadline (March 1) and Federal budget time frame (March 27) makes for both a serious speculative concern but also an opportunity for ‘relief’ rallies. Through the end of the past week, House members suggested a vote for a three-month breather on the debt ceiling buys time to hold riskier assets. On the other hand, the competitive devaluation of the Japanese yen (along with other currencies unique troubles) may in turn offer the US dollar a boost. The dollar has been severely undermined since the Treasury and Fed began their pursuit of aggressive easing policies. With others playing catch up, it puts the dollar on a more even playing field. This patchwork fundamental backdrop will continue to guide the dollar and broader markets until a motivated and decisive trend returns to underlying risk appetite. And, without clear systemic catalyst on deck, we must simply remain prepared.
Japanese Yen: What BoJ Scenario Invites a USD/JPY Reversal?
Without doubt, the currency facing the greatest risk of volatiltiy and possible trend generation next week is the Japanese yen. Over the past two to three months, the currency has dropped over a thousand pips against each of its major counterparts and now stands at or near multi-year lows. As discussed above, this progress has little to do with a significant advance in risk appetite – certainly not the magnitude that would be insinuated by the swell from these carry-based pairs. So, the fundamental drive is clearly founded in the weakness of the Japanese yen – weighed by the threat that Japanese policy makers are soon to embark on an unlimited stimulus regime that rivals the Fed’s early moves and the looming threats of the European Central Bank’s Outright Monetary Transaction (OMT) program. Expectations have clearly been set high given the levels of the yen crosses, so there is a considerable probability that an pullback may result. The most immediate spark would be no unlimited stimulus effort. That is a doubtful outcome. More likely, we find an open-ended effort that doesn’t rival the Fed’s $85 billion per month.
Euro Drops after IMF Warns Greece Needs EU HaircutsEURUSD took a dive Friday with the euro’s general stumble. Though the Bank of Italy’s downgraded 2013 growth forecast (projecting a 1.0 percent contraction) was more tangible, the more likely driver in this selloff was commentary from an ECB officials and the IMF. The central bank’s Coeure made mention of the wind down in the LTRO programs which have been a serious liquid booster over the past year. Perhaps more disconcerting though was the IMF’s warning that Greece would likely need another €5.5 to 9.5 billion and require the EU take haircuts.
British Pound: Focus Shifts from UK’s EU Referendum to GDP
Though UK Prime Minister David Cameron didn’t hold his speech on the possible renegotiation of the UK’s position in the EU and the possible referendum it may draw in the future, the topics he will eventually cover were leaked. Suggestions that the UK may drift out of the Union and major issues threatened the end of the effort hung heavily in the air. The rescheduled time for the speech isn’t known, but the market will likely move on to the next major unknown for the pound moving forward: the expected 0.1 percent contraction in 4Q GDP to be reported on Friday.
Australian Dollar Faces Inflation Readings Next Week
This past week, the Australian dollar absorbed weak employment statistics and an upturn in Chinese 4Q GDP figures. The implications on both fronts are clear, but its influence on Australian interest rate expectations seemed to be absent. We will find a more direct route this coming week with 4Q CPI data, which will likely change the 35 percent chance of a 25bp cut next month and 40bps of cut expected over 12 months.
Canadian Dollar: Should We Expect Anything from the BoC?
The Canadian dollar was particularly active through the final 24 hours of this past week. The currency dropped against all but the British pound Friday under the dour interpretations of the Chinese investment and US consumer confidence figures. Next week, we have Canadain retail sales, inflation and housing figures. Top billing though rests with the Bank of Canada. They are unlikely to change rates, so we’ll watch tone.
Gold Ends Week with First Loss in Five Days
The four day climb from gold this past week was the longest in three weeks, but Friday ended the otherwise unimpressive climb with a strong dollar standing in direct opposition. The warnings from the IMF about further need for Greece seemed to offer little anti-currency sentiment, but the BoJ’s stimulus decisions next week can more than compensate. Then again, if the baseline is unlimited easing, why isn’t gold at $1,800?
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