DOLLAR RALLY MAY HAVE LEGS
Volatility has ripped through the financial markets with currencies and equities staging sharp intraday reversals. All of the major currency pairs have seen an increase in one month volatilities on the fears that valuation and recovery expectations have become overextended. The U.S. dollar strengthened against all of the major currencies, driving the EUR/USD down more than 125 pips in the process. With such a strong reversal, the burning question on the minds of all currency traders is whether the latest move is merely profit taking on dollar short positions or the beginnings of a full fledged reversal.
Pause or Turn?
In order for a full fledged reversal to occur, there needs to be a worthwhile catalyst. Unfortunately that was not the case today. Today’s 1.0% fall in most major indices mirrors the agony that we saw on Friday with stocks first racing higher before reversing aggressively to end the U.S. trading session near its lows. However, being that there was no U.S. economic data to shake the markets, it is a little unclear what caused the panic. One potential explanation is uncertainty surrounding the continuation of the $8,000 tax credit given to first time borrowers. Current congressional discussions are pointing to a possible extension but with the plan to gradually fade out through the next few months. Since many were hoping for an outright extension, this was a bit of a disappointment. It is not hard to believe that the substantial jump in home sales, as exhibited by Friday’s report on existing home sales, would be unsustainable without government assistance making our economic recovery slightly more uncertain. To add on to stock market woes, it was reported that Bank of America’s repayment of government bailout funds is being delayed because regulators are requiring the company build-up more capital through a secondary offering before they would be allowed to loosen ties to the government. The company faces two difficult decisions - either dilute the value of their shares or submit to continued government intervention and unfortunately neither option looks particularly attractive.
Dollar Rally May Still Have Legs
Although the intraday reversal in stocks triggered a sharp selloff in currencies such as the euro, Australian, New Zealand, and Canadian dollars, the lack of a catalyst suggests that the latest move is more likely a relief rally in the U.S. dollar than a bottom. Nonetheless, this rally may still have legs given the strength of today’s move. Consumer confidence is due for release tomorrow and given the drop in the IBD Confidence report and the University of Michigan consumer sentiment survey, weakness is also expected in the Conference Board’s report. If currencies continue to take their cue from equities, then a larger than expected drop in confidence could drive equities lower and the dollar higher in the process as traders unwind some of their recovery trades. Another thing to keep in mind is that the Fed has committed to ending treasury purchases by October 31st. This could lift yields which would help the U.S. dollar. However in the grand scheme of things, a much deeper slide in the higher yielding currencies would be needed to negate the uptrend. In the case of the euro, we would have to see the 1.4600 level broken before the current trend would be invalidated. AUD/USD would have to fall below 0.9000 before we could start talking about a more significant correction. Even though the greenback may be set for an early week rally, it is still unlikely that the gains will be sustainable in the long-run as current economic dynamics have not changed enough to facilitate such a shift.
EUR/USD: LOSING SIGHT OF 1.50
The sharp slide in the EUR/USD today suggests that currency traders have rejected the 1.50 level. Despite claims that China is looking to accumulate more euros, the rally in the most actively traded currency pair has lost its steam. Not only did U.S. equities turn, but German consumer confidence also fell for the first time in fourteen months to 4.0 from 4.3 last month. Survey provider Gfk questioned whether personal consumption will be able to support the economy, like it has in the past few months. Interestingly enough, despite a drop in income, the economic expectations component of the report nearly doubled from last month. The question over the consumers’ ability to spend could be cleared by Thursday’s German employment report. If unemployment continues to rise, then consumer spending could really falter in coming months. So far, ECB officials appear to be comfortable with the rise in the euro which provides shelter from rising commodity prices. Unless the EUR/USD makes new highs, the risk of verbal intervention should remain contained. Tomorrow should be a quiet day overall with only Money Supply and French Consumer Confidence to fill the Eurozone schedule.
USD/JPY: PLANNING ECONOMIC TRANSFORMATION
USD/JPY is managing to come away with small gains, marking its ascent to the highest levels since September 21st. The currency has risen nearly 5.0 percent since its lows hit in early October. One of the main drivers of a USD/JPY rally seems to be rooted in political uncertainty. Japan’s new Prime Minister, Yukio Hatoyama, gave an address to the country’s parliament today in which he reiterated one the main goals he attempts to fulfill in his administration – “building an economy for the people.” This vision involves making a switch in economic drivers, from exports to consumer spending. However, making such a radical change is not so simple, as many worry that governmental pledges of more spending to achieve such growth would expand the already crippling budget deficit. Furthermore, casting the export industry aside may result in unforeseen economic distress that will only create more problems than it resolves. Export dependence is one of Japan’s critical weaknesses, but it is very questionable how the newfound government will be able to move away from such a system. Data should be light until the end of the week when we receive the Bank of Japan’s semi-annual outlook on Friday.
May The Force Be With You.
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