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Dollar Continues to Rally: What is Behind the Move?
Last Updated 10/22/2008 5:16:00 PM EST (GMT +5)
TODAY’S BIGGEST PERCENTAGE MOVERS
THE STORIES IN THE CURRENCY MARKET
EXPECTATIONS FOR UPCOMING FED MEETINGS
DOLLAR CONTINUES TO RALLY: WHAT IS BEHIND THE MOVE?
Dollar bulls continue to take the markets by the horns, driving the British pound to a 5 year low and the Euro below 1.28. Deleveraging and risk aversion have been the primary catalysts for the strength in the low yielders (US dollar and Japanese Yen) but currency bets gone wrong, repatriation and the fears of weak growth in Europe have also fueled the rally.
Although earnings from US banks has been everyone's main focus, European banks will also be reporting earnings soon and they could face some serious losses as well, especially the ones that have recently received assistance from their local governments. Liquidity problems are usually synonymous with major balance sheet problems for banks. In the corporate sector, Citic Pacific and Latin American companies will not be the only ones to suffer losses from currency bets as they try their hands in the FX markets. The outlook for the European economies is very grim and when combined with risk aversion in the financial markets, it translates into severe weakness for the Euro and the British pound against the US dollar.
The Dollar Could Rise Another 5 Percent
After injecting a massive amount of liquidity into the financial markets, central banks are finally seeing their desired reaction as LIBOR rates fall and lending becomes more fluid. In the long run, this should help to stabilize the financial markets and restore confidence, but in the short term, there could be further dollar strength. Since the Purchasing Power Parity levels for the EUR/USD and GBP/USD are approximately 1.15 and 1.56 respectively, the dollar could rally another 5 percent before the dust settles. Furthermore, the Fed has made another announcement in an attempt to stabilize the financial markets. They changed the interest rate that they are paying on excess reserves from 75bp below the Fed funds rate to 35bp. The announcement itself was not a big surprise, but the timing was. They have could have made this announcement next week when they cut interest rates, but their decision to do so now rather than later suggests that they may be preparing for a smaller rate cut next week. Unless the Federal Reserve wants to take interest rates to zero percent, each quarter point rate cut may need to be rationed from here on forward. The Bank of Canada certainly felt this way when they cut interest rates by only 25bp on Tuesday.
How Much Will Dollar Strength Hurt Exporters?
On a trade weighted basis, the US dollar has appreciated more than 18 percent since July. The typical notion is that dollar weakness helps US exporters while dollar strength hurts them but globalization has actually changed this dynamic with some exporters now benefitting from dollar strength. The key is in their expenses because if they manufacture abroad, dollar strength reduces their foreign expenses. A perfect example is Caterpillar Inc, the world’s largest manufacturer of construction and mining equipment. In the third quarter, they actually recorded an exchange rate gain because the strength of the dollar reduced their net liability position in Europe. Google on the other hand took a big hit from dollar strength. Although the company does not export anything, more than 50 percent of their revenues come from outside of the United States. As the dollar appreciates, it reduces the value of their foreign earnings. The same is true for Yahoo. Therefore just because a US company is export driven does not mean that the dollar’s recent strength will be a drag on earnings. At the same time, a multinational service oriented firm is just as vulnerable to currency fluctuations as an export firm.
Global Economic Summit Scheduled for November 15
The Global Economic Summit will be held on November 15 in Washington. The continual weakness in the equity markets and heightened risk aversion will pressure world leaders to come up with new ways to deal with the global economic crisis. Whether the leaders deliver remain to be seen, but the original goal of the meeting is to put more regulation and surveillance in place to prevent a repeat of the crippling financial crisis. Gordon Brown of the UK is in favor of strengthening the surveillance role of the International Monetary Fund (IMF) and giving them the power to coordinate global responses. Large and radical change are expected leading some people to call this meeting Bretton Woods 2. For those who are unfamiliar with Bretton Woods, 44 Allied nations gathered in Bretton Woods, New Hampshire to set up a system of rules, institutions and procedures to regulate the international monetary system towards the end of World War 2. The core of the Bretton Woods system centered around the obligation of each country to fix their currency to the US dollar, which was fixed to gold. Although the major nations of the world may not be looking to bring back those pegs, they do want to return to the discipline that governed the markets in the first Bretton Woods.
WHY DID THE NZD/USD RALLY AFTER THE RBNZ CUT INTEREST RATES BY 1%?
In a dramatic move, the Reserve Bank of New Zealand cut interest rates 100bp to 6.5 percent. This decision was widely expected by the market which is why the New Zealand dollar sold off aggressively leading up to the interest rate announcement. However, in a classic buy the rumor sell news type of behavior, the NZD/USD rallied in the minutes following the rate decision. Central Bank Governor Bollard gave Kiwi dollar bears good reasons to cover their shorts. He said that the weakness of the New Zealand dollar should help exporters and at the same time leave inflation a risk. Even though more rate cuts will be necessary, they will not be as large as the one that we have seen today. The Australian dollar has actually held up relatively well against the greenback despite the $41 drop in gold prices thanks to the hotter CPI numbers. The currency’s resilience suggests that it is nearing a bottom. The Canadian dollar on the other hand dropped to a 3 year low on weaker retail sales and a sharp decline in oil prices. Consumer spending contracted for the first time in 6 months while oil prices fell to a 16 month low.
EUR/USD: HIT FROM 3 DIFFERENT ANGLES
In yesterday’s Daily Currency Focus, we talked about how the EUR/USD should break 1.30 because tough times are ahead for the Eurozone. When the currency pair finally broke that level, the selling did not stop until it fell to 1.2738, the lowest level since November 2006. The EUR/USD was hit from 3 angles; risk aversion, a sharp drop in oil prices and fears of a recession. Two year Eurozone bond yields fell to the lowest level in 3 years. Since July, the Euro has fallen 20 percent against the US dollar and 25 percent against the Japanese Yen. Despite the weakness, don’t expect the European Central Bank to take any steps to stem the decline because a weaker currency will help the export dependent region. Furthermore the decline in commodity prices will make inflation less of a concern and give the ECB the flexibility the focus on growth. Technically, the next level of support for the EUR/USD is 1.25.
BRITISH POUND FALLS 400 PIPS TO 5 YEAR LOW
The recessionary comments made by Bank of England Governor King yesterday continue to weigh on the British pound. Over the past 48 hours, the GBP/USD has fallen more than 6 percent. According to the minutes from the latest monetary policy meeting, the decision to cut interest rates by 50bp alongside other major central banks was unanimous. Retail sales are due for release tomorrow and we expect consumer spending to be weak especially after seeing a drop in consumer confidence and the BRC retail sales index. We continue to expect the British pound to underperform the US dollar and the Euro.
MULTI YEAR LOWS FOR THE YEN CROSSES
The more than 500 point drop in the Dow has driven many Yen crosses to multi-year lows. EUR/JPY for example fell to the lowest level since 2003, while GBP/JPY fell to the level since 2000. The biggest loser on a percentage basis was CAD/JPY which dropped close to 6 percent. Carry trades continue to be plagued by aggressive liquidation and the volatility in the financial markets is certainly not helping. The weakness in the Dow should lead to weakness in the Nikkei which could drive the Yen crosses even lower. The only currency that the dollar did not rally against was the Japanese Yen. Not only does this reflect the strong degree of risk aversion, but it also confirms that the Yen is the only clear winner in the financial market turmoil.
GBP/JPY: Currency in Play Over the Next 24 Hours
GBP/JPY will be our currency in play for the next 24 hours. Due to equity market losses, we have seen the pair fall to eight year lows. UK Retail Sales are due for release tomorrow morning at 4:30 am ET or 8:30 GMT.
Price action in GBP/JPY is firmly planted in the Bollinger band sell zone. The pair has fallen a tremendous 870 points after even larger losses posted in yesterday’s trading. In order to find support levels for the pair, it requires looking back to lows placed nearly a decade ago. The 150.00 level will be the most immediate support both for its psychological factor and how it corresponds with a low placed in late 2000. The level is also significant because if you extend the base of the consolidation triangle that developed for most of the trading last month, from where the consolidation is broken, it measures down to the 150 level. We are placing resistance at 167.76 which is the lows placed in the recent consolidation. In order to invalidate the downtrend, the pair must take significant strides in breaking the resistance that lies above.
About The Author
Lien has extensive knowledge within the interbank market, particularly in trading spot FX and options. She has written for numerous publications, is frequently quoted on financial media outlets, and is the author of several books, including Millionaire Traders. Read more >>