It’s difficult to assign the US dollar a bullish fundamental bias considering the acceleration of the economy’s recession and the fact that American markets are the epicenter to a global financial crisis; but regular economics do not apply in times like these. In normal market conditions, expected returns hang in a delicate balance with a general tolerance for risk.
US Recession Deepening, How Long Can Dollar Strength Hold Up?
Fundamental Outlook for US Dollar: Bullish
- US marks the biggest drop in payrolls since 1974
- NBER confirms the domestic economy has been in a recession since December 2007
- Record lows for manufacturing and service sector activity last month point to a deepening recession
It’s difficult to assign the US dollar a bullish fundamental bias considering the acceleration of the economy’s recession and the fact that American markets are the epicenter to a global financial crisis; but regular economics do not apply in times like these. In normal market conditions, expected returns hang in a delicate balance with a general tolerance for risk. When yield income – valued through assets in a specific country – drops relative to its international equals, that currency depreciates against its counterparts. This sums up capital flows, carry interest and fundamental speculation in interest rates. However, the setting for the markets is clearly far from normal – just look at the advance in the US dollar last week immediately following the report of a 533,000-person drop in national payrolls. Normal market theory has been thrown out the window as investors are no longer concerned about the potential for return. With volatility holding at levels many times greater than what it was just a year or two ago and global economies sliding into a grim recession, large investors and fund managers are merely looking for a place that their accounts won’t shrink. With time we have seen that that place is US Treasuries. Surely, the market must be desperate for a safe haven with three-month T-bills yielding little more than one basis point and two-year T-notes are paying out 0.9 percent per year. In fact, the entire yield curve is at record lows.
How long can a market go against such a basic law of market theory? That depends on speculators. As long risk sentiment holds as the dominant trend across all asset classes and all markets, caution will keep capital flowing towards safe havens. However, that is not to say that the US will always be the currency that panicked traders will turn to. Massive bailout efforts, rate cuts and stimulus packages have offered a sense of stability for the world’s largest economy; but this combined endeavor cannot prevent a recession or even a natural bear market. And, when financial conditions worsen and the economy continues its slide, policy makers will find they have few options left to curb the pain on a national level. Since US officials have been the most aggressive in their efforts, they could reach their limit first; and then the sanctity of US government debt will come into question. There are other countries that are less liquid but are experiencing better stability. As the global recession and financial crisis deepen, these alternatives will grow more and more appealing.
Characteristic of a primary fundamental theme, a shift in this market driver will not change over night - but will happen gradually. The calendar for the week ahead will help steer the bigger trend. Dollar traders have no doubt already priced in a recession; but how severe and lengthy of a contraction have they accounted for? A few growth-related indicators will test this. Pending home sales will gauge the ongoing housing market recession while the trade balance will reveal how effective a cheaper dollar is at drawing less international demand. The consumer will be the more important focus with retail sales for November accounting for the build up in spending trends into the holiday season while consumer sentiment will guide speculation for it going forward. Also thematic is inflation. Though factory and import-level price gauges are usually second tier readings, an expected plunge in annual readings would spell deflation which the Fed has little to no chance at fighting. This will be important considering the FOMC will decide rates on the following Tuesday. - JK
Despite a week of significant event risk the Euro ended the week relatively unchanged as it traded in a narrow 300 pip range. The lack of volatility was surprising considering the fact that the ECB cut interest rates by 75 bps, which was the biggest since the single currency was instituted. The economic calendar also confirmed that the region had entered into a recession as the second reading of GDP printed at -0.2% and the manufacturing and service sectors contracted to the lowest levels on record.
Euro May Remain Range Bound As Rate Cut Fails To Spark Volatility
Fundamental Outlook for Euro: Bearish
- Euro-Zone manufacturing and service sectors contracted further in November, with the composite PMI reading falling to 38.9
- Retail sales dropped 0.8% in October as consumers as consumers retrenched as the region enters a recession.
- ECB cuts benchmark rate by 75 bps, as the regions second reading of 3Q GDP at -0.2% confirms a recession
Despite a week of significant event risk the Euro ended the week relatively unchanged as it traded in a narrow 300 pip range. The lack of volatility was surprising considering the fact that the ECB cut interest rates by 75 bps, which was the biggest since the single currency was instituted. The economic calendar also confirmed that the region had entered into a recession as the second reading of GDP printed at -0.2% and the manufacturing and service sectors contracted to the lowest levels on record.
Although markets are still pricing in over 130 bps of rate cuts by the central bank over the next twelve months, President Trichet in his post rate decision remarks refused to give any indication to future policy decisions. However, the MPC leader would acknowledge that the upside risks to price stability had alleviated allowing for the aggressive policy decision. The committee would lower their inflation expectations for next year to between 1.1% and 1.7% which is below their 2% target. Policy makers also believe that growth will be between -1% and 0 for 2009 as growth risk are firmly to the downside. President Trichet would go on to point out the fact that the central bank had decreased rates by 175 bps in less than two months, which appeared as if he was making the case that the MPC may have taken enough action in the near-term. He would also refute the notion that the economy may experience deflation as committee is forecasting a return to growth in 2010 which should lead to higher inflation expectations in the second half of 2009.
If the past week’s significant event risk failed to break the EUR/USD out of its current range then we may see it continue to trade sideways as next week’s economic calendar is filled with second tier indicators with the German ZEW reading for December providing the greatest chance of volatility. The medium-term forecast for the economy is expected to decline to -57.5 from -53.5, as growth continues to stall in Europe’s largest economy, which was evident by the 7.1% decline in domestic demand for intermediate goods. If markets start to lower their expectations for further easing from the ECB we may see the Euro look to test the upper band of the current range at 1.3000. However, if the central bank’s forecast for a return to growth in 2010 appears unattainable then they may be force to ease further. - JR
Japanese Yen Threatened by Year-End Capital Flows
The Japanese Yen could reverse recent gains next week as seasonal capital flows create the perception of a boost to risk appetite.Fundamental Outlook for Japanese Yen: Bearish
- USD/JPY, Dow Jones Correlation Near 20-Year High
- Japanese Vehicle Sales Lowest Since at Least 1980
- Yen to Retrace Recent Gains against the Euro
The Japanese Yen could reverse recent gains next week as seasonal capital flows create the perception of a boost to risk appetite. Last week, we suggested that stock markets may rise in December as traders prepare for the end of calendar year.Investors often intentionally close some positions at a loss in December to offset the capital gains tax burden. This then pushes shares higher through January as positions are re-established (a phenomenon called the “January effect”). Considering the massive drop in share prices this year, the only traders with any meaningful gains to be taxed were positioned short. Closing out some of this exposure will mean buying back shorted stock and thereby pushing markets higher. Considering the Yen remains 96% inversely correlated with the Dow Jones Industrial Average and 95% inversely correlated with the broader MSCI World Stock Index, the currency will suffer loses should this materialize. Initial signs that stocks are being buoyed by seasonal factors have slowly started to emerge: shares closed Friday’s New York session with a gain of 3% despite news that the economy lost 533k jobs in November, the worst reading in 34 years, sending the Yen lower against nearly every other major currency.
While the economic calendar features several prominent releases, these are unlikely to usurp the dominance of stock performance in setting the Yen’s trajectory. The Current Account surplus is expected to continue to narrow in October as an expensive currency and dwindling global demand punish exporters. The Eco Watchers survey is likely to see merchant sentiment continue to make new lows as acute deterioration in employment crushes consumers’ willingness to spend. October’s Leading Index and November’s Corporate Goods Prices metrics are also unlikely to cause much volatility as their decline is merely a reflection of a recession in the world’s second-largest economy that has long been priced into the markets. To that effect, the final revision of third-quarter GDP figures are likely to have less impact still.
The British pound has been acting tipsy just above its precarious support level at 1.45 against the US dollar. Data this past week was heavy hitting, but no surprises were generated from its collective impact. With risk sentiment holding to a range and technicals defining a clearer path for traders, it will take a significant fundamental shock to finally get the sterling moving – that is if a shift in risk trends or a broad move in the dollar don’t bet the market to the punch.
Pound Threatens Six Year Lows As UK Recession Paces Global Decline
Fundamental Outlook for British Pound: Bearish
- Bank of England delivers 100bps cut – as expected – to bring the benchmark rate to a 52-year low
-Service sector activity hits a record low as employment and new orders contract
- Manufacturing activity tumbled to a new low in November as the icy grips of recession take hold
The British pound has been acting tipsy just above its precarious support level at 1.45 against the US dollar. Data this past week was heavy hitting, but no surprises were generated from its collective impact. With risk sentiment holding to a range and technicals defining a clearer path for traders, it will take a significant fundamental shock to finally get the sterling moving – that is if a shift in risk trends or a broad move in the dollar don’t bet the market to the punch. There have been two primary drivers for the pound over the past six to nine months (interest rate speculation and growth forecasts) and these are likely to define trends going forward. The outlook for both rates and recession are particularly bad for the UK – perhaps the worst of the G10; but this may actually work in pound bulls’ favor. If the market is prepared for catastrophe, there is room for positive surprises (though the level of momentum and one ray of improvement may provide is a different issue).
Looking at the economic docket, the interest rate will be redefined; but it will naturally be less important. After a series of major rate cuts, the country’s benchmark lending rate is now at a mere 2.00 percent. This means that the Bank of England (BoE) has little room left to lower rates – a problem considering Governor Mervyn King has expressed concern that the economy could seen see a period of deflation (and combined with recession that leads to the dreaded stagflation – which far more difficult to recover from). On the docket next week, the Producer Price Index numbers for November will give an early reading on inflation trends. It is interesting to note that factory-gate prices between the UK an US are dramatically different, which could defer divergence in deflation expectations and shift the power in the currency market. As a benchmark, we now see that overnight index swaps measured by Credit Suisse are pricing in less than 50 basis points of additional easing over the coming 12 months. Everything else being equal, this is bullish as the pound will be in a better position when growth and the markets turn around and the appetite for yield returns. However we will see if they are that strong on the 12th.
The more prominent concern for fundamental traders at this point is the shape of the recession the UK is falling into. In a global economic slump, the United Kingdom is pacing the decline thanks to the late-to-reverse market and housing boom, a record level of consumer credit and the fact that London is the world’s financial center. It is true that growth projections are dour even from conservative parties (Chancellor of the Exchequer Alistair Darling expected an ongoing contraction through the first half of 2009 and the OECD has projected a 1.1 percent contraction through the entire year), but how long and severe will the slump actually be and what is the market currently pricing is are the real questions to price action for next week and beyond. We will see plenty data that will help gauge these level of sentiment. The BRC retail sales monitor – though relatively lagging – will provide a solid reading on growth ahead as it gauges consumer spending trends better than the volatility government reading. Before a real recovery in the economy can unfold, the housing market will have to pull out of its nose dive; and the RICS House Price Balance will tell us if that is a reasonable expectation. Finally, the NIESR GDP estimate will help define growth forecasts for traders that are more than weary over speculating against such an overwhelming trend. – JK
The Swiss franc strengthened this week to pick up 200+ points against the U.S. dollar amid the dismal GDP release however, investors are likely to turn over their positions next week as the Swiss National Bank is widely expected to lower the 3-month target LIBOR rate by 50bp to 0.50%. The SNB has certainly stepped up their efforts as they lowered the key rate by 175bp over the last two months, and may ease policy further over the coming months as they carry out their dual mandate to ensure price stability and to foster economic growth.Swiss Franc To Fall Further as Investors Raise Bets For SNB Rate Cut
Fundamental Outlook for Swiss Franc: Bearish
- Switzerland GDP Holds Flat in 3Q
- USD/CHF December Forecast Calls for Bullish Outlook
The Swiss franc strengthened this week to pick up 200+ points against the U.S. dollar amid the dismal GDP release however, investors are likely to turn over their positions next week as the Swiss National Bank is widely expected to lower the 3-month target LIBOR rate by 50bp to 0.50%. The SNB has certainly stepped up their efforts as they lowered the key rate by 175bp over the last two months, and may ease policy further over the coming months as they carry out their dual mandate to ensure price stability and to foster economic growth.
A Bloomberg News survey shows that all of the economists polled anticipate the central bank to lower borrowing costs yet again in order to stave off a deep and prolonged downturn in the economy. Deteriorating fundamentals paired with fading demands from the global economy has certainly dragged on the export-based country as the economy failed to grow in the third quarter, and may face further headwinds over the near-term as its biggest trading partners head into a recession. In addition to the considerable slowdown, the drastic decline in global commodity prices have also raised the risks for deflation as policymakers expect price growth to fall below the 2% target by the end of this year, which could lead the SNB to ease policy further over the coming months as they expects economic activity to contract in 2009. The extraordinary efforts by Governor Roth and his colleagues continues to reflect a dour outlook for Switzerland, and may weigh on the franc going forward as policymakers try to reduce the spillover effects which emerged from the financial crisis. As a result, the Swiss franc may pare gains over the following week, and we may see the USD/CHF continue to move along an upward tend over the near-term as the flight to safety continues. – DS
The Canadian Dollar would steadily fall throughout the week as weak fundamental data and declining commodity prices lowered growth expectations for the economy. Weak domestic data had a significant hand in the currency’s fall as manufacturing activity fell to its lowest level on record on the back of plunging inventory and prices.Canadian Dollar May Break Support On BoC Rate Cut
Fundamental Outlook for Canadian Dollar: Bearish
- 3Q growth in Canada rose 1.3%, as the economy remained resilient despite falling commodity prices
- The Ivey PMI gauge fell to 40.2 from 52.2, which was the worst since record keeping began in 1997
- Canadian employment declined by 71,000 in November, which was the biggest fall since 1982
The Canadian Dollar would steadily fall throughout the week as weak fundamental data and declining commodity prices lowered growth expectations for the economy. Weak domestic data had a significant hand in the currency’s fall as manufacturing activity fell to its lowest level on record on the back of plunging inventory and prices. The Canadian economy would also give back the most jobs since 1982 which was almost triple expectations with both manufacturing and service sectors losing over 35,000 jobs each. Additionally, the unemployment rate rose to a two year high of 6.3% despite the fact that over 48,000 people left the workforce. The “loonie “ may remain under pressure as the economy could grind to a halt if domestic demand follows falling exports.
A BoC rate decision will dominate event risk next week with the MPC expected to cut rates by 50 bps down to 1.75%. However, given the sharp falls in employment and manufacturing we could see a more aggressive more by Governor Carney. Yet, in a November speech in London the MPC leader noted the fact that Canadian banks have not sought public capital and that the banking system has been unscathed compared to other countries and are continuing to provide loans. If Canadian consumers and business continue to have access to funding the economy may be able to rebound sooner than expected from the current downturn. However, the Canadian economy is reliant on exports to the U.S. and demand for raw materials which have both plummeted, the International Merchandise trade balance is expected to see its surplus fall to 3.2 billion from 4.5 billion in October. Therefore, if we see the USD/CAD break above resistance at 1.300 it may look to test 1.3500. However, a hawkish Carney and an expected 50 bps cut could spark bullish “loonie” sentiment and see price action fall back to the 20 Day SMA at 1.2420 which has held as support the past three weeks. - JR
Australian dollar price action was restricted to a clearly defined trading range last week despite a heavy dose of economic event risk. The data docket is markedly less intense in the coming week, with traders surely facing yet another week of risk-driven trading.Australian Dollar Trading to Follow Global Stock Performance
Fundamental Outlook for Australian Dollar: Bearish
- Reserve Bank of Australia Lowers Rates 1%, Hints Cuts are Over
- Trade Surplus Surges in October as Imports Dwindle
- Australian Economic Growth Drops to Lowest in 8 Years
Australian dollar price action was restricted to a clearly defined trading range last week despite a heavy dose of economic event risk. Ignoring the fundamentals, the currency looked to risk sentiment as the impetus for movement. Indeed, as the Dow Jones Industrial Average retraced 50% of the preceding week’s gains and then settled to consolidate, so too did AUDUSD. Indeed, the two have been closely linked since mid-October and now show a hefty 91.8% correlation.
The data docket is markedly less intense in the coming week, giving little reason to suspect that the currency will now become responsive to fundamental releases. Leading indicators point to another decline for National Australia Bank’s measure of business confidence: AiG figures gauging expected performance in the Manufacturing and Services sectors saw both metrics drop to the lowest in nearly 6 years in November. By contrast, Westpac Consumer Confidence bounced sharply higher to 4.3% in November, boosted by initial elation at massive RBA interest rate cuts and a fiscal handout of over A$10 billion. However, traders are unlikely to see much follow-through in the December release as it becomes clear that the Reserve Bank has shifted gears to neutral all the while firms continue to translate a dreary outlook into job cuts. While headline figures showed the labor market added an impressive 34.3k jobs in October, not all is as rosy as it seems: most of the gains were had in part-time employment, were the economy added 43.5k jobs. Meanwhile, full time jobs actually lost -9.2k employment places. The shift from full-time to part-time employment suggests that companies are scaling back on labor expenses, a move consistent with expectations of slowing global demand. Economists expect the economy to shed -15k jobs in November to push the unemployment rate to 4.4%, the highest in a year. Barring any profound surprises, this data offers little that has yet to be priced into the Australian dollar exchange rate.
On balance, traders surely face yet another week of risk-driven trading. It is unclear whether negative US fundamentals still have much of an impact on equity markets after stocks closed Friday’s New York session with a gain of 3% despite news that the economy lost 533k jobs in November, the worst reading in 34 years. In any case, significant US event risk does not enter the picture until late in the week with the Retail Sales release. Seasonal forces may be the dominant catalyst at this point. Stock traders often intentionally close some positions as a loss in December to offset the capital gains tax burden. This then pushes shares higher through January as positions are re-established (a phenomenon called the “January effect”). Considering the massive drop in share prices this year, the only traders with any meaningful gains to be taxed were positioned short. Closing out some of this exposure will mean buying back shorted stock and thereby pushing markets higher. Should this materialize given current correlations between equities and forex markets, the Australian dollar will gain on safe-haven currencies like the US Dollar and the Japanese Yen.
The New Zealand dollar pared gains from the previous week as investors continued to curb their appetite for risk, and the higher-yielding currency may face increased selling pressures over the coming week as demands for carry trades deteriorate. In addition, the interest rate outlook for the Reserve Bank of New Zealand continues to favor a bearish outlook for the kiwi as investors expected the central bank to lower borrowing costs further as the $128B economy faces its worst recession in 18 years.
New Zealand Dollar Under Pressure As RBNZ Hints At Further Rate Cuts
Fundamental Outlook For New Zealand Dollar: Bearish
- Reserve Bank of New ZealandCuts 150bp to 5.00% from 6.50%
- Investors Remain Risk Averse, Limiting Demands for Carry Trades
The New Zealand dollar pared gains from the previous week as investors continued to curb their appetite for risk, and the higher-yielding currency may face increased selling pressures over the coming week as demands for carry trades deteriorate. In addition, the interest rate outlook for the Reserve Bank of New Zealand continues to favor a bearish outlook for the kiwi as investors expected the central bank to lower borrowing costs further as the $128B economy faces its worst recession in 18 years.
RBNZ Governor Alan Bollard stated that additional rate cuts ‘may be warranted’ even after lowering borrowing costs at a record pace during the December 3rd policy meeting as the central bank forecasts the economy to contract 0.2% within the first half of the next year. Credit Suisse overnight index swaps are showing that investors expect the RBNZ to cut the benchmark interest rate by another 100bp over the next 12 months, which will certainly weigh on the currency going forward. Moreover, falling commodity prices paired with risk aversion could also spark increased selling pressures for the kiwi over the trading week, which could drag the NZDUSD to the 11/20 low of 0.5196 over the near-term.
Meanwhile, the fundamental event risks scheduled for the following week also favors a bearish outlook for the kiwi as trade conditions are expected to deteriorate further for the export-driven economy. The terms of trade index is anticipated to contract 2.6% from the second quarter, which would be the biggest drop since 2005, and reflects the dire state of the global economy. Weakening demands from around the world would only heighten the downside risks for growth, and may trigger a sell off in the New Zealand dollar as market participants price-in a worsening outlook for the economy. - DS
Source : Dailyfx.com
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