US Dollar: Policy Tightening and Mounting Risk Build Bullish Pressure
Fundamental Outlook for US Dollar: Bullish
- The Federal Reserve hikes the discount rate, adds to speculation that Fed Funds rates will soon follow
- Risk trends compete with interest rate forecasts for the dollar’s attention
- Was the Dollar’s late-week rally for naught or has the currency seen a critical extension of a larger trend?
There is a reason the Federal Reserve decided to announce the first hike in the discount rate since 2006 after the market’s close this past Thursday. With a precedence of jittery responses to stimulus withdrawal in other countries (most notably the hikes to China’s reserve ratio); the central bankers were concerned such a move could trigger a panic among speculators born from the fear that the fuel for 2009’s rally was disappearing. However, after an initial rally from the greenback immediately after the release; the currency tempered its gains. As much as the fundamental and interest rate backdrop is improving for the US; underlying risk trends are still the primary guide for the benchmark currency. Yet, this connection hasn’t condemned the dollar’s rally. A comparison between the Dollar Index and the Dow Jones Industrial Average these past few weeks shows something quite unusual: a positive correlation. Has something fundamentally changed for the currency or in the global financial market?
Recent history has shown us quite clearly that the US dollar has been an ideal safe haven and funding currency. Yet, if that were the case, we would expect the build in risk appetite and carry that rising capital markets should have supported this past week to weigh the greenback down. Yet, there are a few unusual factors at play. First, for the undercurrent in sentiment, while some of the growth-linked benchmarks have indeed trended higher; this is more a stabilization and reversal of the late-January / early-February slump in risk appetite than a true rebound in optimism. There are many reasons to be concerned over the stability of financial markets and the nascent economic recovery. From the start, the potential for expansion and returns inherent in the otherwise tepid recovery from the worst financial crisis in modest history already reasons asset prices are misaligned. However, the conviction of greed (risk appetite) can keep trends in place longer than fundamentals would otherwise support. What is needed is a catalyst to break this conviction.
The greatest threat to stability is without doubt the situation in Greece. While concerns over the nation’s deficit seem to have subsided; the threat to broader Euro Zone is undeniable. All that is needed is a spark in sentiment for this situation to once again erupt. In the meantime, China could once again roil the markets (and perhaps set off the dominos in Europe). The Far East market is set to open for the first time in over a week; and this epicenter for speculation has yet to price in the most recent reserve ratio hike, not to mention the other developments.
Another consideration is the influence that the hike in the deposit form this past week can have on the dollar. There are two distinct impressions this move has. First, this move helps normalize the monetary policy in the US and moves up the time table for an eventual hike to the Federal Funds rate. Another consideration is that this move has the same implications for risk appetite that the increase in the Chinese reserve ratio had: this is a move that is withdrawing the same stimulus that has facilitated the market’s recovery over the past year. We have already seen the immediate reaction to this data; but don’t expect this development to have already played itself out.
As for scheduled event risk on the docket; there are many big ticket names. However, don’t expect a second reading of GDP, durable goods or consumer confidence numbers to distract the market from the bigger, more pressing themes already in motion. - JK
- Euro starts the week on the defensive on Greek Debt Crisis
- Surprise Fed rate hike pushes Euro to fresh yearly low
- Euro/US Dollar Technical Forecast remains firmly bearish
The Euro finished the week almost exactly unchanged against the US Dollar, sustaining a drop to fresh year-to-date lows before bouncing into Friday’s close. Indecisive financial markets made price action especially hard to predict and kept the Euro in a choppy range until the US Federal Reserve surprised markets and raised borrowing costs for banks on Thursday. At that moment the US Dollar surged higher and forced the Euro key support at $1.3600 in mere minutes. Yet traders showed little interest in pushing the US currency to further highs, and a late rally in the US S&P 500 left the EUR/USD firmly above 1.36 through time of writing. Relatively limited economic event risk in the week ahead suggests price action may remain choppy, and volatility expectations have likewise fallen ahead of what traders predict will be muted currency moves. Of course, any and all developments in the ongoing Greek sovereign debt crisis could quite easily force substantive volatility in the Euro Zone currency.
Top foreseeable event risk will come on German IFO Business Climate and Unemployment Change data due Tuesday and Thursday of the upcoming week. The former is likely to show that business sentiment remained relatively unchanged through February—approximately in-line with German ZEW Economic Sentiment survey data. Markets predict that Unemployment Change numbers will nonetheless show the domestic economy shed jobs at the fastest rate since June, 2009 through the same period. Countervailing consensus forecasts underline the level of indecision surrounding economic outlooks and arguably explain the deadlock in financial markets. It may take an especially large surprise in either of these reports to force big moves in European asset classes and the Euro itself. Currencies will otherwise continue to respond to developments in broader financial market risk appetite—especially as it relates to the ongoing Greek debt saga.
The recent meeting of the Euro Zone Economic and Financial Affairs Council stated that the EU would take measures to preserve the financial stability of the single-currency area, but the lack of specific details leaves much undecided. The council stated that Greece would have one month to essentially get its accounts in order before the EU decided on any further action. Rumors that the Greek government may seek to raise funding through a 10-year bond sale has many in fixed income markets especially spooked; a failed auction would only augment fears of Greek insolvency. Thus traders should keep a special eye out for any rhetoric related to said topic and any other developments in Greece. As the worst crisis since the adoption of the Euro, Greek debt problems threaten to derail confidence in the common currency and send it significantly lower against major counterparts. Barring any major developments in said situation, however, the Euro/US Dollar pair may see another relatively uneventful week of trading. – DR
- U.K. Consumer Prices Exceed Upper Bound of 3%
- Bank of England Votes Unanimously, Labor Market Weakens
- Mortgage Approvals Unexpectedly Weaken in January
- Household Spending Disappoints
The British Pound tumbled lower against the greenback, with the exchange rate slipping to a fresh yearly low 1.5347, and the currency may continue to retrace the advance from the previous year as policy makers see a risk for a protracted recovery. The Bank of England minutes showed the MPC voted unanimously to hold the benchmark interest rate at 0.50% and to suspend its asset purchase program earlier this month, but the board maintained the option to “provide further monetary stimulus” as they sees the economy facing “considerable” headwinds over the coming months.
In addition, the BoE held a neutral outlook for future policy and said there wasn’t “an immediate need for further relaxation,”, and noted that the recent rise in inflation was merely a “temporary deviation” as underlying price pressures remain to the “downside.” At the same time, BoE Governor Mervyn King continued to see a “substantial margin” of slack in his letter to Chancellor of the Exchequer Alistair Darling, but went onto say that he would be willing to tighten policy if price pressures continue to intensify over the medium-term. As a result, the ongoing weakness in the private sector paired with the deterioration in the labor market is likely to weigh on the prospects for future growth, which could certainly dampen price pressures over the coming months, and the central bank may adopt a wait-and-see approach throughout the first-half of the year as they assess the impact of the emergency measures.
Nevertheless, the economic docket for the following week is expected to encourage an improved outlook for the U.K. as market participants project the preliminary 4Q GDP reading to show a 0.2% expansion in economic activity, while business investments are expected to increase 0.1% during the same period after contracting 0.6% during the three-months through September. However, consumer confidence is anticipated to have stalled in February following the rebound in the previous month, and households may lower their outlook for the economy as they continue to face tightening credit conditions paired with the deterioration in the labor market. - DS
Fundamental Forecast for Japanese Yen: Neutral
- Bank of Japan Maintains Dovish Posture, Hinting USDJPY Gains Ahead
- Japanese Service Demand Disappoints, Drops Most in Nine Months
- Fourth-Quarter Economic Growth Tops Expectations on Trade Rebound
The outlook for the Japanese Yen has become clouded as a likely recovery in risk appetite competes with currency traders backtracking on overdone US Federal Reserve rate hike expectations for control over near-term price action.
The Yen was the single worst-performing currency last week after losing a hefty 1.78 percent against the US Dollar, with selling initially set off by firmer risk appetite but truly encouraged after the US Federal Reserve unexpectedly hiked the discount lending rate. The announcement came just a day after the Bank of Japan reinforced their dovish posture against a backdrop of relatively hawkish minutes from the Fed’s late-January monetary policy meeting, which had already put upward pressure on USDJPY given the pair’s sensitivity to relative yield differentials. Traders looking for aggressive tightening out of the US central bank were disappointed by the end of the week however as January’s consumer price index figures broadly disappointed, with core inflation (excluding energy and food prices) issuing the first monthly decline in at least 13 years. This quickly stopped the USDJPY rally in its tracks as lackluster price growth deflated expectations that any significant tightening from the Fed was becoming imminent.
Looking ahead, the Yen is likely to find firmer footing at the start of the coming week as Asian traders have their chance to price in the US CPI result and unwind some of their long USDJPY positions. However, risk sentiment may return to the forefront as the primary driver of directional momentum for the Japanese unit. Indeed, the emergence of hawkish cues out of the Fed in the middle of last week disrupted an otherwise orderly correction in risk appetite as the debt problems in southern Europe faded into the background after the EU gave Athens until mid-March to show serious efforts in tackling its fiscal shortfall. Barring any unforeseen surprises, this process should now resume, boosting most of the majors at the expense of funding currencies (Dollar, Yen) as carry trades follow stocks higher.
The final outcome that the combination of these conflicting forces will produce for the Yen is unclear at this point. However, considering risky assets were on the way lower long before the Greek issue because the headline reason to be selling, a deeper upward correction now seems like a more lasting catalyst. If this proves accurate, the Yen is likely to move lower against all major currencies with the possible exception of USD, where relative monetary policy considerations between Japan and the States hold an arguably greater sway.
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