Tag Archive | "Dollar Index"

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Nervous Markets Await Fed and Employment


Nervous global markets anxiously await news from the US Federal Reserve and the new Labor Department unemployment data to be released on Friday. Improved data from Europe boosted European equity markets and raised the euro against the USD as the dollar regained footing against the yen.

Markets appear edgy about what Federal Reserve Chairman Ben Bernanke will announce regarding the possible tapering of the current stimulus. Most likely the news will be tempered at best. With unfavorable growth in GDP expected and with modest gains of about 185,000 new jobs expected, there simply is not enough impetus for the Fed to alter policy significantly, if at all. A gain of 185,000 jobs would trim unemployment to 7.5 percent, a step in the right direction but not a level likely to dissuade the Fed.

On Tuesday, US equities continued paring down but are poised to post record gains for the month. Eight of ten S&P 500 sectors declined for the day. All three major indices lost ground Tuesday. Yet, equities are ready to close the month with the sharpest gains since October, 2011. Early Wednesday trading indicated a rally in equities.

Also of interest to Wall Street is the successor to Chairman Bernanke. President Obama’s choice will likely influence markets with hawks boosting markets and selection of a dove bolstering the dollar.

The European Central Bank (ECB) is meeting this week and new forward guidance is expected from the ECB and from the Bank of England (BOE). The euro and the pound have strengthened in anticipation of new guidance and in response to encouraging data.

European equity markets closed flat for the day but the MSCI index of world stocks fell 0.5 percent.

Dollar Nervous

The dollar gained some strength overnight but slumped 0.5 percent against the yen on Tuesday to 97.93. Just last week, the dollar hit new highs against the yen. The dollar index briefly touched a five week low at 81.785.

Lee Hartman, a currency strategist with the bank of Tokyo explained; “The dollar faces a lot of key event risk in the week ahead with the release of the U.S. Q2 GDP report and the latest FOMC policy meeting on Wednesday, followed by the release of the U.S. employment report for July on Friday.”

The 10-year Treasury notes fell 3/32 with yields closing at 2.57 percent on Friday. Over the last two weeks, yields have ranged from a low of 2.l3 percent to a high of 2.63 percent, uncommon volatility. On July 8, 2013, yields hit 2.78 percent, a two-year high.

The German bund ended a comfortable bounce with a decline on Tuesday. Disappointing trade caused the decline.

Japan’s Nikkei touched a three-week low, sliding 3.3 percent. The stronger yen and poor data from Japan’s exporters hit equities unusually hard. The possibility of a new sales tax is weighing heavily on Japan’s economy.

Latin American Currencies

As the USD has strengthened and become more appealing to foreign investors seeking quality, Latin American currencies have suffered. As the Fed has considered tapering, Latin American currencies have fallen sharply over the past two weeks. A number of factors could continue to impact these currencies negatively in coming months.

Brazil’s industry index slumped to its lowest level in four years. The Brazilian real lost 0.4 percent on Tuesday on a sharp plunge in industry confidence.

  • The Mexican peso slid 0.6 percent to 12.7555 per USD, a two-week low.
  • The Chilean peso lost 0.7 percent to 511 USD, a one-month low.
  •  The Argentine peso shed 0.58 percent to 8.61 USD and has lost 21.25 percent this year.
  • The Mexican peso slid 0.6 percent to 12.7555 per USD, a two-week low
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Euro Slides, Dollar Rises, Italy Plays With Fire


On Friday, the euro fell to its lowest rate against the USD since January 10 and to its lowest point against the yen in three weeks. A number of factors came together to keep the euro in a steady slide and the yen on a steady rise.

In Europe, the euro zone’s 17-member nations released economic information that painted a bleak picture for the region during 2013. Only Germany seemed to discount the overwhelming evidence of another recession. The German confidence index climbed for the fourth straight month, despite a dismal finish to 2012 and data suggesting manufacturing in the country and the region was dialing down.

The euro fell to $1.3166, well below the 15-month peak of $1,3711

The euro fell to 122.23 yen, down  1.4 percent

The dollar index struck a five-month high at 81.508.

In addition to projections that euro zone unemployment would remain in the 12 percent range for 2013 and that Spain’s unemployment rate would stay at 20 percent, there were other factors that are too unsettling to overlook. The ECB had anticipated banks would  pay back 131 billion euro of borrowed funding but fell far short of the mark, repaying just 61 billion euros on Thursday.

Spain announced the country would fall far short of its debt reduction goals in 2012 and well below euro zone requirements. The events in Spain and Italy should be observed by US politicians as examples of what happens when politics and economic concerns face off against each other.

Recent production numbers from the US indicate that businesses are uneasy about how politicians will handle the sequestration due to fall off the March 1st cliff on Friday, March 1, 2013. Coupling this event with the upcoming debt ceiling expiration, the stage is set for a perfect storm that will leave the middle class crippled and the country mired in what will surely become another recession.

And, the political rhetoric in Washington marches on.

On Thursday, minutes from the Federal Reserve’s January meeting were released. The possibility that the Fed will raise interest rates earlier than expected strengthened the dollar against the declining euro.

In addition to the economic woes in Europe, the political theater is unnerving economies outside the region. The amazing but disturbing popularity of Italian bad boy and financial nightmare Silvio Berlusconi have shaken confidence in Italy’s future and thus the future of the euro zone.

Is it possible that the regions third largest economy could turn a blind eye to the unscrupulous Berlusconi? Apparently so as the former Prime Minister is locked in a three way run between himself, current prime minister Mario Monte and Luigi Bersani.

Many economists hold Berlusconi responsible for the lax financial oversight that sank the nation’s economy. However, Italians seem to prefer the wayward ways to the disciplined approach to correction that Monti has advocated.

The euro zone produces 20 percent of the global output. The European Commission said that the euro zone will not return to growth until 2014, dimming hopes of China and the US for their export markets.

Across the region, consumer inflation could deal another blow to the economy. Projection call for an inflation rate increase to 1.8 percent in 2013.

In Washington, Congress returned and seemed undisturbed by the pending negotiations that could set the country back into recession in a very short time. The inability of Congress to put their political rhetoric aside and act responsibly has been repressing the economy since the fourth quarter 2012.

On Thursday, new unemployment claims surpassed analyst expectations as signs of the political weight on the economy continue to mount.

It appears President Obama will stick to his word on reducing spending and increasing taxes. Republicans can move to the middle or cause another economic collapse. If so, it may be 2014 before Democrats regain the house and finally accomplish meaningful legislation about jobs, guns and immigration.

 

 

 

 

 

 

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Euro On Rise?


Despite the Obama Administration’s resistance to contributing funds to the IMF in support of the euro zone, the euro has gained some traction.  The currency has climbed well above the $1.26 trough and is flirting to move past the current the $1.2867 level.  Traders suggested that the euro remains volatile and the currency may not have bottomed yet.

In October, the euro rose to $1.3145 against the dollar.  Analysts believe that until the currency crosses that threshold the bottom has not been found. 

The Thursday bond sales in France and Spain will serve as a good barometer for how much the S&P downgrades have hurt the euro zone.  Investors are cautiously optimistic in the wake of a bond sale in Portugal that sold 2.5 billion euros in debt and was fully subscribed.  Germany’s Wednesday auction also had more demand than anticipated.

Since last Friday, the dollar index has fallen from 81.784 to a two-week low of 80.473.  The Australian dollar gained strength climbing to an 11-week high of $1.0419. The Australian dollar is holding well above its 200-day moving average.  Australia is believed to have added 10,000 in December.

The Dow Jones equities continue to holdover 12,500.  Much of that support is the result of better banking news than expected.  The major financials appear to have fared better in the 4th quarter and will not require additional capital.

The positive euro zone activity seems foolhardy.  Greece is meting with private investors on Thursday in a last gasp effort to gain approval for their debt swap program, which is little more than a restructured default.

The structured default must occur by week’s end to avoid a breech in the 13.4 billion euro call in March.  Another major problem looms.  There is doubt that investors and hedge funds burned by Greece will stay out of the European bond sale market.  U.S. equities are strong and the dividends are especially appealing.

Treasury Secretary, Tim Geithner, informed the IMF that Europe would have to solve their own problems. U.S. taxpayers cannot come to the aid of countries like Greece, Italy and Spain.  The people lack the will and are clearly supportive of more aggressive jobs legislation.  The political fallout from a bailout of Europe would be devastating to President Obama. 

On the other hand, the European banking sector fell 32 percent in 2011.  Even with a temporary rescue plan, Greece will continue to need funding and Euro Zone members will face this same crisis sooner rather than later.  It is time for private investors to take what little money they can and let Greece go its own way. The negotiations with private investors are tense and it is difficult to see why hedge funds and other investors would throw good money after bad.  That is a business model that is fine with Greece but has no appeal to larger markets.

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All Eyes on the US Dollar in 2011


According to Standard Life Investments, the US Dollar will be one of the top currencies in 2011. (The other currency they cited was the British Pound). How can we understand this notion in the context of record high gold prices and commentary pieces with titles such as “Timing the Inevitable Decline of the U.S. Dollar?”

The Dollar finished 2010 on a high note, both on a trade-weighted basis and against its arch-nemesis, the Euro. Speculators are now net long the Dollar, and according to one analyst, it is now fully “entrenched in rally mode.” Never mind that its performance against the Yen, Franc, and a handful of emerging market currencies was less than stellar; given all that happened over the last couple years, the fact that the Dollar Index is trading near its recent historical average means that the bears have some explaining to do.

To be sure, none of the long-term risks have been addressed. US public debt continues to surge, and will not likely abate in 2011 due to recent tax cuts. Short-term interest rates remain grounded at zero, and long-term yields have only just begun to inch up, which means that risk-taking investors still have cause to shun the Dollar. Ironically, signs of economic recovery in the US have reinforced this trend: “The [positive economic] data, which one would ultimately assume is positive for the U.S., looks better for risk, which in turn puts downward pressure on the dollar.” Finally, the the Financial Balance of Terror makes the US vulnerable to a sudden decision by Central Banks to dump the Dollar.

So what’s driving the Dollar in the short-term? The main factor is of course continued uncertainty in the Eurozone over still-unfolding fiscal crisis, which is directly driving a shift of capital from the EU to the US. Next, the budget-busting tax cuts that I mentioned above are predicted to both boost economic growth and make it less likely that the Federal Reserve Bank will have to deploy the entire $600 Billion that it initially set aside for QE2. (To date, it has spent “only” $175 Billion in this follow-up campaign, compared to the $1.75 Trillion that it deployed in QE1). According to The Economist, “JPMorgan raised its growth forecast for the fourth quarter of next year to 3.5% from 3% as a result [of the tax cuts]. Macroeconomic Advisers, a consultancy, says the new package could raise growth to 4.3% next year, up from its current forecast of 3.7%.”


In fact, long-term rates on US debt have started to creep up. They recently surpassed comparable rates in Canada, and even risk-taking investors are taking notice: “U.S. bond yields are attractive and interesting again,” indicated one analyst. Of course, when analyzing the recent increase in bond yields, it’s impossible to disentangle inflation expectations from concerns over default from optimism over economic. Nevertheless, the consensus is that rates/yields can only rise from here: “The CBO [Congressional Budget Office] estimates that interest rates on 3-month bills and 10-year notes will reach 5.0% and 5.9%, respectively, by 2020.”

As if this wasn’t enough, the exodus out of the US Dollar over the last few decades has virtually ceased, with the US Dollar still accounting for a disproportionate 62.7% of global forex reserves. Furthermore, economists are now coming out of the woodwork to defend the Dollar and argue that its supposed demise is overblown. At last week’s annual meeting of the American Economic Association (and in a related research paper), Princeton University economist Peter B. Kenen “argued that neither Europe’s nor China’s currency presents a valid substitute–nor an International Monetary Fund alternative to the dollar that was created some 40 years ago.” Even if the RMB was a viable reserve currency – which it isn’t – Kenen points out that for all its bluster, China has shied away from taking a more active leadership role in solving global economic issues.

In short, as I’ve argued previously, the Dollar is safe, not just for the time being, but probably for a while.

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“Risk-On, Risk-Off”


It sounds like a play on words, based on the Karate Kid refrain, Wax-On Wax Off, and for all I know it was. Still, I rather like this characterization – coined by a research team at HSBC – of the markets current performance. Moreover, you’ll notice from the placement of that apostrophe that I’m not just talking about forex markets, but about the financial markets in general.

What we mean is that when risk appetite is high, credit markets and equities and high-yielding currencies tend to rally together. When risk appetite fades, “those assets fall and government bonds and safe-haven currencies, including the U.S. dollar, the Swiss franc and, in particular, the Japanese yen rally.” Data from Bloomberg News confirms this phenomenon: “The 120-day negative correlation between Intercontinental Exchange Inc.’s Dollar Index and the Standard & Poor’s 500 Index was at 42.4 percent today, and has been mostly above 40 percent since June 2009.”

Skeptics counter that this correlation is tautological. Anyone can point to a stock market rally and declare that “Risk is Back On.” In addition, it’s not wholly unsurprising that there are strong correlations between low-risk currencies and low-risk assets, and between high-risk currencies and high-risk assets. According to HSBC, however, this time is different.

US Dollar Versus S&P

For example, models suggest that the recent decline in volatility should have caused these relationships to break down. That they defied predictions and remained strong suggests that we have witnessed a significant paradigm shift. In the past, “Rising correlations are also tied to weak macroeconomic conditions.” At the moment, this could hardly be more true, with global economic growth flagging.

Statisticians love to teach the dictum, Correlation does not imply causation. Nonetheless, I think that in this case, I’d wager to say that the equity and credit/bond markets are driving forex, rather than the other way around. Consider as evidence that, “[Retail] Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year,” and shifted this capital into bonds. While this wouldn’t in itself be enough to drive the Dollar higher, it epitomizes the steady shifts that have been taking place in capital markets for nearly a year, broken only by the S&P/Euro rally in the spring (which now appears to have been an aberration).
Investors Shift Money from Stocks to Bonds
In fact, these shifts are once again creating shortages of Dollars: “This week, two banks bid at the European Central Bank’s weekly dollar liquidity providing auction – the first time there have been any bids since May – suggesting that they could not raise dollars in the market.” This suggests that demand for the Dollar could continue to grow.

Some analysts have suggested that the low-yielding US Dollar is already on its way to becoming a funding currency for carry traders, but I think this is wishful thinking. The HSBC report supports this conclusion, “A weakening of the ‘risk on-risk off’ paradigm is likely only once macro conditions are improved in a sustainable way…Currency performance will likely be tied to the ebb and flow of the perception of risk for some months to come.” In short, until there is solid proof that the global economy has emerged from recession (even if ironically it is the US which is leading the pack downward), the Dollar will probably remain strong.

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Oil Increases to Smash Equity Rally, Halt Consumer Spending


The price of oil topped $82 per barrel on Wednesday.  After a slight fallback on Thursday, oil is ready to open at $81.63 on Friday morning.  Meanwhile, US equities are riding an eight-day winning streak and have the 12,000 mark in sight as the S&P 500 reached its highest point since October 2008.

Yet, a feeling of doom still persists over equity markets and the dollar index.  And, the price of oil is very much at the center of the concern.  Rick Szpila of JPMorgan Futures discussed the tenuous relationship between oil and equities with CNBC on Thursday.

oil

“If you take a look at the movement of crude oil and the S&P 500 Index through most of 2009 and 2010, it has moved pretty much in the same direction.  As equity indexes have risen, the oil index has moved up.  The price of oil has not been a hindrance to equity markets,” suggests Szpila.

Another analyst, J.J. Burns of J.J. Burns and Company was more cautious about the oil-equity relationship.  Using the fact that every one-cent increase in the price of gas accounts for $1.3 billion in diminished funds available for consumer spending, Burns stressed that a major equity disaster was looming.

Citing the fact that consumer spending is the key to national and global economic recovery, the price of oil is very much an issue.  Twelve months ago, the average price of one gallon of gas in the U.S. was $2.60.  Today that price is closing in on $3.00.  The $0.40 per gallon increase translates to $52 billion in diminished consumer spending.

American motorists are now paying more for gas than any any time since October 2008.  Prices rose further on Thursday on expected Spring and Summer increased demand.

The Thursday per gallon price rose to $2.799, once cent above Wednesday’s close.  Prices have increased 18.9 cents in the last 30 days and 87.9 cents in year-over-year comparisons.  Americans are now spending approximately $300 million more per day to fuel their vehicles than they did one-year ago.  The U.S. Energy Department projects $3.00 per gallon gas by mid-spring.

The Repercussions

Last year crude oil was valued at about half of today’s $80 per barrel rate.  On October 23, 2008, one gallon of gas averaged $2.83.  Round Earth Capital Chief Investment Officer, John Kilduff, told CNBC that this summer he expects gas to hit the $3.10 level.

Most analysts expect a severe downturn in consumer confidence at the $3.00 mark.  Low-income earners are already feeling the pinch, and retailers who cater to these consumers are nervously tracking spending habits.  Stores like Wal-Mart and K-Mart are beginning to pare inventories in anticipation of the oil increase.  The Southeast and West Coast are expected to be hardest hit by the rate increases.

Areas that presently have high unemployment or that rely on the construction industry are likely to be especially hard hit.  One analyst projected that if prices top the $3.00 mark, the average Mississippi driver will spend about 11% of their income on fuel.  One positive fact is that U.S. consumers are using less driving fuel than in recent years.

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The Dollar in 2010


I thought it would be fitting to follow up my last post (Forex in 2009: A Year in Review), with one that looked forward. And what better way to do that then by squarely examining the US Dollar, which is still the undisputed heavyweight champion of forex markets, and from which most other forex trends can be ascertained and comprehended.

December (I know I said I wouldn’t look backwards, but come on, a little context is necessary here…) was the best month for the Dollar in 2009. From December 1 to December 31, it rose 4.7% against the Euro and 7% against the Yen, as part of an overall 4.8% appreciation against a basket of the world’s six other major currencies. “The dollar rally which has taken place in December is significant in that it has brought an end to the powerful downtrend which had been in place since March following the Fed’s decision to begin quantitative easing,” summarizes one analyst. As a result of the Dollar’s strong turnaround in December (and the forgotten fact that it actually appreciated in the beginning of last year), the broadly weighted Dollar Index finished 2009 down a modest 4%.

Dollar index 2009

Analysts summarized this turnaround using a few main paradigms. The first was that logic had returned to the forex markets, such that the negative correlation between equities (which serve as a broad proxy for risk sensitivity) and the Dollar had broken down [See earlier post: “Logic” Returns to the Forex Markets, Benefiting the Dollar]. As a result, good economic news was once again good for the Dollar. The second interpretation was a direct contradiction of the first, and argued that the Dubai debt bomb, coupled with credit scares in Europe, had in fact increased risk aversion, and reinforced the notion that the Dollar is still a safe haven [Edward Hugh mentioned this in my interview of him]. The third theory represents a slight twist on the first one- that concern over Fed interest rate hikes will shift interest rate differentials and cause the Dollar carry trade to break down. Technical analysts, meanwhile, argue that the Dollar had been oversold, and that the year-end rally was merely a product of the closing of short positions and profit-taking.

The key to predicting how the Dollar will perform in 2009, then, largely rests in correctly discerning which paradigm currently underlies the forex markets. Let’s begin by comparing the first possibility – that good economic news will be good for the Dollar – to its antithesis – that the Dollar remains the safe havens. I think two WSJ headlines can shed some light on which interpretation is more accurate: Dollar Rises On Lower Demand For Riskier Assets and Dollar Slumps As Investors Snap Up Risky Assets. In other words, the market logic is that the Dollar is still a safe-haven currency, to the chagrin of market fundamentalists.

While there are certainly “naysayer” analysts that think the US stocks will soon outpace their counterparts abroad (namely in emerging markets), such a view can best be ascribed to the minority. The majority, then, believes that good economic news (from the US, or anywhere else from that matter) is a sign that risk-taking is relatively less risky, and will lead to capital flight from the US. In short, “It’s too early to dismiss the negative correlation between equities markets and the dollar, i.e., when risk appetite declines, that still seems to favor the dollar even though we’ve seen a slight decoupling from that in early December.”

With regard to the notion that the Dollar is being driven by expectations that the Fed will tighten monetary policy at some point in 2010, that seems to have some traction. The markets have priced in a 60% possibility of a Fed rate hike by June, and a majority of economists (9 out of 15 surveyed) think that the Federal Funds rate will be higher at the end of the year. This optimism is a product of the last month, which saw strong improvements in non-farm payrolls, housing sales, durable goods orders, ISM supply index, and more. Some of these indicators are now at their highest levels since 2006; “That speaks better about the health of the U.S. economy and that could help move up the timetable for the Fed to boost interest rates,” goes the accompanying logic.

That investors believe the Fed will hike interest rates and that it will be good for the Dollar is not so much in dispute. Whether investors are right about rate hikes, on the other hand, is less certain. To be sure, momentum is growing in the US as the economy shifts from recession to growth. While current data is unambiguous in this regard, the future is less certain. A vocal minority of analysts argues that the apparent stabilization is largely due to government incentives. When these expire, then, the result could be a double dip in housing prices, and a second act in the economic downturn.

The result, of course, would be a delay and/or slowing in the pace of Fed rate hikes. Some economists predict that that Fed will indeed hike rates in 2010, but only incrementally. Others have argued that it won’t be until 2012 that the Fed lifts its benchmark FFR from the current level of approximately 0%. Instead, the Fed will first move to withdraw some of the liquidity that it unleashed over the last two years, of which an estimated $1.1 Trillion still remains “in play.” Such would be directed primarily at heading off inflation, and wouldn’t do much for the Dollar.

Regardless, the implication is clear: “The fate of the dollar is in the hands of Ben Bernanke. If he begins the exit process and starts to raise interest rates, the dollar will perform okay this year.” If he stalls, and investors accept that they may have gotten ahead of themselves, well, 2010 – especially the second half – could be a sorry year for the Dollar.

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Dollar at a (Technical) Crossroads


I deliberately concluded my last post (US Dollar: Same Old Story) on a somewhat ambiguous note; even though though the deck is stacked against the Dollar, its 14% decline in 2009 has left it perilously close to record lows, and traders are nervous about pushing the limits further.

Euro

On the one hand, everyone believes that the Dollar is fundamentally still in a weak position. The US balance of trade remains deep in deficit. Government spending has exploded, with record-setting deficits and an expansion in the national debt. Interest rates are at rock bottom, and are by some measures, the lowest in the world. Despite signs of life, the economy remains mired in recession. The money supply has also expanding, to the extent that some long-term investors are wondering out loud about the possibility of future inflation.

As a result, the decline in the Dollar since last spring has suffered very few blips, with volatility declining at the same pace as the currency, itself. “There seems to be a paradigm shift underway where more and more foreign investors are becoming concerned that the long-term path of the dollar is downward,” summarized one analyst. The consensus among investors is almost eerie. “Speculators betting that the dollar index will fall outnumber those betting that it will rise by nearly 2 to 1, according to the Commodity Futures Trading Commission.”

Some (mainstream) analysts have even begun to open consider the possibility of a crash in the Dollar, a view that had previously been relegated to conspiracy theorists and doomsday scenarists. “In a run on the dollar, that thinking would create a cascade — fearful global investors would shy away from dollars, expecting further steep declines, creating a self-fulfilling prophesy.” Adds a former Chief Economist of the IMF, “Every time the dollar starts depreciating there is angst and everybody starts raising the question what happens if there is a collapse.” While the majority of Dollar-watchers still believe that a Dollar crash is unlikely, the point is that they are now discussing it actively.

Despite the fact that all of these factors are already in place, the Dollar remains relatively buoyant. Personally, I think this is because investors don’t really want to acknowledge that this is a real possibility. For one thing, the alternatives aren’t any better. While forex investors in recent years have enjoyed ganging up on the Dollar, the fact remains the fundamentals for the other major currencies remain just as weak. For example, a model of purchasing power parity developed by “the Organization for Economic Cooperation and Development finds the dollar is worth roughly 0.85 euro, compared with its market valuation of 0.67 euro, suggesting that the euro is 21% overvalued.” Likewise, the Yen is held to be 22% undervalued.

Dollar Valuation 2009

As a result, the market as a whole is having trouble pushing the boundaries. The Dollar has approached the psychologically important level of $1.50/Euro on several occasions, but has retreated each time. “People are wondering whether we’re going back to $1.46 in euro/dollar or heading toward $1.54. But one thing is for sure, as we head toward $1.50, we’re going to experience a lot of volatility,” summarized one analyst.

“Risk reversals, a measure of currency sentiment in the options market derived by looking at the difference in implied volatility between out of the money calls and out of the money puts, show a bias for euro puts, trading at a mid-market level of 0.2. That means investors are hedging their short dollar positions with bets for a euro downside even though no one expects the euro to fall.” Meanwhile, volatility has edged up slightly, reflecting an increased level of uncertainty surround the near-term direction of the Dollar. It could be the case that if the Euro breaks through $1.50, heartened investors will send the currency up even higher, while a failure to break through means investors just aren’t read to commit. A classic technical crossroads!

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Carry Trade Still Popular, but Doubt is Growing


It’s safe to say that the inverse correlation observed between the Dollar (and also the Yen) and global equities is largely a product of the carry trade. “The U.S. stock market bottomed and the U.S. Dollar Index peaked almost simultaneously in March. While U.S. stocks are up more than 50% in that time, the Dollar Index (which measures the greenback’s value against the euro, the yen, the British pound, the Canadian dollar, the Swedish kroner and the Swiss franc) is down nearly 12%,” observed one analyst.

On one level, this represents a return to 2008, prior to the explosion of the credit crisis, when carry trading was THE dominant theme in forex markets. However, there is one important difference. While the Dollar and Yen were the funding currencies then and now (due to their low interest rates), there has been a slight shift in the currencies selected for the opposing/long end of the trade.

am-af721_carryh_ns_20090417053224
Traditionally, the most popular long currencies were those of industrialized countries, rich in commodities and backed by high interest rates and often rich in commodities. To be sure, these currencies have shined in recent months, certainly due in part to speculative (carry) trading. “Strategists at Wells Fargo Bank in New York ‘believe that the gains in the dollar-bloc currencies (Australia, New Zealand, Canada) have run ahead of the gains in commodity prices.’ ” The Bank of Canada also noticed that “At the time of its last statement, oil prices were about $75 a barrel, but now they are in the $60-to-$65 range. That suggests the currency’s appreciation has outpaced the demand for its commodity exports.”

But the run-ups in the Kiwi, Aussie, and Loonie have been overshadowed by even more rapid appreciation in emerging market currencies. This shift is largely a product of changes in interest rate differentials, which are now gapingly large between developed countries and developing countries. Compare the 2.75%+ spread between the US and Australia, with the 8.5% spread between the US and Brazil or 12.75% between the US and Russia. For investors once again becoming complacent about risk, the choice is a no-brainer.

Still, some analysts are nervous about this change in dynamic: “While the new carry trade may be less leveraged, it’s an inherently riskier bet. As such, it’s more vulnerable to the kind of swift unraveling of risk appetite observed across all nations and sectors in 2008, but which occurs with far more frequency in emerging markets.” Meanwhile, emerging market stocks have behaved volatilely over the last few weeks (with Chinese stocks even entering bear market territory), and some investors are concerned that they may be temporarily peaking. There are also signs that bubbles may be forming in carry trade currencies, with bullish sentiment at high levels. Accordingly, one strategist suggests waiting out a 5% pullback in the Australian dollar, and a 10% pullback in the New Zealand dollar before going back in.

There is also the outside possibility that the Fed will raise interest rates, which would crimp the viability of the US Dollar as a funding currency. Granted, it seems unlikely that the Fed will tighten within the next six months, but investors with a longer time horizon could begin to adjust their positions now, rather than wait until the 11th hour, at which point everyone will be rushing for the exits.

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