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Daily Market Commentary

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What is Behind the Dollar Rally?

Tue, Dec 2 2008, 22:17 GMT
by Kathy Lien

GFT

Fresh concerns about the global economy have triggered sharp gains in the US dollar and the Japanese yen. Risk aversion continues to seep through the markets as the National Bureau of Economic Research finally admits that the US economy fell into recession in December 2007. The first trading day of the last month in the year has been exceptionally brutal with the Dow Jones Industrial Average falling more than 635 points or 7 percent. Even President Elect Barack Obama’s nomination of Hillary Clinton as Secretary of State has failed to help the markets.

Dollar Remains the Safe Haven Play, Bernanke Signals More Rate Cuts

There is no question that the meltdown in the equity market singlehandedly triggered the sell-off in the currency market today. Most people knew that the US economy was already in recession, but as reality hits with the official NBER announcement, investors bailed out of equities once again. In fact, we have seen a global flight to safety today with stock exchanges across Europe slipping more than 5 percent. The flight to safety has led to repatriation back into US dollars even though there is still more trouble ahead for the US economy. On day when manufacturing indexes across the globe hit decade to record lows, the US Federal Reserve was the only central bank to offer practical reassurance. Fed Chairman Ben Bernanke said in a speech today that further interest rate cuts are certainly feasible and even though their scope for conventional rate policy is limited, their other options include buying long term Treasuries or agency securities in substantial quantities.

Cyber Monday May Not Save the US Economy

Investors are looking to Cyber Monday in the hopes that retail sales may support the economy but even if consumers spent more this year than last, it is a result of discounts rather than underlying demand. Foot-traffic at the nation’s retailers on Black Friday was stronger than expected but many forecast that because the discounts were so deep this season, often reaching more than 50%, increased sales will not transfer into strong profits. The shopping event that transpired last Friday was more of an act of desperation by retailers than anything else. Industry groups, such as the National Retail Federation, note that weekend traffic fell-off significantly as buyers felt satisfied that they took advantage of all available discounts during Friday’s rush. In addition, more shoppers indicated that they were already done with their holiday shopping this year than last. Buyers also specified that gift purchases will be constrained to the younger audience, with older friends and family agreeing to forgo adult gifts. This type of behavior suggests that the momentum may be difficult to sustain for the remainder of the month.

Dollar Rally Should Continue

This is the week where the problems in the US economy will come to forefront as reality sets in and investors realize the US is still in big trouble. If the data is as bad as we expect, the dollar rally should continue. We said often that recession trades such as short EUR/JPY and USD/JPY should thrive in this current environment and that is exactly what we have seen today. Contributing to the sell-off in US equities was the ISM manufacturing report which fell to a 26 year low. Every single subcomponent of the report either declined or remained unchanged with big drops seen in the prices paid and employment components. As we week progresses, we will be looking at the leading indicators for non-farm payrolls for clues on the degree of job losses in the month of November. The manufacturing ISM report suggests that the sector will see its 29th consecutive month of job losses. The fate of the Big 3 automakers will play a central role in determining whether this continues.

GBP/USD: BRITISH POUND TAKES A BEATING

With the recession in the UK economy in full swing and the Bank of England scheduled to cut interest rates this week, further weakness in the British pound was expected. However not many people could have anticipated the degree of the sell-off that we saw in the British pound today. The currency fell 3 percent or close to 500 pips against the US dollar, 2.8 percent (230 pips) against the Euro and a whopping 5.4 percent (800 pips) against the Japanese Yen. This price action indicates that the latest pieces of UK economic data suggest that the economy may be in weaker state than everyone initially anticipated. The Bank of England has a tough decision ahead of them and a full percentage point rate cut is the minimum that we expect on Thursday.

The contraction in the UK manufacturing sector continues with the purchasing managers’ index falling to a record low of 34.4 in the month of November. Not only was the index much weaker than expected, but the new orders component also slipped to a record low. The deterioration in business confidence amid the mild improvements in consumer confidence suggests that consumers may not be translating their less pessimistic attitude into stronger spending. Mortgage approvals also fell to the lowest level in 9 years as the credit markets remain tight. Bank of England Governor King has previously said that the single most challenging task at hand is to get credit to flow into the economy again. This is one of the main reasons why the central bank has been very aggressive in recent weeks. If the BoE still believes that over-delivering is the right solution, then we could see a bigger move on Thursday. Even if rates are only cut by 100bp, the next rate cut will certainly not be their last. While the Monetary Policy Meeting of December 4th will likely see rates decline to 2.00 percent, interest rates may not hit a bottom until 1.00 percent.

AUD/USD: RESERVE BANK EXPECTED TO CUT 75BP

It is a big night for Australia with retail sales, current account and an interest rate decision on the economic calendar. The Reserve Bank of Australia is expected to cut interest rates by 75bp to 4.5 percent. Of the major currencies, Australia has the second highest interest rate, but that has not stopped the Australian dollar from being the second worst performing of the year against the US dollar. The RBA has already cut interest rates by 175bp this year and the monetary easing this evening will drive Australian rates to 6 year lows. Since the OECD believes that Australia will avoid recession and the government believes that the weakness of the Australian dollar should help support growth, it remains to be seen whether the RBA will signal further rate cuts. If they do, the Australian dollar could break 63 cents but if their statement is neutral, the Australian dollar should rally. Like the rest of the world, Australia reported a sharp decline in their manufacturing PMI report for the month of November. There was no data from New Zealand overnight, but Canada reported the fastest pace of annualized GDP growth in 1 year. Although the Canadian dollar initially rallied after the reports, the gains were not sustained as oil prices slipped and the Bank of Canada warned that a slowdown in growth will prompt continued rate cuts.

EUR/USD: WEAK ECONOMIC SUPPORTS NEED FOR LARGER RATE CUT

The theme of today’s trading can be emphasized as broad contraction in global manufacturing. We have seen Manufacturing-related indicators from across the globe show that the world may truly be in a Manufacturing recession. Euro-zone PMI was reported to be the worst on record since the figure was established a decade ago. German and Italian PMI reiterate the results from the broader measure. German Retail Sales were also much weaker than expected, showing a 1.6 percent compared to a +0.5 percent forecast. EUR trading responds with seemingly small declines amidst some impressive falls in GBP/USD and USD/JPY. At this time, all attention will be concentrated on Thursday’s ECB rate decision. Today’s economic results certainly support the need for a larger rate cut. When compared to it peers, the ECB has not reacted with much force when easing monetary policy, perhaps opening the door to a sizeable rate cut later this week. Tomorrow, we will see EZ Producer Prices, likely to elicit little attention as the focus has long been diverted from inflation.

USD/JPY: BOJ PREPARES FOR EMERGENCY MEETING

Although the Bank of Japan’s plans to hold an emergency policy meeting this week should have helped spur demand for the Japanese Yen, it was the sharp drop in equities that really drove the currency higher. Once again, the Yen has outperformed all of the major currencies including the US dollar as risk aversion hits the markets. However the announcement from the BoJ should not go unnoticed. Recognizing that interest rates are at ultra low levels, the BoJ is searching for other ways to stimulate the economy. According to the Japanese press, the bank will be looking into creating a special lending program aimed at stimulating lending by bands. Under the plan, the BoJ would accept lower credit rating corporate bonds as collateral. Even though any announcement from the BoJ should help the Japanese financial system, it may not impact the Japanese Yen. Keep an eye on equities as the Nikkei may open lower, adding pressure on the Japanese Yen crosses.

AUD/USD: Currency in Play for the Next 24 Hours

AUD/USD will be the currency in play for the next 24 hours. The Australians are engineering one of their most influential economic days of this month. Among the vast array of expected economic indicators, the Current Account Balance and Retail Sales Trend will be released at 00:30 GMT and the much anticipated RBA Rate Decision is scheduled for 3:30 GMT.

AUD/USD has been able to maintain itself within the range-bound Bollinger band zone for the last few days. The pair has been in a volatile consolidation phase that has lasted for most of the month of November. Traders are still debating whether or not the economic conditions in Australia warrant the further continuation of a strong downtrend. Several areas of support exist below current prices. While the first and second-standard deviation Bollinger bands will be important levels, the most significant support should be in the form of the lows placed at 0.6084. Lying above, resistance takes shape at 0.6609, which saw its significance develop as it has resisted several rally attempts in the last week. If this resistance level is broken, it is conceivable that prices may be able to extend toward the 0.7000, a major high placed on November 4th. However, a break of the 0.6084 may be the start of a new leg in this crippling bout of Aussie devaluation.

Published on  Tue, Dec 2 2008, 22:20 GMT