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Daily Market Commentary

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How Much Further Can the US Dollar Fall?

Tue, Dec 16 2008, 22:39 GMT
by Kathy Lien

GFT

How Much Further Can the US Dollar Fall?

With dollar denominated assets yielding next to nothing, we have continued to see money flow out of the US dollar.  The greenback fell to the lowest level against the Euro since September and dropped to a new 13 year low against the Japanese Yen.  The losses have been even more staggering since the beginning of the month.  The dollar has fallen 14 percent against the Euro and 8 percent against the Japanese Yen.  This significant sell off begs the question How Much Further Can the Dollar Fall? If you watched the price action in the currency market this past year, you will know that trends dominate.  With only 2 weeks until the end of the year, we could be stepping into a longer phase of dollar weakness.

5 Factors that Could Drive the US Dollar Lower in 2009

There are 5 factors that could drive the dollar lower in the first quarter of 2009:

1.    Weaker Economic Data

2.    Disappointing Corporate Earnings

3.    Quantitative Easing

4.    Fiscal Stimulus

5.    Investor Outflow

With more Americans losing their jobs or having their salaries frozen, there is no question that the US recession will deepen in the first quarter of the New Year.  Therefore not only do we expect fourth quarter GDP to be particularly weak, but we also expect a larger decline in retail sales and non-farm payrolls.  In combination with the strength of the US dollar in the third and fourth quarters and the losses sustained in the Madoff Ponzi scheme, there is a strong chance that Q4 corporate earnings will be very weak for both financial and non-financial companies.  Disappointing data could raise fears that the recession will turn into a depression, which could fuel further losses in the US dollar.  In addition, quantitative easing and fiscal stimulus will pick up next year.  Quantitative easing is akin to printing money, which dilutes the value of the dollar.  More fiscal stimulus means more spending by the US government, which is also dollar bearish.  These reasons along with the ultra low level of US rates are why investors could stay out of US dollars in the first quarter of 2009.

Does it Matter if Other Central Banks are Cutting Interest Rates?

One question that we have been asked multiple times today is whether it will matter if other central banks are still cutting interest rates at a time when the Fed has run out of room to reduce interest rates.  The Euro currently has a 225bp interest rate premium over the US dollar.  The ECB would have to cut interest rates by a lot in order to bring them anywhere close to US levels.  Therefore, money will still flow into the higher yielding currencies, particularly the ones where the central bank is considering not cutting interest rates at their next monetary policy meeting (EUR and AUD).  We do expect the trend of dollar weakness to eventually reverse as Quantitative Easing and Fiscal Stimulus finally helps the US economy, but that may not be until the second half of 2009 at the earliest.  The only thing that could turn the dollar around would be if all of sudden the ECB cuts interest rates by another 75bp at their next meeting. 

USD/JPY: What Happens When the Interest Rate Spread Goes Negative?

This is not the first time in recent history that US interest rates have fallen below Japanese levels. It has happened 5 times in the past 40 years - the most recent was in 1993.  The following chart illustrates how USD/JPY performs whenever the interest rate spread between the US and Japan dips below zero.  As you can see, it almost always precedes a sharp drop in USD/JPY that lasts can last for months. 

EUR/USD: CONSEQUENCES OF THE EURO RALLY

The Euro had its strongest intraday rally today since its debut in 1999.  The move is a testament to the impact of interest rates on currencies.  We have long said that this is the number one driver of currency trends and the decline in liquidity near the end of the year has only exacerbated the rally.  Although the latest move in the Euro has some bank analysts revising up their EUR/USD 2009 forecasts to 1.60 and above, we want everyone to realize that the higher the EUR/USD rises, the more strain it will put on the Eurozone economy and the more reason it gives to the European Central Bank to cut interest rates.  When the ECB first started to talk about pausing in January, the EUR/USD was trading around 1.26 and it has now appreciated 14 percent.  Even though we also believe that the EUR/USD will continue to rise, we think that it may have a difficult time cracking above 1.48 and eventually, the trend will change. France’s largest bank BNP Paribas has been hit hard by the Madoff scandal.  This is an example of the troubles plaguing European corporations.  Consumer prices declined 0.5 percent last month, giving the central bank plenty of flexibility to cut interest rates if necessary. 

GBP/USD: UNEMPLOYMENT RATE HITS DECADE HIGHS

The title of our GBP/USD commentary yesterday was “Be Cautious of the Rally” and therefore it should be no surprise to our readers that the British pound was the only currency pair to sell off against the US dollar today.  The labor market numbers were very weak with the number of people claiming benefits rising 75.7k last month, the largest since 1991.  This drove the unemployment rate to 6 percent, the highest level since July 1999.  The minutes from the most recent monetary policy meeting reveal that the committee voted 9-0 to cut interest rates by 100bp to 2 percent.  The only reason why they held back on cutting interest rates even more was because they did not want to trigger an excessive drop in the British pound.  More rate cuts are expected and part of the reason why the GBP/USD underperformed today.  BoE Governor King openly warned that inflation will be completely out of their control for the next 2 years and in his letter to Chancellor Darling, he said that they are abandoning their efforts to meet the 2 percent target. Looking ahead, retail sales are due for release tomorrow.  Given the sharp decline in unemployment and the drop in BRC retail sales, consumer spending should have been very weak. Meanwhile the Euro continues to charge ahead against the pound, driving the EUR/GBP currency pair to a new record high of 0.9326. 

USD/CAD: CANADA IS ALREADY IN A RECESSION

All of the commodity currencies continued to strengthen against the US dollar today. Mark Carney, the Governor of the Bank of Canada announced that Canada is already in recession and as a result he plans to be more assertive with monetary policy.  He hinted at a new macro-prudential approach which “assesses current risks by looking at the broad economic and financial conditions that can contribute to the buildup of risks to the financial system and the economy as a whole.”  Meanwhile oil prices dropped 3.10 despite the fact that OPEC announced a larger production cut.  More easing is expected from the BoC, which could weigh on the Canadian dollar going forward.  Wholesale sales were very weak, suggesting that we could see a sharp decline in retail sales tomorrow.  Weak economic data has not prevented the AUD/USD from rally.  Both skilled vacancies and leading indicators deteriorated from the prior month.  Tomorrow, Australia will report the Westpac Survey for Industrial Trends, while New Zealand is scheduled to produce its NBNZ Business Confidence report.

USD/JPY: BOJ POISED TO FOLLOW FED’S LEAD?

The Bank of Japan will be making a monetary policy announcement tomorrow.  Although interest rates are already very low, there is a growing chance that the BoJ could actually cut interest rates.  A consensus has indicated that there is more than a 50/50 chance of a rate cut tomorrow.  Now that the Fed has brought rates below that of Japan for the first time since 1993, the BoJ may be willing to follow by example. After a disastrous period of harsh economic growth spurred by zero-bound interest rates earlier this decade, it seems inconceivable that the country would want to embark down these roads once more. However, in the midst of yet another recession, political pressure is mounting, credit markets are seizing-up and exports have come to a complete halt; there may be a chance that the BoJ will make one more last-ditch effort to restore some levels of confidence. We still believe that they won’t.  On a longer-term basis, the central bank will most likely join the US in quantitative easing to further inhibit liquidity expansion. 

EUR/GBP: Currency in Play for Next 24 Hours

EUR/GBP will be the currency in play for the next 24 hours. For the euro, we will see the release of the German IFO at 4:00 am ET or 9:00 GMT, which includes important economic measures such as the Business Climate, Current Assessment, and Expectations. For the UK, we are expecting Retail Sales and Public Sector Net Borrowing at 4:30 am ET or 9:30 GMT.

EUR/GBP is definitely within the Bollinger band buy zone. In fact, it is becoming difficult to come up with resistance levels, as each move higher is another record. Using Fibonacci extensions we can see that price action has already broken the 161.8% extension, of course we will still need to see a close above the level to confirm it has been broken. Any further resistance is probably better suited for psychological levels, like 0.9500. Support could be seen as the 0.9000 level, another psychological level that has also supported today’s low and previous highs. Obviously, such a situation is difficult to predict technically, but it is clear that further price action is biased to the upside.

Published on  Wed, Dec 17 2008, 22:18 GMT