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U.S. Dollar: The Divergence Trade

Last updated 2/25/2010 5:46 PM ET (GMT -5) 2 Comments

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Kathy Lien

Director of Currency Research, GFT

THE STORIES IN THE CURRENCY MARKET

• U.S. DOLLAR: THE DIVERGENCE TRADE
• EUR/USD: GAINS COULD BE FLEETING
• GBP/USD: COLLAPSES UNDER WEIGHT OF MONETARY POLICY
• NZD/USD: TRADE RETURNS TO SURPLUS
• AUD/USD: SHARP RISE IN PRIVATE CAPEX
• USD/CAD: OIL DOWN, GOLD UP
• USD/JPY: EURJPY HIT 1 YR LOW

EXPECTATIONS FOR UPCOMING FED MEETINGS

U.S. DOLLAR: THE DIVERGENCE TRADE

It has been another interesting trading day in the financial markets with equities and currencies staging a sharp end of day reversal.  The EUR/USD traded within a hair of its 9 month low on an intraday basis a few times before moving into positive territory.  Economic data in the U.S. was very weak and more troubles in the Eurozone caused a wave of risk aversion throughout the European and early U.S. trading session.  However it was the encouraging comments from Fed President Bullard that stoked the recovery.  Traders were also relieved that Bernanke did not say anything particularly damaging in the second day of his testimony on monetary policy.  Today’s reversals in the forex market may be important but not as much as the divergence in price action across various currency pairs.  

The Divergence Trade

The WSJ published a big story yesterday about a Texan hedge fund manager who bet on the divergence between growth in Germany and Greece (2 members of Eurozone). His wager paid off handsomely with Greece now in such deep trouble that they may have to seek a bailout from Germany.  Economic divergence is one of those long term factors that can have a big impact on currencies, equities and bonds but usually take a long time to pan out.  At the beginning of a recovery, the market pays particular attention to economic divergence as they try to figure out who will raise interest rates first.  In the current recovery, economic divergence is even more important because not only are different countries growing at a different pace, but each part of the world is dealing with different issues.  Another name for the economic divergence trade is the relative growth trade which we have talked about in the past.  Today’s price action in the currency markets is an example of economic divergence or relative growth in action.  Having been down as much as 180 points at one point, the reversal in the equity market helped some but not all of the major currencies.  The euro benefitted the most with the sell-off in the U.S. dollar pushing the currency into positive territory.  Although the Eurozone is plagued with problems, the EUR/USD had become deeply oversold in recent weeks, which is why its recovery was stronger than others.  The commodity currencies also captured back more than 50 percent of its prior losses while the GBP/USD ended the day only marginally off its lows. USD/JPY suffered terribly after weak U.S. economic reports and remained under pressure throughout the NY trading session. Risk appetite and the dollar are important but the degree of the moves in various currencies will largely depend upon relative growth.  This also means that we could see some big trends in the crosses in the coming months. 

Fed Comments vs. U.S. Data

Bernanke’s comments today were virtually identical to the comments that he made yesterday.  He did touch a bit more on the damage that high deficits may have on confidence and investment and urged China to have flexibility in the Yuan.  His comment about the Chinese currency was related to a letter submitted by 15 Senators on Thursday to Commerce Secretary Gary Locke.  The senators called for action against Chinese currency manipulation which they feel acts as a subsidy for their exporters.  In response, China reaffirmed their intention to keep their exchange rate steady.  The markets have become use this dance between the U.S. and China and we believe that the outcome this time around will be exactly the same.  The U.S. needs China to keep buying Treasuries and as a result will avoid any official criticism of their currency.  Meanwhile Bullard helped to pacify some fears by calling the recovery reasonably good.  As for this morning’s economic reports, they were filled with disappointments.  Even though durable goods orders rose 3.0 percent, if you take away the big contribution from non-defense (think Boeing) aircraft orders, durable goods fell 0.6 percent, the biggest decline since August 2009. Yet what really triggered dollar bulls to sell were the jobless claims figures. First time claims jumped for the second week in a row to 496k from 474k, the highest level since November. Two weeks of sharply higher jobless claims raise red flags for the labor market especially since economists thought claims would drop. Continuing claims also rose from 4.61M to 4.617M.  It will be a busy day in the U.S. tomorrow with the second release of U.S. fourth quarter GDP, Chicago PMI, the final February University of Michigan Consumer Sentiment numbers and existing homes on the calendar.  

EUR/USD: GAINS COULD BE FLEETING

It has been an extremely active day in the EUR/USD.  The currency pair came within a whisker (7 pips) of its 9 month low during the Asian trading session but recovered sharply in early Europe.  However when U.S. traders joined the fray, they took the EUR/USD down once again, this time within 11 pips of its 9 month low.  When the U.S. equity markets opened, the dollar was sold aggressively pushing the EUR/USD to a high above 1.3530.   Yet just as quickly as those gains were achieved, the EUR/USD gave it all back before lunchtime. Only after 12 noon NY Time did the EUR/USD begin its final ascent which eventually took it to the day’s high of 1.3571.  As you can see, it has been a rollercoaster ride for anyone trading euros as developments in Europe, U.S. data, comments from Fed officials and equities all fight for control of the currency pair.  Despite the recovery in the EUR/USD, Greece remains in the background. Standard & Poor’s warned that Greece could face a 1 or 2 notch downgrade in a month if they do not get their act together.  According to S&P, “Downside risks for Greece’s real and nominal growth are likely to increase the size of needed fiscal consolidation, raising questions about the feasibility of the country’s ambitious budget goals,” and “Political risks" may impede "the timely implementation" of the "fiscal reforms."  The WSJ has also warned that Spain could be the next problem area in the Eurozone.  Meanwhile, Eurozone confidence numbers were pretty much in line with expectations. German unemployment numbers however were strong with the number of people filing for unemployment benefits rising only 7k compared to the market’s 16k forecast.  Yet this did not stop the unemployment rate from rising to 8.2 percent on a seasonally adjusted basis.  The European Union kept their 2010 growth and inflation forecasts unchanged with growth expected to rise by 0.7 percent this year and inflation expected to increase by 1.1 percent.  These are very lackluster numbers especially considering the Fed expects growth to expand in a range of 2.8 to 3.5 percent this year.  The EU is worried about “serious adverse risks” in the financial markets and mounting concerns on sustainability of public finances.  The recovery in the region is fragile and if EU nations are forced to cut spending or raise taxes to rein in their deficits, various countries could hit a “soft patch” later this year.  Given the headwinds and hurdles that still exist for the Eurozone in the coming months, the recovery in the EUR/USD is clearly linked to the recovery in stocks.  In the long run, we continue to expect the euro to underperform the dollar.  

GBP/USD: COLLAPSES UNDER WEIGHT OF MONETARY POLICY

The worst performing currency today was the British pound which fell sharply against the U.S. dollar, euro and Japanese Yen.  In fact, the sell-off in the GBP against the EUR was the strongest since October.  Despite all of the troubles that the Eurozone may be facing, traders are still opting to buy euros over sterlings simply because the Bank of England is talking openly about more monetary stimulus.  This shows you the power that monetary policy can have on a currency.  Although MPC member Barker tried to sound like the good soldier by saying that she is encouraged by the improvement in growth and that employment has not fallen as much as expected, MPC member Miles did not share her sentiment.  He solemnly said that there is a lot of slack in the U.K. economy and there are more risks to U.K. growth not returning to normal.  Miles also added that depending on the economy, the BoE may add to purchased stock and so it is premature to write the obituary of the central bank’s QE policy.  Overall, the underperformance of the GBP is clearly linked to Bank of England’s monetary policy stance.  Total Business Investment was the only piece of U.K. economic data released this morning and unfortunately based upon the report, business investment plunged 5.8 percent in the fourth quarter.  This should not be all that surprising considering the softness of the economy and the tightness of credit.  The second release of Q4 GDP will be announced tomorrow and economists are looking for a small upward revision.  However if GDP is revised down and not up, leaving it at flat to negative growth in the Q4, we could see additional weakness in the British pound.   

NZD/USD: TRADE RETURNS TO SURPLUS

Although the New Zealand, Australian and Canadian dollars ended the day lower against the greenback, they recovered more than 50 percent of earlier losses.  Economic data from Australia continues to be strong, highlighting the country’s economic divergence and outperformance.  Private capital expenditure jumped 5.5 percent, the biggest increase in 12 months.  The strong increase in activity clearly reflects the influence that China is having on Australia and also validates the extremely hawkish comments made by RBA Deputy Governor Battelino earlier this week.  New Zealand also reported its first trade surplus in 7 months as imports fall faster than exports.  Despite being a neighbor of Australia, New Zealand isn’t experiencing the same degree of growth. Even though exports to China remain at elevated levels, they actually decreased in January.  Building permits also fell 2.8 percent which was more than the market had anticipated.  There was no data from Canada but that will change tomorrow with the current account numbers due for release.  An increase in trade and foreign demand for Canadian denominated securities is expected to reduce the current account deficit in the fourth quarter.  Australia is expected to release its private sector credit numbers and given the strength of the housing market, we expect credit to rise for the third consecutive month.  

USD/JPY: EURJPY HIT 1 YR LOW

Japanese Yen crosses fell across the board with EUR/JPY hitting a 1 year low on an intraday basis.  The weakness in USD/JPY prevented a meaningful recovery in the Yen crosses.  Talk of Yuan revaluation has most likely contributed to the rise in the Yen because Japan’s currency is typically perceived as the proxy for Asia.  If Chinese revalues the Yuan it is also positive for the Yen because it reduces the competitive advantage of Chinese exporters.  There was no major economic data released from Japan last night but Japan has a busy day ahead. A number of key releases will shed new light on the state of the Japanese economy. Manufacturing sector PMI is due for release along with consumer prices, industrial production, retail sales and housing starts.  Weak numbers are expected all around.

GBP/USD: Currency in Play for Next 24 Hours

he currency in play for the next 24 hours is GBP/USD.  The second release of UK Q4 GDP is due 9:30GMT or 4:30AM EST. This will be followed by the U.S. Personal Consumption and second Q4 GDP figures at 13:30GMT or 8:30AM EST. The U. of Michigan Confidence will be released at 14:55GMT or 9:55AM EST and Existing Home Sales at 15:00GMT or 10:00AM EST. The latest sell-off in the GBP/USD has pushed the currency pair deeper into the sell zone, which we determine using Bollinger Bands. The pair seems to be in a consistent downtrend which means that it may test the psychologically important support level of 1.5000. The Sell Zone is negated once the pair closes above the first standard deviation located at 1.5460.   

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Comments (2)

aea

February 25, 2010 at 07:01 PM ET

tanks Kathy , i could buy eur/usd . your analysis is excellent .

FXDragon

February 26, 2010 at 01:17 AM ET

I think you misinterpreted the article:)
Anyway we're selling stocks on any rally. Looks like that game will go on for a while.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.