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Can the Dollar Rally Continue?

Last updated 1/30/2009 5:40 PM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

THE STORIES IN THE CURRENCY MARKET

• CAN THE DOLLAR RALLY CONTINUE?
• GBP/USD: FRUITS OF BOE LABOR
• EUR/USD: HITS 1 MONTH LOW
• AUD/USD: BREAKS DOWN AHEAD OF RATE DECISION
• NZD: HITS 6 YEAR LOW
• CAD: GDP GROWTH HITS 5 YR LOW
• USD/JPY: SHARP DETERIORATION IN JAPANESE DATA

EXPECTATIONS FOR UPCOMING FED MEETINGS

CAN THE DOLLAR RALLY CONTINUE?

Over the past 6 months, being long US dollars has been one of the best trades in the currency market but as the dollar extends its gains, many traders wonder how much further it can rise.  In the currency market, trends can last much longer than anyone would normally anticipate especially if it is driven by fear. As humans, we run from uncertainty and not towards it. Risk aversion has been pushing investors into the safety of the US dollar and out of higher yielding currencies.  When Main Street reads in the papers tomorrow about the slowest pace of economic growth in 26 years, their shock could turn into more selling.  Next week, we also have the US non-farm payrolls report due for release.  A sour mood could hang over the markets for most of the week as traders fear that another 500k jobs were lost in the month of January.  The only thing that could improve risk appetite and give investors a reason to cheer would be if the Senate passes President Obama’s economic stimulus package.

Busy Week Ahead

For the US, the most important economic release is undoubtedly the non-farm payrolls report .  However it will be one of the few weeks where the significance of economic data abroad can challenge the impact of US data on the currency market.  There are 3 interest rate decisions on the calendar from Australia, the UK and the Eurozone.  Two out of the three central banks are expected to cut interest rates but all are expected to signal more easing to come.  Although in past recessions, we typically see a rebound in non-farm payrolls, the massive layoffs this month suggests that there may be no relief for the US labor market.  We could easily see another half a million people out of work and unfortunately that may not be the end of it.  In addition to the NFP report, manufacturing and service sector ISM are also on the calendar.  Bad news in the beginning of the week could easily drive the EUR/USD to a fresh year to date low as traders grow more cautious ahead of non-farm payrolls.

US GDP: Bad but Not Ugly

The big number that everyone was watching this week was fourth quarter GDP .  The US economy was expected to slow significantly and it obliged by reporting the largest contraction in 26 years.  However analysts were overly pessimistic about growth as they called for GDP to drop by 5.5 percent.  In yesterday’s Daily Currency Focus , we called for a better GDP number on the basis that the trade balance narrowed to a 5 year low in November.  The details of the report indicate that inventory growth in the last 3 months of the year helped to prevent growth from slipping further but the buildup in inventory will mean more cutbacks in the first quarter.  Even though the Chicago PMI report contracted for the fourth consecutive month, the nationwide ISM manufacturing index may have rebounded in December because improvements were reported in the Philly Fed, Empire State and Richmond Fed manufacturing indices.  

USD/JPY and the VIX

The bottom line is that the dollar rally can continue as long as investors remain nervous.  The only currency that is reacting properly to the trend of US economic data continues to be USD/JPY, but USD/JPY is also a measure of the market’s risk appetite. The following chart illustrates the tight correlation between USD/JPY and the VIX index which measures the volatility in the equity market (the VIX chart is inverted).  If the equity market remains nervous, driving the VIX higher, USD/JPY could continue to fall.

GBP/USD: FRUITS OF BOE LABOR

The British Pound finishes the week on solid footing. Having appreciated for five consecutive trading days, the GBP broke above 1.45 against the US dollar and hit a 6 week high against the EUR .  Economic data was actually weaker than expected with consumer confidence deteriorating and consumer credit declining.  Mortgage approvals rebounded but that was the only upside surprise.  The recent outperformance of the British pound suggests that investors are finally waking up to the fact that the UK government has done a lot.  Although their initiatives have been criticized, they have hit the economy with stimulus from all angles and we are beginning to see the fruits of their labor.   The Bank of England is expected to cut interest rates next week as their stability is far from permanent.  UK interest rates are already at a record low and another 50bp rate cut will take it down to 1 percent.  The question that the BoE will need to answer is whether UK interest rates are headed to US levels.  In addition to the BoE meeting, manufacturing PMI, Nationwide Consumer Confidence, service sector PMI, industrial production and producer prices are due for release.  The rebound in the distributive trades survey suggests that we may actually see an improvement in manufacturing activity.  

EUR/USD: HITS 1 MONTH LOW

The EUR/USD hit a one month low following weaker Eurozone economic data and stronger US data. The schedule of conferences and speeches given at the World Economic Forum in Davos, Switzerland are proving to have important implications for the euro. For one, we have heard the cynical remarks given by German Chancellor Angela Merkel. The chancellor firmly believes that the reasons for the current depressed economic state are undeniably due to “irresponsible speculation” and the “excesses of the market”. Although these statements are hardly revelations to traders, her disgust with “unfettered capitalism” does cast some concerns about the possibility of additional financial regulation. Trichet’s speech at the event took the form of a warning against the financial markets’ persuading banks to resist lending opportunities. While all of the main policy makers in the Euro-zone are sharing their concerns with the legions of economists, conditions in their countries continue to deteriorate. EUR/USD has finished a three day retreat and is poised to finish a month with more than an 8.0% loss. France is discussing additional lending to their struggling automakers, with the condition that domestic factories are not closed. Other disheartening information can be found in a higher unemployment rate of 8.0% and a lower CPI Estimate of 1.1%. If Trichet and Merkel are trying to restore the confidence of the financial markets, they seem to have many factors running against them. EZ PPI will be released on Tuesday along with Retail Sales on Wednesday. However, the most le market moving factor for next week will be the ECB interest rate decision even though rates are expected to remain unchanged.  

AUD/USD: BREAKS DOWN AHEAD OF RATE DECISION

The Australian and New Zealand dollars sold off significantly against the US dollar.  Risk aversion, weaker economic data, and the prospect of an interest rate cut drove the AUD/USD to a 7 week low .  Australian leading indicators fell unexpectedly for the first time since 1992 while private sector credit increased by the smallest amount since 1994.  The Reserve Bank of Australia is expected to cut interest rates by another 100bp on Tuesday to 3.25 percent.  In addition to the RBA rate decision, service sector and manufacturing sector PMI along with retail sales are due for release.  Meanwhile the New Zealand dollar fell to a fresh 6 year low following dovish comments from RBNZ Governor Bollard who said that the central bank could drop interest rates into uncharted territory. Building Permits declined by 6.0% during December, reflecting a weak housing market that has been hit by tight credit.  The only significant report number due from New Zealand next week is the labor market report.  As for the Canadian dollar , it also sold off against the greenback but not by nearly as much as the other commodity currencies. GDP growth fell for the second consecutive month by 0.7% in November, which was the largest contraction since 2003.  

USD/JPY: SHARP DETERIORATION IN JAPANESE DATA

Risk aversion continued to dominate the markets as the Yen appreciated against all of the major currencies except for the British Pound. The Japanese economy is on the verge of entering the worst recession in nearly half a century as the jobless rate continues to rise while industrial production tumbles. Industrial production has set a new record low of -9.6% in the month of December as businesses continue to struggle with availability of credit. The jobless rate has increased drastically from 3.7% in October to 4.4%; this outcome largely effected household spending which declined for the 10th month during the past year. What is more alarming is a possibility of deflation as CPI is continuing to show no signs of strengthening. Japanese manufacturing sector has been hit the hardest which attests to the continuation of lay-offs, lower growth guidance, and record loses.  On top of that, the Japanese Yen might experience more appreciation as exporters and money managers will need to return their assets to Japan as fiscal year comes to an end in March. A stronger Yen will only be a detriment for the economy, so speculation still remains that the Bank of Japan will need to intervene in the foreign exchange markets.

GBP/USD: Currency in Play for Next 24 Hours

The currency in play for the following week will be GBP/USD based on the release of Manufacturing PMI from the U.K. on Monday at 9:30GMT or 4:30AM EST. Later in the day, U.S. will release its figures for Personal Spending around 13:30GMT or 8:30AM EST, followed by ISM Manufacturing PMI at 15:00GMT or 10:00AM EST. After the pair reached a quarter century low late last month it rallied for five consecutive days, currently lingering in the Range Trading Zone established through the Bollinger Bands. Current resistance is originating at 1.4720 which is a 78.6% retracement of September 2008 high and 2009 low that coincides with 50-day SMA. Support is at an important psychological level which is also the first standard deviation of the Bollinger Bands around 1.4000-1.4025.     

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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.