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Worse Of Both Worlds For The Dollar

Last updated 9/15/2011 4:53 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

• WORSE OF BOTH WORLDS FOR THE DOLLAR
• EUR: ANY FIREWORKS FROM ECOFIN?
• GBP: BETTER CPI DOESN’T CHANGE BOE DIRECTION
• RBNZ: DELAYS RATE HIKE
• CAD: MANUFACTURING SALES REBOUND
• AUD: SHRUGS OFF DECLINE IN GOLD
• JPY: BOJ INTERVENTION CONCERNS RETURN

EXPECTATIONS FOR UPCOMING FED MEETINGS

WORSE OF BOTH WORLDS FOR THE DOLLAR

The U.S. dollar sold off against all of the major currencies and its performance along with the rise in equities and slide in gold prices are clearly a reflection of optimism. Rather than alienate and criticize Greece for struggling to achieve their deficit reduction targets, Germany and France have put forward a united front that has made everyone feel less worried about a Greek default. Central banks have followed up with a coordinated effort to increase dollar liquidity, preventing a credit crunch in Europe. Although we believe that the risk of a Greek default is still real, the schizophrenic nature of the markets means that the sovereign debt crisis has moved from the front to the middle of the minds of forex traders. The lack of inspiration from today's U.S. economic reports did not help as they further exposed the challenges faced by the Federal Reserve. Up until next week's Federal Reserve monetary policy meeting, the dollar will most likely continue to trade on safe haven needs especially with some European developments expected to unfold within the next 48 hours. The reason is because what the Fed will do next week is still very much up in the air.

CPI - Worse of Both Worlds for the Greenback

Of all the economic reports released from the U.S. this morning, the most important was the consumer price index. Consumer prices rose 0.4 percent last month, which was much stronger than expected. On an annualized basis, CPI growth rose from 3.6 to 3.8 percent, the highest since September 2008. Most importantly however, core CPI rose back to 2 percent, a level not seen since November 2008. With core CPI back at the central bank's 2 percent target, the argument for more stimulus has hit a major road block. The main reason why central banks around the world were even open to the possibility of more stimulus was because inflationary pressures around the world have declined but the latest U.S. numbers show otherwise. If the Fed were to introduce another round of Quantitative Easing, they risk stoking inflation expectations at a time when the U.S. economy is extremely vulnerable.

Unless the Fed believes that the uptick in prices are temporary (and unfortunately the rise in core CPI suggests that it isn't), this morning's CPI report means the central bank could be less aggressive next week. Higher CPI is both good and bad for the dollar in that it reduces the chance of bold stimulus by the Fed which is dollar positive but higher prices can also be negative for U.S. consumers and the U.S. economy and hence the U.S. dollar.

As for other economic reports, the current account balance also improved in the second quarter thanks to an increase in the balance of incomes. The Empire State manufacturing survey and jobless claims reports on the other hand weakened. Manufacturing activity in the NY region declined for the fourth consecutive month, reaching its weakest levels since November 2010. Industrial production slowed but in Philadelphia, manufacturing activity improved. Jobless claims also ticked higher to 428k from 417k. As long as claims remain above 400k, both investors and the Federal Reserve will remain on edge about the outlook for the labor market.

Meanwhile the Treasury International Capital flow report and the September University of Michigan Consumer Confidence survey are scheduled for release tomorrow. The market will be looking at the TIC data to see if investors have reduced their appetite for U.S. dollars during the debt ceiling debate, which had sparked the fear of a downgrade. We believe that chances are we will not see much decline in investor demand for dollars. As for consumer confidence, a rebound similar to that already seen in the IBD Investor Optimism index is also expected. These reports could be mildly positive for the greenback but when it comes to U.S. data, the only factor that needs to be considered is how the economic reports will impact the Federal Reserve's decision to increase or decrease stimulus. Unfortunately none of these reports are expected to give us a clear cut answer to what the Federal Reserve should do and in fact conflicting signs from the U.S. economy is their greatest problem. There is no question that the central bank is considering QE3 but recent comments from Federal Reserve officials suggests that they are not committed to it. One of the problems for traders banking on QE3 is that inflation is on the rise.

EUR: ANY FIREWORKS FROM ECOFIN?

The euro continued to recover against the U.S. dollar thanks in large part to the rebound in equities. This of course was partly fueled by the European Central Bank’s emergency lending facility announcement. The central plans to conduct 3 liquidity providing operations with a 3 month maturity in coordination with the Federal Reserve, Bank of England, Bank of Japan and Swiss National Bank. Part of the reason why this was a big deal is because it is a global coordinated effort but more importantly, it alleviates concerns about European banks’ ability to borrow in dollars for the rest of the year. By providing the liquidity operations, the central banks are in essence providing banks with dollars. Unfortunately this continues to be yet another short term patch to a longer term problem. Despite Germany and France’s commitment to helping Greece, the risk of a default remains high and the need for Eurobonds still seem to be a hotly contested subject. Tomorrow is the meeting of Europe’s Economic and Financial Affairs Council (also known as Ecofin) and U.S. Treasury Secretary Geithner will be attending the meeting. Expectations are high but so is the possibility of disappointment. Going into the meeting, we know that Germany and France will show a united front with Greece and that a six pack of economic governance reforms could be announced but unfortunately the reforms are aimed at preventing future crises and not dealing with the current one. The unique presence of Geithner could mean some sort of assistance from the U.S. which could be a game changer, but in all likelihood, his presence is probably more a reflection of America’s concerns about Europe’s woes. In other words, the euro has rebounded on the hope for results out of the Ecofin meeting but the gains could evaporate quickly if Finance Ministers fail to deliver. Moody’s review of Italy is set to be completed tomorrow and back in June, the rating agency warned that they could downgrade the country’s sovereign debt rating. This is a potential risk over the weekend that EUR/USD traders may not want to be exposed to. Meanwhile the Swiss National Bank left interest rates unchanged and reiterated their commitment to fighting Swiss strength. Our colleague Boris Schlossberg talked about this extensively in his report when he said the “The SNB came out with a very aggressive monetary policy statement in support of its 1.2000 EUR/CHF peg noting that it “will enforce the minimum exchange rate of CHF 1.20 per euro set on 6 September with the utmost determination,” adding,” even at a rate of CHF 1.20, the Swiss franc is still high and should continue to weaken over time. If the economic outlook and deflation risks so require, the SNB will take further measures.” The Swiss central bankers are clearly concerned about the risk of deflation, no doubt exacerbated by the recent CPI and PPI readings both of which were negative. The Swiss producer and import prices in particular showed very strong deflationary evidence with prices dropping the most in 33 months to decline by -1.2% versus expectations of -0.3% fall. Overall, the message from the SNB was unequivocal and clear, “Don’t challenge us.”

GBP: BETTER CPI DOESN’T CHANGE BOE DIRECTION

After selling off for 3 straight trading days, the British pound finally rebounded against the U.S. dollar. However the gains were difficult to maintain as the currency pair ended the day well off its highs. This week’s U.K. economic reports were mostly better than expected but up until today, it has failed to help the pound. The reason is because despite these improvements or lack of deterioration in data, Bank of England monetary policy officials are still talking about the need for easier monetary policy. This morning’s U.K. economic data were better than expected but still shows continued weakness in the consumer sector. Retail sales fell 0.2 percent in the month of August, pushing the annualized pace of retail sales growth down to zero from 0.2 percent. Excluding auto fuel, sales were slightly better, falling by only 0.1 instead of 0.2 percent. The riots in the month of August did not have as much of an impact on the economy as the market had feared but based upon the price action of the pound, that is not good enough. Sterling extended its losses against the euro and remains weak in general against the dollar and unfortunately this dynamic is not expected to change anytime soon because next week’s BoE minutes will most likely reinforce the overall belief that the central bank is actively considering moving back into active easing mode. According to Bank of England Monetary Policy Committee member Weale who had voted for higher interest rates up until August, the risk of recession has increased in July and more Quantitative Easing is possible if consumer prices undershoot substantially and one of the ways to implement QE would be to buy bonds on the long end of the market. Considering that the annualized pace of CPI is still at 4.5 percent, which is well above the central bank’s pain threshold and target, the chance of CPI “undershooting substantially” in the near term is slim. On the other side of the spectrum, Blanchflower who is a former BoE member predicts the BoE will move to QE by November. Either way, the direction that the central bank is moving towards is clear and explains the underperformance of the currency.

RBNZ: DELAYS RATE HIKE

The rally in stocks and overall improvement in risk appetite helped to lift the New Zealand, Australian and Canadian dollars higher against the greenback. The big story last night was the Reserve Bank of New Zealand’s decision to delay their rate hike. When they last met, they talked about the strong need to unwind the 50bp of stimulus doled out after the earthquake earlier this year but when push came to shove last night, they chose not to raise interest rates. Like everyone else around the world, they are worried about what is happening in Europe and the U.S. and they want to wait and see how things play out before taking an action that will be difficult to retract.  In the words of the RBNZ, "given the recent intensification in global economic and financial risks, it is prudent to continue to hold the OCR at 2.50%." The New Zealand economy has recovered since the earthquake and if rate hikes were based upon the performance of the domestic economy alone, the RBNZ would have raised rates.  However Central Bank Governor Bollard is worried about the "real risk that global economic activity slows sharply" which would impact demand for New Zealand's exports and for this reason he has decided to hold onto the stimulus delivered earlier this month, a rare luxury no other central banks have.  In other words, they are still looking to raise rates, just not right now.  Compared to other central banks, they are still more hawkish and for this reason, the New Zealand dollar is one of the day's better performers.  Economic data from Australia on the other hand was mixed with higher consumer inflation expectations met with weaker new motor vehicle sales growth.  In Canada, manufacturing shipments rose 2.7 percent, which was the strongest pace of growth since January. The Australian and Canadian economic reports played second fiddle to risk appetite which is clear driver of the appreciation in the comm. dollars. Looking ahead New Zealand consumer confidence numbers are scheduled for release this evening followed by Canadian International Securities Transactions.  These numbers are tier 2 economic reports and so their impact on the comm. dollars should be nominal.

JPY: BOJ INTERVENTION CONCERNS RETURN

The Japanese yen traded lower against all of the major currencies with the exception of U.S. dollar. As German and French leaders threw their supports behind Greece’s intention to remain in the euro zone, traders sought out high-yielders amid improved risk appetite. The Japanese economy is expected to grow more than 2 percent in the fiscal year beginning in April 2012 according to Prime Minister Yoshihiko Noda. Nonetheless, "there are downside concerns from overseas factors such as European sovereign credit risks, the weak U.S. economic recovery and the strong yen,” Noda said in a parliament meeting on Thursday. In a recent Reuters’ survey, manufacturing confidence climbed to +8 in September. However, the pace of recovery has slowed as manufacturers’ forecasts reflected dimmer outlook due to contracting global demands. In addition, the yen’s safe haven appeal continues to fuel the strength in the currency. Finance Minister Jun Azumi called for a “decisive” monetary policy from Bank of Japan, signaling the government’s frustration with the efforts by the bank so far. Meanwhile, BoJ has been calling banks for rates alerting traders for possible intervention. Should the bank proceed, the effect could be short-lived. In an earlier effort to weaken the yen, the Ministry of Finance sold a record of 4.51 trillion yen on August 4 ^th . But USD/JPY had quickly erased all of its gain and returned to the pre-intervention level on August 7 ^th . Although the market could see another unilateral action of yen selling by BoJ, USD/JPY could remain vulnerable as a stalling recovery looms over developed nations. Looking ahead, with no economic data on the docket, trading in yen would hinge on the news flow in the U.S. and Europe.

EUR/USD: Currency in Play for Next 24 Hours

EUR/USD will be our currency pair in play for the next 24 hours. From Europe, we are expecting current account data at 4:00AM ET/ 8:00 GMT, followed by trade balance at 5:00AM ET/ 9:00 GMT. In the U.S., there will be Net Long-Term TIC Flows report at 9:00AM ET / 13:00 GMT and U of Michigan Confidence index at 9:55 AM ET/ 13:55 GMT.

Despite falling to a six-month low earlier this week, EUR/USD has climbed back into the range-trading zone, which we determined using the Bollinger Bands. The first level of resistance lies at the psychologically significant 1.4000 handle. Beyond that, the pair’s rally could be contained at 1.4218 where the 50-day SMA and 50% Fibonacci retracement meet. On the flip side, today’s low of 1.3703 would be the first support. If EUR/USD declined further, the six-month low of 1.3494 is the next key support level.

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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.