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Why The Dollar Could Head Higher

Last updated 9/23/2011 5:06 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

• WHY THE DOLLAR COULD HEAD HIGHER
• EUR: GREECE STILL TEETERING AT THE BRINK OF DEFAULT
• GBP: LIFTED BY STRONGER HOUSING DATA
• NZD: EXTENDS LOSSES AS COMMODITY PRICES TUMBLE
• AUD: SHRUGS OFF WEAKER LEADING INDICATORS
• CAD: CARNEY TO SPEAK SUNDAY
• JPY: FLIRTING WITH INTERVENTION LEVELS

EXPECTATIONS FOR UPCOMING FED MEETINGS

WHY THE DOLLAR COULD HEAD HIGHER

Courtesy of the Federal Reserve - it has been an extremely tough week in the financial markets and it is now time to lick our wounds and take an assessment of the carnage.   The S&P 500 fell approximately 7 percent this week, reaching an 11 ^th month low in the process.   Two year and ten year U.S. Treasury yields dropped to record lows while gold prices experienced its largest one day decline in 5 years. Similarly large moves were also seen in silver, copper and oil prices. In the foreign exchange market, the U.S. dollar and Japanese Yen rose more than 6.5 percent against the New Zealand dollar, close to 6 percent against the Australian dollar and approximately 2.25 percent against the euro and British pound.   This widespread selling was set off by the Federal Reserve who warned about significant downside risks to growth but came up short in terms of solutions.  When combined with the risk of a Greek default, slower growth in China and downgraded GDP forecasts by the IMF, we can sympathize with all of the investors who decided to liquidate out of risky assets and park their money in low yielding safe haven currencies.  Despite the end of week relief rally in risk, we believe that the dollar could be headed higher. 

The reason has less to do with the outlook for the U.S. economy and more to do with the factors that the market hasn’t considered going forward.  Everyone seems to agree that given the severity of the market’s reaction, the Federal Reserve will not be able to stop at Operation Twist.  However what investors have yet to consider is how far other central banks will go in following suit.  Some economists are beginning to talk about the possibility of an ECB rate cut as early as next month – a notion that many investors have a hard time believing because the ECB raised interest rates as recently as July.   To go 180 degrees in the opposite direction is difficult to fathom but with CDS spreads skyrocketing, economic data weakening and inflationary pressures declining, the ECB could respond with aggressive measures.  The only question is whether this will be the last act made by Trichet or the first act made by Draghi.  Either way, EUR/USD traders have not discounted the possibility of a rate cut by the ECB and this is where the opportunity lies.  If the idea of an ECB rate cut gains momentum, we could see further weakness in the euro against the U.S. dollar.  The same is true if the Bank of England bites the bullet and decides to increase their asset purchases, which at this point in time would be a more aggressive move than Operation Twist.  There is also a reasonable chance that the Bank of Canada and the Reserve Bank of Australia will start to talk about lowering rates as well and when this happens, investors will need to reposition accordingly.  In other words, if other central banks move into easing mode, it could hurt their currencies to the benefit of the U.S. dollar.

There are a number of U.S. economic reports scheduled for release next week.  These numbers will help determine how quickly the Federal Reserve will need to act again.   The reports to watch include new home sales, consumer confidence, durable goods, the third released of Q2 GDP, pending home sales, personal income, personal spending and Chicago PMI.   Aside from these economic reports, we will also be watching for any market moving comments from the G20, World Bank and IMF.  

EUR: GREECE STILL TEETERING AT THE BRINK OF DEFAULT

The euro may have rebounded against the U.S. dollar but don’t get too excited because the Eurozone remains deep in the woods.  The buzz on the street is that European officials and banks are gearing up for a Greek default.  As much as they have tried to help the country avoid a default and continue to do so as we speak, they are coming to the realization that a default may not be avoidable and for this reason, they are beginning to prepare for one.  At this point, it is not even clear if Greece will be able to receive its next bailout payment.  Last week, it appeared that progress was being made but there is now talk that the bailout needs to be renegotiated.  All of this back and forth on Greece has sapped confidence in the currency and led to a sharp increase in short EUR/USD positions according to the latest CFTC IMM data.  Net short positions rose to 79,460 contracts compared to 54,459 contracts the previous week –the highest level since June 2010.  Given that the EUR/USD has extended its losses since then, we would not be surprised if this positioning increased even further.  With Greece teetering at the brink of default, it will be news flow from the ECB or European Union that determines the fate of currency.  If they sweep in with additional support, it will help to lift the EUR/USD back above 1.36 but the longer they wait, the more pressure it will put on the euro.   Next week’s European economic reports will show just how much of a toll the European sovereign debt crisis and slower global growth has had on the Eurozone.  Germany is set to release its IFO report on business confidence, unemployment and retail sales numbers along with EZ economic confidence.  We have many reasons to believe that sentiment has been hit significantly by the uncertainties and cutting off the gangrenous arm could be the only way to save Europe.  Meanwhile don’t expect much downside in the Swiss Franc as the SNB remains committed to fighting strength in the currency.

GBP: LIFTED BY STRONGER HOUSING DATA

The British pound strengthened against the greenback and the euro as the British Bankers’ Association reported a better-than-expected figure for new mortgage approvals.  There were 35.2K new mortgage approvals in August versus 33.2K expected and following 33.4K in July.  The banks’ new mortgage lending has increased in the past few months as a result of higher demand, and some business sectors are edging towards year-on-year borrowing growth.  Although, the general landscape is still one of households not wanting to take on more borrowing and businesses waiting for industry conditions to improve before borrowing to expand or invest.  Against this backdrop, paying down existing debt was the main contributor to the net lending figure.  U.K. Chancellor of the Exchequer George Osborne said his deficit-reduction plan can survive the economic slowdown.  Speaking to reporters in Washington today, he said the monetary policy and the automatic stabilizers – the lower tax burden and higher spending on welfare that happens during periods of weakness – would support the economy.  However, the U.K. economy faces no growth and rising unemployment, which are very bad for deficits.  Additionally, the world economy is not providing any assistance as it teeters with the possibility of extremely slow growth.  This has caused Bank of England officials to consider restarting their bond-purchase program.  Economic releases in focus next week include the nationwide housing price index, GfK consumer confidence, Bank of England credit conditions survey, and CBI retail sales figures.  Particular emphasis is on the house price index which is expected to show an increase of 0.2 percent after turning negative in August.

NZD: EXTENDS LOSSES AS COMMODITY PRICES TUMBLE

The New Zealand dollar extended its losses against the greenback while the Australian and Canadian dollars strengthened.   The Australian dollar rebounded briefly from its lowest levels in more than five months against the greenback as the Group of 20 nations pledged to address rising risks to the global economy.   However, the majority of the market is in a risk-averse mode and is moving away from riskier high-yielding currencies.  Australia’s leading economic indicators declined again in July for the second straight month.  The index fell 0.1 percent in July following a 0.8 percent drop in June.  Five of the seven components of the index increased in July but were offset with declines in building approvals and share prices.   The Reserve Bank of Australia also released its biannual financial stability review today.  The overall tone was more hawkish, yet there remains concern over the soft global economy and its impact on Australia.  Commodities fell to a nine-month low as silver, copper, and nickel tumbled on intensifying concern that policy makers are running out of tools to avert another global recession, hurting demand for metals, fuel, and food.  The Canadian dollar ended positive but erased earlier gains as commodities began to slip and skepticism surrounded claims for central banks to save the global economy.   No new economic data was released from Canada today, but Bank of Canada Governor Mark Carney will be giving a speech on Sunday.  Also, focus next week will be on the Canadian GDP figures with the market expecting an expansion of 0.3 percent following last quarter’s expansion of 0.2 percent.   New Zealand’s stocks, the developed world’s best performers this year, erased gains after the nation’s economic growth practically stalled and optimism about employment retreated.   Additionally, the Group of 20 nations warned of “heightened” risks to the global recovery.  Significant releases next week for New Zealand include building consents and the NBNZ business confidence index.

JPY: FLIRTING WITH INTERVENTION LEVELS

The Japanese yen traded lower versus all of the major currencies today except the Canadian and New Zealand dollar. The volume of risk trades picked up after G20 pledging to stabilize the global economy. The strength in yen has been haunting the Japanese economy as it tries to recover from the Fukushima nuclear crisis. With profit margin thinning, major manufacturers are prompted to restructure domestic operations and to invest oversea. The latest trade deficit published on Tuesday indicated the growing woes for the exporters. The Japanese Finance Minister Jun Azumi warned on Thursday: "the yen remains at high levels, being sought mainly on external factors. That may serve as a drag on Japan's economy.” Meanwhile, the Bank of Japan Governor Masaaki Shirakawa kept alive expectations of further monetary easing. According to a survey done by Yomiuri Shimbun, more than 80 percent of the companies are concerned about the continued appreciation of the yen. Furthermore, 60 percent of the respondents stated that their business performance was affected by the recent strength in yen. Looking ahead to next week, we have the retail sales on Wednesday and manufacturing PMI on Thursday, followed by CPI and industrial production data. If there were more signs of weakening in retail and manufacturing sectors, it could be only a matter of time before more easing measures implemented by BoJ.

EUR/USD: Currency in Play for Next 24 Hours

EUR/USD will be our currency pair in play for Monday. We expect German IFO Business Climate from Europe at 4:00 AM ET/ 8:00 GMT. From the U.S., there will be new home sales at 10:00 AM ET/ 14:00 GMT.

Despite the short relief rally in risk trades, EUR/USD remains in a downtrend, which we determined using the Bollinger Bands. The pair’s continued decline could find support at 1.3408, the 50% Fibonacci retracement. As more risk-aversion flows put downward pressure on EUR/USD, the lower second standard dev. Bollinger Band could provide further support at 1.3284,. On the flip side, the pair’s rise could see resistance at the psychologically significant 1.4000 handle and its 50-day SMA – 1.4154.

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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.