U.S. Dollar's Relationship With Earnings

Last updated 4/9/2009 5:03 PM ET (GMT -5) 0 Comments - Add your comment

Forex Trading involves high risks, with the potential for substantial losses and is not suitable for all persons. Past performance is not necessarily indicative of future results.

Kathy Lien

Director of Currency Research, GFT

THE STORIES IN THE CURRENCY MARKET

• U.S. DOLLAR’S RELATIONSHIP WITH EARNINGS
• EUR/USD: COLLAPSES ON ECB COMMENTS
• GBP/USD: RATE DECISION MARGINALLY BEARISH
• USD/CAD: UNEMPLOYMENT RATE HITS 7 YEAR HIGH
• AUD/USD: UNEMPLOYMENT RATE HITS 18 YEAR HIGH
• NZD/USD: OIL AND GOLD PRICES HIGHER
• USD/JPY: ABOVE 100 THANKS TO EQUITIES

EXPECTATIONS FOR UPCOMING FED MEETINGS

U.S. DOLLAR’S RELATIONSHIP WITH EARNINGS

The big story in the financial markets today was not the improvements in economic data, but the improvement in earnings. The health of the financial sector is critical to the recovery in the U.S. economy and therefore investors are keeping a particularly close eye on the reports from the banking sector. In order for the global economy to have any chance of recovering, banks need to stabilize and start turning a profit so they will feel comfortable enough to lend. Therefore the better than expected results from Wells Fargo has been received positively by the equity and currency markets. The U.S. dollar sold off against the commodity currencies and rallied against the Japanese Yen. The dollar also gained strength against the euro and British pound, which is not in line with the improvement in risk appetite because of euro and pound specific reasons that we will discuss further in the respective sections.

The Impact of Earnings on Currencies

The reason why equities appreciated so much today was because Wells Fargo reported the largest profit ever. This says a lot considering that we are in the midst of a recession and could foreshadow what may be to come for other banks. Wells Fargo benefited strongly from the acquisition of Wachovia and a surge of refinancings. This could also be a good quarter for other banks because of relaxed mark-to-market accounting rules. Most banks are expected to pass the stress tests, which many analysts criticize for being nothing more than a publicity stunt by the U.S. government with the goal of bolstering confidence in the banking sector. Stronger bank earnings should add fuel to the current equity market rally which in turn could drive the U.S. dollar lower. However, reports from the financial sector will have to contend with the reports from retailers. Wal-Mart came up short today with sales rising less than analyst expectations. Clothing sales increased according to Limited Brands and Gap Inc but only due to discounting. The relationship between earnings and currencies is that earnings can determine where the dollar is headed as they reflect on the state of the U.S. economy.

The Impact of Currencies on Earnings

The relationship is actually symbiotic as currencies can also impact earnings. In the first quarter of 2009, the U.S. dollar appreciated materially which can negatively impact U.S. companies that are selling products aboard by reducing the value of their international sales. To explain this further, imagine that McDonald’s sell a Big Macs in the U.K. for 2 British pounds at a GBP/USD exchange rate of 1.80. For U.S. based McDonald’s, that would mean revenue of $3.60 per Big Mac. Suppose that the British pound weakens 20 percent, bringing the GBP/USD exchange rate down to 1.44. The 2 British pounds that they charge for each Big Mac now equals revenue of only $2.88 instead of $3.60. Compound this by millions of Big Macs sold abroad and you understand how a strong dollar can hurt a company like McDonald’s. This leaves the companies faced with the difficult of decision of raising prices to keep margins intact or maintain their competitiveness by reducing prices and taking a hit to profitability.

Smallest U.S. Trade Deficit Since 1999

With that in mind however, the U.S. trade deficit fell 28 percent to -$26.0 billion in February, the smallest level in close to 10 years. The last time the trade deficit was smaller than current levels was back in November 1999. In a strong economy, a smaller trade deficit is positive but in the current market environment, a shrinking trade represents weakness and not strength. However the U.S. dollar has rallied against the Japanese Yen on the heels of the report as the details reveal the first increase in imports since June 2008. Although it is far too early to scream for a recovery in exports, the positive number still provides a bit of relief. Imports continue to be the primary reason why the trade deficit is shrinking as the recession cuts back U.S. demand for foreign goods. As the deficit closes in on zero, traders will start to wonder whether the U.S. could turn a trade surplus, which is something that hasn't happened in more than 17 years. We do not rule out this possibility but will also be more worried than pleased that it has happened. Trading in the currency market should grind to a halt until Monday evening with

U.S. Markets closed tomorrow for Good Friday and European markets for Easter Monday.

Larry Summers Takes Questions About the Economy

EUR/USD: COLLAPSES ON ECB COMMENTS

The euro has come under aggressive selling pressure as the European Central Bank leans closer to Quantitative Easing. This morning, ECB President Trichet basically told the market that interest rates are headed to 1 percent while Governing Council Member Nowotny said that the central bank could start buying debt to ease the credit markets. Wellink added his 2 cents by warning that inflation could turn negative for a couple of months. The ECB is only making these clearly dovish comments because they want to send a message to the markets. In general, they like to prepare the markets for any major changes in monetary policy so as to reduce volatility when the actual announcement is made. Therefore the gradual decline in the euro over the past week is probably exactly what they were hoping for. The European Central Bank released their April monthly bulletin this morning and unsurprisingly the report repeated the same bearish message contained in the press conference given by Trichet following the most recent ECB meeting. We continue to expect the euro to underperform other major currencies ahead of the May ECB meeting.

GBP/USD: RATE DECISION MARGINALLY BEARISH

As expected, the Bank of England left interest rates unchanged at 0.5 percent. Their statement did not contain many details other than the fact that the Committee voted to continue with their asset purchases totaling GBP75 billion. So far, they have bought GBP26 billion worth of assets and expects their total purchases to be completed in 2 months. The rate decision was slightly bearish for the British pound because some traders expected the central bank to reduce their targeted purchases. The minutes from the meeting will be released in a few weeks along with the Quarterly Inflation report in May. These reports will provide more detail on the outlook for growth and inflation. In the meantime, economic data was mixed with the trade deficit widening and producer prices increasing. Higher commodity prices have been boosting inflation globally which could become a big concern for central banks whose monetary and fiscal policies are also inflationary. The deterioration in trade came primarily from a decline in exports.

BoE Rate Cuts Reach Bottom

USD/CAD: UNEMPLOYMENT RATE HITS 7 YEAR HIGH

The Canadian, Australian and New Zealand dollars managed to appreciate against the U.S. dollar despite a further deterioration in the labor market. Even though the pace of job losses slowed in Canada, the unemployment rate surged to a 7 year high as the deepening recession caused another 61,300 Canadians to lose their jobs last month, marking the fifth consecutive month of net job losses. Thankfully the improvement in the trade balance helped to take the market’s focus away from the employment numbers. After running a trade deficit for the past 2 months, Canada finally turned a marginal surplus as shipments of cars and aircrafts increase. Job losses also accelerated in Australia. Last month the unemployment rate surged to an 18 year high of 5.7 percent as 34,700 Australians were laid off. However these negative reports were completely overshadowed by the rise in U.S. equities and the improvement in risk appetite.

USD/JPY: ABOVE 100 THANKS TO EQUITIES

The U.S. dollar ended the shortened trading week above the pivotal 100 level against the Japanese Yen thanks to stronger U.S. economic data and the rally in equities. Japan’s Prime Minister Taro Aso plans to revive a package worth as much as ¥15.4 Trillion or $154 Billion, about 3% of GDP. The package would push total spending to roughly ¥25 Trillion or $250 Billion since Prime Minister Aso took office in September of last year. Spending themselves out of a recession will be difficult for the government as Japan’s debt may rise as high as 197% of gross domestic product by the end of next year. Meanwhile, BOJ’s Governor Masaaki Shirakawa proclaimed a floor for interest rate reductions at 10 basis points as additional cuts may hurt the economy. The governor pointed out that a further reduction in the interest rates would make lending unprofitable and would slow the flow of credit in the economy. Economic figures were mixed - Machine Orders unexpectedly rose for the first time in five month, while Machine Tool Orders dropped by the highest margin on record to -84.5% from a year earlier making it 10th consecutive month of decline.

Will Japan's Stimulus Package Work?

EUR/JPY: Currency in Play for Next 24 Hours

EUR/JPY will be the currency in play for the upcoming 24 hours. Japan is set to release variety of figures concerning the state of credit and money supply as well as BOJ’s minutes, today at 23:50GMT or 7:50PM EST. Afterwards, Euro-zone will release Frnch CPI, Industrial and Manufacturing Production at 6:45GMT or 2:45AM EST. After reaching a bottom in the beginning of the year EUR/JPY rallied significantly, currently lingering within the Range Trading Zone. The pair is likely to continue the uptrend if it manages to break through resistance and enter into the Buy Zone of the Bollinger Bands. Crrent resistance is placed at the 1st Standard Deviation of the Bollinger Bands 133.50. Nonetheless, if the pair pierces through support the uptrend may be negated. First support is placed at 20-day SMA at 131.25, while second support deems to be effective at a psychological level of 130.00.

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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.