Currencies | Jan 18 2011
By John Kicklighter, Currency Strategist for DailyFX
Earnings may seem one of those fundamental matters that is uniquely tailored to the equities market; but the health of an economy’s business sector has considerable consequence for nearly every asset class. This is especially true now as the US economy faces a persistently high level of unemployment necessitating an unprecedented level of stimulus, leading speculative appetites to become increasingly dependent on the promise of high returns and dividends to keep optimism afloat.
Over the coming two weeks, some of the United States’ largest companies are expected to release their fourth quarter earnings figures (though some are running on different fiscal counts). The first means for establishing what impact this impact this round of activity will have over the FX markets is to establish what general themes will be activated through this data. Looking back over the past two years, earnings have had a wildly fluctuating influence over the general state of investor confidence in the US markets. During the worst of the financial crisis through the end of 2008 and into the opening half of 2009, market participants scrutinized the financial data looking for a reason to fear the entire asset class. Naturally, through this leveraged fear, global investors would exit seemingly high risk investments like stocks (both domestic and foreign) and moved the capital over to money markets and other safe havens (thereby boosting the US dollar).
In the subsequent period of market stabilization scrutiny was enhanced by the Federal Reserve’s stress test (Supervisory Capital Assessment Program) whereby 19 systemically important financial institutions were measured for their ability to weather a further financial crunch. After these statistics were released in May 2009 and a number of banks were forced to raise additional capital; the market graduated to the long process of recovery. The optimism that has developed since then is certainly rooted in meaningful economic improvement; but the pace at which the benchmark equities indexes (like the S&P 500 and Dow Jones Industrial Average) has been excessive. While responsibility for this state can be partly assigned to the ‘moral hazard’ of excessive stimulus and availability of loans at the highest corporate level among other factors; it is also intrinsically developed through the seemingly unflappable performance of large firms and especially financial institutions. Yet, the restrained outlook, a reliance on government support, the limits of creative account and the eventual release of TARP recipients data among other things paint a picture of an inevitable reversion to reality. It is not a matter of ‘if’ but only of ‘when.’
As mature and abnormally consistent risk appetite trends (like the one seen in the S&P 500 chart below) reach new historical highs; the burden for maintaining speculative interest gradually intensifies. Eventually, we will come to the point where expectations will overreach event the optimistic projections of US firms. Depending on the timing and influence of this particular round of data, it could even mark the long-awaited reversal in risk appetite (though there are other potential drivers – like European financial markets and Chinese asset inflation – that will compete for that role).
Taking stock of the major earnings releases over the coming two weeks (the season itself can continue for a number of weeks more than this concentrated time frame), many of the most potentially inflammatory releases will cross the wires over the coming days. While there are a few Blue Chips due before the week is out; our real interest will be concentrated on the banks expected to post results. Starting off with a big ticket release, Tuesday brings Citi – a banking conglomerate that has been under intense examination in the wake of its remarkable bailout. Following up soon after that, Goldman Sachs, US Bankcorp, Well Fargo, Morgan Stanley, Fifth Third Bancorp, Bank of American Capital One and BB&T will give a dense update on many of those banks stress tested two years ago.
After the first week, the market will have a good sense as to the performance of the fourth quarter performance of the overall market – giving way to a general trend. However, that does not mean we should ignore the following week’s listings. Depending on how many of these companies perform, we will see capital markets and economic expectations further shaped.
For the equities market, the outcome of the data will have a blatant influence over expected price action. However, the spillover can be quite significant depending on the evolution of the sector’s performance. The most immediate opportunity for impact on the FX market is to see a dramatic shift in risk appetite to guide a subsequent trend in carry interest in those pairs that have a risk-based as well as safe-haven component. Between two scenarios (one of optimism and pessimism); a disappointment would catch the most market participants off-guard and would thereby have the greatest consequence in price action. Alternatively, an impressive display is something that has been seen for a series of quarters now; and skepticism has grown in the background. As such, follow through on a display of improving health would not carry nearly as much weight.
What currency’s and pairs are most prone to a meaningful outcome? As suggested above, a broad round of improvement won’t likely materially alter the bearings for much of the FX market as there are competing fundamental trends that are more pressing than confirmation of an existing belief. On the other hand, a general disappoint will carry a lot of weight for carry and it will also encourage an unwinding from those currencies that are considered less fundamentally stable. On that point, AUDUSD could finally be encouraged into a more prominent reversal. Many Aussie dollar based pairs will be exposed to the same; while the dollar would subsequently reap much of benefit as a safe haven currency.
The views expressed are not FNArena's (see our disclaimer).
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