Currencies | Mar 14 2011
By John Kicklighter, Currency Strategist
– Dollar Won’t Rally Unless the S&P 500 Finally Collapses…With Conviction
– Euro: Will After-Market EU Summit Concessions Change the Market’s View of the Euro-Region
– Japanese Yen: Why Did this Currency Rally after a Devastating Earthquake and Rally in Risk
– British Pound’s Interest in Inflation Indicators Already Tempered Post-BoE
– Swiss Franc Traders will Keep the Focus on Sentiment, Overlook the SNB Decision
– Gold Following Volatility in Financial and Currency Markets Rather than Direction
Dollar Won’t Rally Unless the S&P 500 Finally Collapses…With Conviction
It seemed as if the dollar was finally on track to put in a long-awaited recovery heading into the final trading day of this past week. And yet, the remarkable bullish drive the currency was able to secure in the Asian session was completely retraced by the time the New York markets closed. The responsibility for this failed rally fell not to the US economic calendar, Fed talk or the seemingly intra-day fluctuations in growth expectations (as many financial media sources would have us believe); but rather, it was the direct performance of the S&P 500. As we have discussed numerous times before, the greenback is fundamentally valuable in only a few scenarios. Generally, when risk appetite is climbing, low rates in the US encourages borrowing and reinvestment abroad; and even in most circumstances, investors seeking safety will unwind carry through the yen or divert funds to the Swiss banking system. To truly bolster demand for the dollar, we need safe haven flows and concern that the global financial markets themselves are freezing up. That was the initial sentiment Friday morning with the record-breaking earthquake in Japan and a preliminary collapse in global equities. However, follow through was not meant to be; and the speculative markets would quickly stabilize and rebound to non-threatening levels. That said, doubt has already started to seep in. A follow up decline this week will not be so easy to correct.
Looking ahead, not only does the month-long period of congestion and hesitant efforts to sell off risky positions put investor sentiment in danger (and the dollar in a position to rally); but the lack of conviction in Friday’s recovery undermines the effort to keep markets buoyant. Looking at turnover over the S&P 500, volume was 19 percent lower than the previous day’s activity and other risk-sensitive assets marked a similar lack of conviction. The docket ahead holds meaningful data and speeches; but dollar traders should be watching correlations and not the ticker.
Euro: Will After-Market EU Summit Concessions Change the Market’s View of the Euro-Region
The euro put in for a remarkable end to this past week: both on fundamental and technical terms. Looking purely at the activity of the currency, EURUSD followed up its sharpest decline in four weeks and what many would consider a meaningful change in trend with the biggest rally in four weeks. So, in effect, we were left with a dramatic increase in activity but without the clear sense of direction. That said, the performance of this particular pair does not provide the most accurate reflection of the individual currency’s health. Against the Japanese yen, the Australian dollar and the New Zealand dollar; the euro actually lost significant ground. The reason: these currencies hold tighter correlations to underlying investor sentiment trends. The euro has taken on the attributes of a risk-favorable currency thanks to the outlook for yield that the ECB leveraged at its last rate decision and the dependence the EU has for stable market conditions in holding down financing costs for member nations. Yet, with the notable reversal in sentiment seen Friday, the high-yield currencies and the volatile Japanese funding unit would present a better destination for capital.
Where investor sentiment goes, so does the currency market. However, the euro may very well deviate from the traditional risk lines and may even define them over the coming week as the market weighs in on the comments that followed the end of the special EU summit in Brussels. A precursor to the official gathering on the 24th and 25th, expectations for material changes in the financial rescue effort were restrained. Yet, there were a few remarkable points of progress. Most notable was the suggestion that Greece was offered a conditional 100bp decrease in its emergency lending rate and an extension on loans to 7.5 years. Furthermore, it was agreed that the EFSF would be able to directly purchase bonds on the open market (putting the ECB more directly onto its inflation path). That said, the group did not make a similar concession of reduced rates for Ireland (likely due to Prime Minister Kenny’s refusal to raise the nation’s corporate tax); and the group seemed to ignore any market concern with Portugal. The question heading into the new trading week is: how skeptical is the market about Europe’s stability?
Japanese Yen: Why Did this Currency Rally after a Devastating Earthquake and Rally in Risk
Even during normal trading conditions, the fundamental roles specific currencies play can be difficult to ascertain; but when we have a reaction like that seen from the yen this past Friday, it seems to break the bounds of logic. With the Asian session, the financial headlines were plastered with news that the sixth largest earthquake in recorded history struck Japan and triggered a destructive tsunami. Yet, despite the domestic hardship such an event posses, the yen began a steep rally. With the natural disaster, investors that were holding explicit and implicit carry trades with funds invested in local emerging markets would be encouraged to unwind. This dynamic would help sustain the currency’s appreciation through the climb in risk trends through the US session; and the lack of conviction in the rally would further support the yen.
British Pound’s Interest in Inflation Indicators Already Tempered Post-BoE
Given the big fundamental themes and aggressive price action market wide, it was easy to overlook the sterling’s individual performance. However, it is worth noting that the currency struggled when sentiment was firming up even though factory-level inflation data accelerated to its highest level since October of 2008. This may be evidence that rate speculation has cooled – at least until the minutes are released.
Swiss Franc Traders will Keep the Focus on Sentiment, Overlook the SNB Decision
Historically, the ECB and SNB follow very policy paths. This seems intuitive given the ties between the two economies and the tremendous flows of capital between the two regions’ markets. So, does this mean that the SNB will take a hawkish turn; and will the market care? Conditions in Switzerland have supported a hike well before the ECB. That said, the SNB moves at a quarterly pace and risk trends are in flux right now.
Gold Following Volatility in Financial and Currency Markets Rather than Direction
This past week was a remarkable one for gold. After six consecutive weeks of steady advance, the precious metal was finally shaken out of its climb on Thursday. This reversal and the subsequent bounce on Friday maintains an unusual, positive correlation to risk trends. In reality, this performance is indicative not of the metal, but of the currency it is dominated in – dollars. Priced in euros, gold is still range bound.
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