Dollar Rally Driven Entirely by Oil

09/24/2008 12:00 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

The eyes of everyone from investment managers to stock and currency traders were glued to testimony of the three biggest players in the latest financial crisis. US Treasury secretary Paulson, Federal Reserve chairman Ben Bernanke, and SEC chairman Cox urged the Senate Banking Committee to approve their request for $700B of taxpayer money. Instead of calming the markets, Paulson and Bernanke spent their time warning of the doomsday scenario should the Senators fail to approve their plan. As a result, stocks came under severe selling pressure. Volatility has been vicious in the financial markets today, but the one thing that has remained relatively consistent is dollar strength. The greenback traded higher against every major currency. On Monday, the dollar's weakness was triggered by the sharp rally in oil prices, and today, the retracement is leading to a recovery in the US dollar. Since the beginning of the year, the EUR/USD has had a close 70 percent correlation with oil prices. Over the past 3 months, that correlation has become greater than 90 percent.

From Main Street to Washington, No One is Happy with Paulson's Plan

Based upon the criticism by the Senators, the backlash from economists, commentators, and average Americans, no one is happy with Paulson's plan. The big question on Main Street is whether Paulson is putting the private interest ahead of the public. This is certainly a heavy debate, and one that we will not take up in this column. Instead, we acknowledge the fact that no other viable solutions have been offered, and instead Paulson has simply relented to more oversight. This lack of confidence or clarity in Paulson's plan is a big reason why the US dollar could fall by another 5 percent. Like banks, investors from around the world are pulling their money out of high-risk investments and hoarding their cash. According to The Independent, hedge funds are suffering mass redemptions. Foreign investors continue to lose confidence in dollar denominated investments, which is reflected in the sell-off in the stock market and rally in US Treasuries. For currency traders, this means that the US dollar is headed lower.

The Problem is Counterparty Risk

Paulson's argument is that by freeing up capital for the banks, they can resume making loans for individuals and businesses. However the problem that lenders face is not necessarily a lack of cash, but the fear of counterparty risk. The only encouraging thing that came out of the statement was a peculiar comment from Fed chairman Ben Bernanke. Rather than stick to his prepared testimony, Bernanke spent his time talking about buying assets at their value if held to maturity over buying them at fire sale prices. If this is what they actually do, we could see banks revise up their write-downs. Unfortunately, this is another band aid that masks some of the troubles in the financial crisis and not a new solution aimed at boosting lending, reducing risk aversion or stimulating growth. Unless these problems are tackled head on, the US economy could be in for more trouble.

More Signs that Mr. Scrooge is Coming this Holiday Season

The Richmond Fed manufacturing index and the report on house prices were both weaker than expected, but the big disappointment came from the National Retail Federation's warning that spending this holiday season could be the slowest in six years. More consumers may be forced to think like Mr. Scrooge, which will lead to weaker growth and slower hiring. Existing home sales are due for release on Wednesday. We expect sales to continue to slow, because even if homeowners have money to buy, lenders are making it very difficult for them to take out a loan in excess of their down payment.

Euro: Expect a Disappointment in German Business Confidence

The combination of weaker euro zone economic data and the bounce in the US dollar has kept pressure on the EUR/USD throughout the US trading session. Both the euro zone manufacturing and service sector PMI reports fell deeper into contractionary territory. This deteriorating was due mostly to a slowdown in German activity. Service sector PMI for France actually rebounded into expansionary territory. The improvement, however, did not stop the composite PMI number, which includes the service and manufacturing activity from falling to the lowest level since November 2001. The Belgian business confidence index also fell to the lowest level in 5 years, which suggests that the German IFO report, the measure of business confidence will deteriorate materially as well. With the global financial crisis continuing to exacerbate, there is little reason for German businesses to be more optimistic. Weaker economic data could add pressure on the Euro but any big moves will be triggered by the market's sentiment towards US dollars.

British Pound: Back and Forth Action

Although the British pound ended the US trading session lower against the US dollar, it is important to point out that the weakness is mild compared to move in the Euro. In fact, the currency pair has been contained within a 150-pip trading range for the past 24 hours. There was no event risk on the calendar and the only comments came from the outgoing deputy governor of the Bank of England, John Gieve. He hinted that he could favor an interest rate cut, but given that he will be stepping down early, he may not see that rate cut through. More specifically, Gieve's concern was the deflationary impact of the credit crisis but this contradicts somewhat the comments that he made yesterday, when he stressed that the central has only goal, which is to keep inflation stable. Two other members of the BoE are scheduled to speak tomorrow and their stance on inflation and interest rates could provide more color on which way the central bank leans. The CBI Distributive Trades report is due for release Wednesday morning; we expect this measure of consumer spending to reflect more weakness.

USD/JPY Holds Steady, but the Rest of the Yen Crosses Collapse

In an interesting twist of fate, all of the Japanese yen crosses weakened except for USD/JPY. This actually confirms our belief that today the theme is a recovery in the US dollar and not a rise in risk aversion. With that in mind however, we still believe that risk aversion will reassert its impact on the currency market, which will in turn drive USD/JPY lower. After all that Paulson and Bernanke have sprung on the markets, we have yet to see any concrete evidence of stability. However, Paulson and Bernanke have another chance when they testify before the Joint Economic Committee and the House Financial Services Committee tomorrow morning. Rather than pleading for the approval of their $700B plan, perhaps Paulson and Bernanke may spend some of their time talking about other solutions to the financial crisis. If they do, we may see a further recovery in the dollar and a rebound in the stock market. If they do not, expect more losses in the stock and currency markets. Canada, Australia, New Zealand Continue to Track Commodity Prices The Canadian, Australian and New Zealand dollars all weakened against the greenback. Commodity prices have given back some of their gains, which has contributed to the sell-off in the commodity dollars. Canada was the only country of the three to release any economic data. Headline consumer price growth slowed but prices actually increased on a core basis. This indicates that inflation is sticking in some parts of the economy, which will in turn encourage the Bank of Canada to keep interest rates on hold. New Zealand consumer confidence is due for release tomorrow. We would be surprised if consumer confidence managed to improve in the third quarter.

EUR/USD: Currency Pair in Play Over Next 24 Hours

The EUR/USD will still be the currency in play over the next 24 hours because the German IFO report is the most important economic release on the calendar on Wednesday. The data is due at 4:00AM ET or 8:00 GMT. Although the EUR/USD retraced today, it is still trading within our “buy zone,” which is established by Bollinger bands. We believe that the German IFO will be euro bearish, but the level to watch is 1.4600. Not only would the currency pair need to break that level, but it would need to hold below the buy zone for the uptrend to be negated. If it does not close below 1.46, there is still scope for a rally towards 1.4950, which is the 50-day SMA and the 50% Fibonacci retracement of the July to September sell-off. If it closes below 1.4600, we could see a move back towards Monday's low 1.4438.

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By Kathy Lien of GFTForex.com

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