US Dollar Remains the Currency of Choice as Traders Avoid Risk

10/22/2008 9:59 am EST

Focus: FOREX

Just when we thought that risk sentiment was improving a bit, flight-to-safety led to huge gains for the US dollar and treasuries, and losses for stocks and commodities on Tuesday.

A slew of new intervention efforts were announced, including the French government’s decision to lend a total of 10.5 billion euros to six French banks, including Crédit Agricole, BNP Paribas, and Société Générale. Meanwhile, the Federal Reserve created yet another lending facility, the Money Market Investor Funding Facility (MMIFF), which is meant to support a private-sector initiative that will provide liquidity to US money market investors. JPMorgan will run five units that will buy up to $600 billion of certificates of deposit, bank notes, and commercial paper with a remaining maturity of 90 days or less and the Fed will provide up to $540 billion of those funds.

From a fundamental perspective, there is little in the way of positive news from the US and it is clear that risk aversion is driving the dollar’s rally. While overnight interest rates continue to fall, the fact that various government efforts still need to be implemented to try to boost liquidity suggests that investor confidence has still not improved substantially. This leaves the odds in favor of US dollar strength, even though economic data suggests the country is in the midst of recession.

Euro, British Pound Break Below Critical Support; BOE Minutes Provide Heavy Event Risk

The euro and British pound continue to trade as “anti-dollar” currencies, and that is much to their detriment. In fact, as we mentioned yesterday, EUR/USD needed to hold above 1.3300/15 and GBP/USD must stay above 1.70-1.71 in order to avoid more substantial declines. Both of these levels were broken on Tuesday, with EUR/USD reaching the lowest levels since February 2007 and ending the day just above 1.3050 while GBP/USD reached the lowest levels since November 2003. According to technical strategist Jamie Saettele, support looms just below current levels for both pairs, but looking at long-term charts, GBP/USD seems like it could dip as low as 1.6500/35, and the pair actually faces significant event risk on Wednesday as the minutes from the Bank of England’s last meeting will be released. The BOE meeting minutes tend to be a huge market-mover for the British pound, and this time is unlikely to be any different. During the October meeting, the BOE’s Monetary Policy Committee met a day early in order to take part in the October 8 coordinated rate cut, during which they reduced the Bank Rate by 50 bps to 4.50 percent. The key to trading this release will be the vote count, as any dissents in favor of leaving rates unchanged could lead the British pound to jump as they would suggest the BOE may not immediately cut rates again at their next meeting on November 6. However, if the vote to cut rates was unanimous and the MPC’s discussion sounds dovish, cable could pull back sharply.

Canadian Dollar Dives on BOC Rate Cut; New Zealand Dollar Faces RBNZ Rate Decision

The Canadian dollar pulled back sharply as the Bank of Canada cut the overnight rate target by 25 bps to 2.25 percent, the second reduction this month after participating in the October 8 coordinated rate cuts. While the reduction was less than expected, as a Bloomberg News poll of economists had forecasted a 50 bp cut, the BOC’s policy statement suggested that additional rate cuts were on the way as they said “some further monetary stimulus will likely be required” in order to achieve the 2 percent inflation target. Indeed, the BOC is very concerned about prospects for Canadian growth given the weaker outlooks for global demand and commodity prices, as well as the "marked tightening" in credit conditions. These factors are also likely to contribute to a drop in inflation pressures, as the BOC forecasts that headline CPI will peak in Q3 2008 and subsequently fall below their 2 percent target in 2009. The Canadian dollar may face additional declines on Wednesday as consumption numbers will be released. Canadian retail sales are expected to slip 0.2 percent, but given the 1.5 percent drop in wholesale sales, there is potential for this headline reading to fall more than expected as the wholesale figure tends to serve as a good leading indicator.

The Australian dollar and New Zealand dollar also remain weak, especially as commodity prices have slumped throughout the day and ahead of the releases of Australian CPI tonight at 20:30 ET and the RBNZ rate decision tomorrow at 16:00 ET. The Australian figures are expected to show a broad pick up in inflation pressures during Q3, but given the tightness of the credit markets and the slowdown impacting the Australian economy, these CPI results are unlikely to prevent the Reserve Bank of Australia from cutting rates further. The bigger story, though, will be the RBNZ monetary policy decision as they are anticipated to slash rates by 100bps to 6.50 percent. While inflation measures remain very high, the New Zealand economy has officially fallen into recession as GDP contracted for two consecutive quarters (-0.3 percent in Q1, -0.2 percent in Q2). The key to the New Zealand dollar’s reaction, though, will be RBNZ Governor Bollard’s post-meeting commentary. If the RBNZ cuts rates by 100 bps and signals that they will reduce rates further, this sentiment may be exacerbated and the New Zealand dollar will likely plunge. On the other hand, a smaller than expected 50 bp – 75 bp cut, and comments suggesting that the RBNZ may pause next time could allow the currency to recover.
  
Japanese Yen Gains On Carry Trade Selloffs

Like the US dollar, the Japanese yen strengthens during times of marked risk aversion in the markets—particularly versus high-yielding currencies like the Australian dollar and New Zealand dollar—and today was no exception. In fact, the low-yielding yen gained nearly 2 percent against the US dollar and Swiss franc, 4.5 percent versus the Kiwi, and 6.36 percent against the Aussie. However, some of the Japanese yen crosses like EUR/JPY are trading near major support levels, suggesting we could see some sort of bounce overnight or on Wednesday.

Written by Terri Belkas, Currency Strategist, DailyFX.com

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