Is the Dollar Rally Over?

11/20/2008 12:01 am EST

Focus: FOREX

Kathy Lien

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

Since the summer, the US dollar has staged a remarkable rally, but with manufacturing data surprising to the upside, and the US dollar giving back its gains today, everyone is wondering whether the dollar rally is over. The British pound, which has seen one of the most severe declines this month, rose close to 2% on little to no news. For some market watchers, this may represent currencies that have become overstretched, but in our opinion, all signs still point to more trouble for the global economy.

Leaving the Mess for Obama

Even though the global recession is underway, and the problems in the US economy continue to deepen, there are increasing signs that the Bush administration wants to leave the clean-up job to Barack Obama. According to Treasury secretary Paulson, even though the first half of the $700 billion bailout package is being used up quickly, the Bush administration will not be asking Congress for the remaining $350 billion. With eight weeks to go before Bush leaves office, the current administration is more focused on wrapping things up than starting new initiatives. Paulson said it best: "I'm going to do what we need to do to keep the system strong, but I'm not going to be looking to start up new things unless they're necessary, unless they make great sense." and ".I want to preserve the firepower, the flexibility we have now and those that come after us will have." This was the same spirit that Bush took at this weekend's emergency meeting of G20 nations. The meeting was a big disappointment as the group failed to deliver any specific solutions. Instead, they set an action plan for March 31 and another meeting for April 30th. The G20 is clearly waiting for the new administration to take charge before putting the pedal to the metal. The only question is, will the global economy be able to wait that long?

General Motors: Biggest Risk This Month

The fate of General Motors will be the biggest event risk until the end of the month. In my opinion, the US government will not allow GM to fail. President-elect Barack Obama has already pledged on numerous occasions to support the auto and retooling industry. To back off his promises so early in the game would be a reputation killer, and not something the world expects from Obama. House speaker Nancy Pelosi has also called on Congress to pass an emergency rescue package for the industry. Given that one in ten jobs in America deals with the auto industry (from dealerships, auto parts etc), there is no question that the US government will extend life support to General Motors. Nonetheless, the longer the US government stalls, the more strain it puts on the financial markets, because investors don't like uncertainty.

Citigroup to Cut 50,000 Jobs, How Do Non-Farm Payrolls Fare in Recession?

Citigroup announced this week that they will be cutting more than 50,000 jobs in the "near term." This is on top of the 23,000 jobs that they have already cut, and will leave the company with approximately 300,000 employees globally. Even though non-farm payrolls dropped by more than 200,000 in September and October, Citigroup's layoffs and job cuts by other companies will drive non-farm payrolls even lower. In analyzing non-farm payrolls data during recessions, we see that at the beginning of an official recession-as defined by the National Bureau of Economic Research-non-farm payrolls start to decline rapidly. However, after falling between 200,000 and 300,000, job cuts stall and then pick up once again. We saw this trend in the 1981-1982 recession, the 1990-1991 recession, and during the 2001 recession. The following chart illustrates the double-dip trend of non-farm payrolls during the 2001 and recession.

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Stronger Industrial Production Does Not Invalidate Recessionary Conditions

Industrial production and the Empire State manufacturing survey were better than forecasted, but that does not draw away from the strong risk that the US economy will fall into a technical recession when third quarter GDP numbers are released next week. A resumption of mining after hurricanes Gustav and Ike helped industrial production rebound last month. The Empire State manufacturing survey fell to a record low of -25.43, but that was marginally better than the market's expectations. Given that the global recession is underway, we continue to believe that the US dollar and Japanese yen will outperform all of the major currencies. Producer prices and the Treasury's international capital flow reports are due for release on Tuesday. The drop in oil prices should alleviate price pressures.

GBP/USD: Undervalued Currency Sees Strong Rebound

Since the middle of July, the British pound has fallen more than 27%. In past editions of the Daily Currency Focus, we said that 1.55 is the approximate fair value level for the GBP/USD. With that in mind, the currency pair is now undervalued on the basis of purchasing power parity (PPP). Of course, PPP is far from accurate, and as we have seen in the past, currency pairs can overshoot their fair value levels for some time. Nonetheless, this helps to explain why we have seen a strong recovery in the British pound today-not only was it the day's biggest market mover, but it was also the best-performing currency. House prices continue to decline, with Rightmove reporting a 2.9% drop this month. The UK economy is in a recession, and we expect next week's third quarter GDP numbers to confirm that. The Confederation of British Industry, the country's biggest business lobby group, expects GDP to drop by 1.7% next year, which would be the largest decline since 1980. Consumer prices are due for release tomorrow, and given the drop in producer prices, CPI should ease as well.

EUR/USD Consolidates, but Problems Still Exist

The euro does not seem unnerved by developments abroad and is benefiting from the fact that attention has shifted to the recession brewing in the Japanese economy and the problems in the UK economy. The fear that the euro zone economy will reach recession has been realized, taking some uncertainty off of the table. However, the risks still exist for the euro zone. The region reported that their trade balance has narrowed significantly, from -9.4B to -5.6B. The impact of a strong currency in the first half of the year is kicking in, as exports take a big hit. French business sentiment also fell to multi-year lows. The health of the French economy is crucial, as it is one of the only large EZ economies not to be in a recession. Tomorrow's schedule includes Italian trade balance and current account, as well as EZ construction output.

AUD/USD: Will the RBA Minutes Signal More Cuts Ahead?

Even though the Australian and Canadian dollars strengthened against the greenback today, the New Zealand dollar edged lower. Oil and gold are still under heavy assault, with crude prices hitting a 22-month low. Australian retail sales were positive, which is sure to be the envy of the US, but the 0.1% rise was weaker than analyst expectations. Like the rest of the world, Australia has experienced a sharp decline in spending at cafes and restaurants, while clothing-related purchases also took a hit. Tomorrow, traders will be focused on the minutes from the Reserve Bank of Australia's most recent monetary policy meeting. Currency traders are always looking for some indication or prediction for continued cuts, and hope they will receive such hints in the upcoming minutes. The AUD Westpac Index will also be released tomorrow. There are no reports from Canada or New Zealand over the next 24 hours. New Zealand's Prime Minister-elect John Key said today that the budget deficit under his administration will be wider than forecast because he doesn't want to slash spending amidst a recession.

USD/JPY: Japan Is Officially in Recession

The Japanese economy has not fared well in the face of a massive global slowdown. The second largest global economy reported a 0.1% contraction in growth, putting the country into an official recession. Even though Japan had relatively low exposure to the toxic assets that plagued the rest of the world, it was significantly hurt by the slowdown in international demand. The tertiary index served as another blowing reminder that the domestic service sector has slowed, with activity falling by 0.6% after a decline of 1.3% last month. All of the factors create an interesting dilemma for the members of the BoJ at Thursday's meeting. After dropping rates by 20bp already, an additional cut would leave rates at the near-zero level. It seems unlikely that the commission would want to risk another 1990's-like scenario, which saw a recession lingering for years. A zero interest rate would take the ability to cut rates off the table for policy makers if the economy continues to slump. Therefore, while it is unlikely that the BoJ would cut rates further, it is likely that they will resort to either pumping more liquidity into the system, or develop some new, unconventional programs. Surprisingly, in the middle of horrible economy news, Japanese stocks are stronger as traders hunt for bargains. Tomorrow, we expect the final leading index for the month of September, which is expected to hold steady.

GBP/USD: Currency in Play for the Next 24 Hours

The GBP/USD will be the currency in play for the next 24 hours, based on the release of several important reports from both countries. In the UK, the Consumer and Retail Price Index will be released at 4:30 am ET, or 9:30 GMT, and the US will report the Producer Price Index at 8:30 am ET, or 13:30 GMT.

Despite some strong gains in today's trading session, GBP/USD still remains within the Bollinger band sell zone. This is the most significant rally in at least a week, however, today's price action stopped upward momentum immediately after touching the 23.6% retracement- drawn from October 30th highs and recent lows-at 1.4563. We are placing support at that level of 1.4563. If these lows were to be broken, we would be looking at levels not reached since 2001. Nothing much is below this except a low placed in early 1985 at 1.0345. Even though the 2001 lows are more than 1,000 points under, it is a strong example of how historical these movements are. As a potential bullish indication, there is an engulfing pattern (see circled candlesticks) that might result in a strong upward move. The level to watch is 1.363, the ten-day simple moving average. A close above that price level will negate the downtrend.

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