USD Bounces Back—Are Risk Appetites Set to Worsen?

03/30/2009 1:28 pm EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

One week after the USD plunged against other major currencies, the greenback has come bouncing back. The reversal stems from many reasons, but the keys to watch are:

Fears over USD devaluation stemming from the Fed's buying of Treasuries were allayed by solid investor demand for $98 billion of new Treasury issues spanning the two-, five-, and seven-year terms. Contrast that with a failed UK auction (demand was less than the amount offered) of only about GBP 1.7 billion in 40-year bonds.

Outlooks elsewhere worsened further. Euro zone industrial new orders plunged to a YoY decline of -34.1%-and that was January data. Do you think orders picked up in February or March? Not bloody likely. The March Swiss KOF leading indicator fell to -1.79, a new low in the current downturn. UK retail sales slumped -1.9% MoM in February after a slight improvement in January. In Japan, retail trade in February dropped further to -5.8% YoY from -2.4% in January.

  1. Anticipated ECB rate cut next week and potential moves to quantitative easing (more below).
  2. Greater detail from the US Treasury on plans to entice private capital to take on toxic bank assets. This is still a work in progress and we'll need to see if the buyers and sellers are able to find satisfactory price levels to engage, but it dissipated a negative hanging over the USD.
  3. Lack of follow-through. Much of the week was spent testing the USD downside, with some notable action following ill-considered comments from Treasury secretary Tim Geithner on the USD reserve role, but the lows established last week held firmly and USD sellers eventually threw in the towel.

This week, I look for the USD to continue to recover higher against most other major currencies. The EUR looks especially vulnerable going into the ECB rate decision, but also may get whacked by a likely somber quarterly economic update by ECB president Trichet to the European Parliament on Monday. The 1.3250/70 is the key support area, below which exposes a full retracement of last week's rally back to 1.3120/50, but I would not expect the selloff to stop there. Many long EUR positions have been cut, but there are still some longs hanging on, and fresh shorts do not yet seem in abundance, suggesting potential down to 1.2830/70 area base of the Ichimoku cloud. If EUR/USD drops below the cloud, an even larger decline to the 1.23/1.25 area seems likely. GBP also looks poised to see losses extend, having tried and failed above the daily Ichimoku cloud top this week, and set to close below the cloud base at 1.4311. The Kijun line at 1.4217 appears to be the last source of support, with weakness below that level exposing further downside potential to the 1.3850/1.3900 area next.

The JPY is also exceptionally vulnerable as the Japanese financial year ends on Tuesday and the 1Q Tankan corporate outlook survey is released on Wednesday morning in Tokyo. USD/JPY may eventually overcome reported official selling interest between 99/100, opening up further gains to the 102/105 area, and I remain a buyer of USD/JPY on dips. The least vulnerable appear to be the commodity currencies, AUD, CAD, and NZD, which surrendered less of their gains this week and look set to fare relatively well in coming months.

The USD has been a leading indicator in terms of overall market risk sentiment over the last several months (USD up, fear reigns/USD down, risk is bought) and the significant USD bottom seen this week may signal a broader deterioration in risk appetites in coming weeks (USD up/risky assets down). Stocks globally have rallied significantly since making new lows just a few weeks ago, but gains have been on air-positive prognostications from bank CEO's, Treasury's public/private partnership details, Fed QE lowering rates-but many of those sentiment boosters are already fading. The global recession is still upon us, and the only basis for continued gains is an optimistic outlook, which is inherently fragile. Bargain-basement valuations have since been adjusted, and profit taking by recent buyers seems set to continue. Should risk appetites sour in coming weeks as I suggest, the USD should benefit primarily, and the JPY crosses should soften further. Within this outlook, I would expect the combination of USD strength to see the non-JPY legs of the JPY crosses bear the brunt of weakness (i.e. EUR/USD, GBP/USD down more than USD/JPY), but one can never rule out an ugly slide in USD/JPY amid a larger risky asset selloff. But I would view any weakness into the 94/96 area as a tremendous buying opportunity on a multi-week strategic basis.

G20 and SDR Talk Is Just Noise

I'll spare you the reasons why for now, but if the USD is ever sold again on talk of SDR's (special drawing rights) replacing the greenback as the global reserve currency, consider it a short-term opportunity to buy the USD. The same goes for any talk of major initiatives emanating from the G20 meeting next weekend. Disappointment over the lack of fresh economic stimulus measures is a more likely result. (This may be my shortest bullet point ever.)

MORE: ECB Meeting a Likely Catalyst for More EUR Weakness |pagebreak|

The European Central Bank is expected to cut its target interest rate to 1.00% from 1.50% on Thursday at 11:45 GMT. The forecast is a bit contentious, with some economists looking for a less aggressive -25 basis points cut, while a minority see the ECB standing pat on rates. We think the overwhelming likelihood is that the bank does the full -50 basis points in an effort to not be perceived as being even further behind the curve. Thus the main focus will once again be on the press conference, which follows at 12:30 GMT.

ECB president Trichet could give an early preview of what to expect as he is scheduled to testify before the European Parliament Economic Committee on Monday at 14:30 GMT. There is speculation that the ECB will announce some form of quantitative easing at the upcoming meeting, and market participants will be watching Trichet for any hint that this is the case. Indications are that the bank will extend the terms of loans to major euro zone banks and that they may buy corporate debt to ease strains on firms facing difficulties in securing credit. Indeed, ECB vice president Papademos alluded to some of these measures earlier in the week when he mentioned the possible purchase of private debt.

If the ECB does announce some form of balance sheet expansion, the EUR is likely to come under renewed pressure on the notion that the bank is now printing money, much like the Fed. If the ECB fails to announce measures beyond a rate cut, the market is likely to exact punishment on the EUR just as well, as the economic outlook will be expected to deteriorate further and they will appear helpless to prevent it. In other words, it may well be a lose/lose proposition for the EUR. The overall strategy remains to sell EUR on strength rather than buy it on dips. If the ECB cuts rates by the expected -50 basis points and indicates that aggressive quantitative easing is on the horizon, we would expect that the take profits on the short EUR/USD weekly strategy of 1.3150 and 1.3040 will be well within striking distance.

Key Data and Events to Watch This Week

The US economic calendar is pretty busy this week with some top-tier data on tap. The action starts on Tuesday with the S&P Case-Shiller home price index, Chicago PMI, and consumer confidence all due up. Wednesday is quite eventful with the ADP employment report, ISM manufacturing, pending home sales, construction spending, vehicle sales, and the weekly oil inventory numbers. Thursday is on the lighter side with weekly jobless claims and factory orders, while Friday rounds out the week with the all-important employment report and the ISM services index. On the policy front, Treasury secretary Geithner is on tap Sunday, while Fed chairman Bernanke is scheduled to make a speech on Friday.

In the euro zone it is also a top-tier data week ahead. Monday starts it off with the euro zone business climate indicator, and euro zone business and consumer confidence. Tuesday has euro zone CPI estimate, French housing starts, and German employment lined up. On Wednesday, we'll see euro zone PMI manufacturing, euro zone employment, and German retail sales, while Thursday brings French producer prices. Friday closes out the week with euro zone PMI services and German import prices. Look for ECB president Trichet on Monday as he is testifying before the EU Parliament in what could be a prelude to the ECB rate decision and press conference later in the week on Thursday (more on this above).

In the UK, it is a pretty light one and it starts with the Hometrack housing survey on Sunday. Consumer credit and the GfK consumer confidence index are up on Monday. PMI manufacturing is the highlight Wednesday, and Friday has the PMI services index on deck. Look for the Bank of England quarterly credit conditions survey on Thursday for an update on UK lending trends as well.

Japan's calendar is light as well, but with some important releases nonetheless. Sunday starts the action with industrial production, and on Monday we get the employment report. Tuesday is busy with housing starts, small business confidence, and the key Tankan business surveys lined up. Vehicle sales close things out on Wednesday.

Canada has perhaps the least busy calendar of the bunch. Tuesday has the only noteworthy data with the all-important monthly GDP and industrial product prices on tap. Look for a speech from Bank of Canada governor Carney on Monday as well.

It's relatively busy down under. New Zealand building permits start the week off on Sunday, while Australian new home sales are due on Monday. Tuesday has New Zealand business confidence, Australian private sector credit, and Australian performance of manufacturing index. Australian retail sales and building approvals are on Wednesday, and the Australian trade balance and performance of services index close out the week on Thursday.

By Brian Dolan, chief currency strategist,

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