USD Pummeled as Risk Rally Extends Gains

05/11/2009 11:42 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The USD succumbed this past week, falling across the board, as stocks and commodities continued to strengthen as incoming data continues to suggest the worst is over in the current downturn. Employment data in Australia and Canada surprised to the upside when further job losses were expected, and those currencies continue to lead the way higher. US April jobs data were also not as bad as forecast, though the unemployment rate continues to rise. US bank stress tests revealed a less dire situation for the largest US banks, though many are skeptical of their significance in the event of a more protracted downturn, and financial shares led the way higher overall for stock markets. Commodity prices also rallied strongly throughout the week, both on USD weakness and less-bad data that suggests demand may recuperate sooner than expected.

In FX, serious technical damage was done to the USD, with EUR/USD closing above its 200-day moving average (1.3464) for the first time since last August. The strength in EUR/USD also saw the pair close above a key trend line at 1.3530, drawn off the all-time highs seen last summer in the 1.6040 area and the high seen in December around 1.4720. That break was mirrored in a similar breakdown in the USD index. USD/CAD fell to a key low around 1.1500, which marked a significant low last November. AUD/USD rallied to essentially close the gap down from last October at the 0.7700/50 area. Sterling faltered around 1.52 and did not see the same degree of advance after the BOE moved to increase its asset purchase plans (see below), but still managed to close out on new highs above 1.5200. USD/CHF closed decisively below the key 1.1250 level.

The driving dynamic continues to be one of improving risk appetites, which see the USD sold as safe-haven demand diminishes. Improving risk sentiment also aids carry trades (JPY crosses), though the advance in carry this week was less than might have been expected.

Staying Cautious on Further Advance

That sentiment has improved significantly in recent weeks is clear, but the question remains, how much more room is there for further improvement? A number of potentially negative hurdles have been cleared (bank stress tests, 1Q earnings, stabilization in data deterioration), or bullets dodged if you will, and the recovery in risky assets is the result. However, significant negatives still remain, and sentiment may simply be plateauing after rising from excessively pessimistic, worst-case scenario levels. For instance, the leading components of the April US employment report (hours and temporary employment) continue to accelerate lower, suggesting significant job cuts in the future. As well, absent US government hiring for the census, US NFP declines would have been -611K, not as significant an improvement as was reported. Continuing claims also continue to rise, having reached a new all-time high of 6.35 million. Elsewhere, unemployment in Australia and Canada is still expected to increase despite the surprisingly positive April results, while central bank action in the UK and  euro zone suggest policymakers foresee extensive further weakness in the months ahead. As for the bank stress tests, markets are relieved, but far from convinced that banks are in the clear, especially in light of S&P's forecast of another $600 billion in expected losses this year.

In financial markets, we see signs of hesitation and potential stalls in the current advance, which has come a long way indeed from the lows and looks overstretched. For instance, despite the universally acclaimed, "better than expected" US April NFP, the S&P 500 failed to make new highs on Friday. The broader Nasdaq market was nearly flat on the week, presenting a doji on weekly candles, suggesting indecision for the current rally. Momentum in shares is in danger of stalling and we will be very alert for any pullbacks there due to the exceptionally high levels of intermarket correlations observed recently (see below). We will be watching the S&P 500 945/950 level (just above the highs for the year) closely for signs that further gains are commencing. Generally speaking, Friday had the flavor of bears capitulating, both short covering in stocks and bailing out of USD longs.

In currencies, we would note that the USD selling accelerated significantly after the London close and most of the USD losses occurred in thin NY afternoon conditions, which makes many of the moves suspect. As well, FX has come a long way and in many cases, has reached significant levels (see above) where individual currencies may top out against the USD. At the same time, we recognize the breaks of key levels and that this may be an emerging trend. In short, we don't want to chase this move lower in the USD, but we will look to sell bounces in the USD and buy pullbacks in AUD, EUR, and GBP. We will also be alert for any significant reversal signals after this week's USD selloff, and quickly move back to a long USD bias should the news turn more negative. Lastly, we would note China's US ambassador on Friday remarked that the USD would continue to be the world's reserve currency for some time and that China would continue to buy US Treasuries. (Keep an eye out for Chinese data next week: trade balance, retail sales, and industrial production.)

NEXT: Intermarket Correlations Continue to Dominate |pagebreak|

Ever since the equity market bottomed in early March, we have witnessed some interesting correlations between different currency pairs and asset classes. These will be important to keep in mind if and when we get any relapse in the seemingly endless rally in risky assets.

The US dollar has weakened discernibly on the back of the risk rally as "safe-haven" trades got shunned. The DXY (dollar index) has seen a near -90% correlation with the CRB (commodities) index and -80% correlation with US equities, to boot. The price action in the USD, however, has made for a pretty curious relationship between gold and USD/JPY. Those two have seen a -70% correlation since the stock market bottom. The explanation for this is that while yen crosses tend to rally in a "risk on" environment, the selling of the USD safety play kept the pair trading mostly sideways. Gold has also been in consolidation mode. The precious metal tends to rally when the USD sells off as investors seek out an alternative to the depreciating buck. However, the rally in risk also keeps the gains in gold pretty limited as traders find less of a reason to own a hard asset with no yield in an environment of rallying equity marts.

One of the strongest relationships we have found is that between US equities and the commodity currencies. AUD/USD and the S&P 500 have enjoyed an excellent 98% correlation in this time period, while USD/CAD has had a similarly strong, albeit inverse, correlation with stocks of -95%. Much of this can be attributed to the commensurate rally in the commodity space in general. AUD and CAD have moved in tandem with the CRB index at least 80% of the time during this span. The rest has likely been due to improved economic fundamentals in both Canada and Australia, especially the newly released and much better-than-expected employment reports there.

The price action in euro has been interesting to say the least. Despite the sharp leg down in the USD overall, EUR/USD has only managed to move in tandem with stocks about 68% of the time since early March. Indeed one of the strongest relationships for the pair has been with oil prices, coming in at 83%. Much of the breakdown in the euro correlation with stocks was likely due to the risk surrounding the ECB meeting and any potentially aggressive, and dilutive, quantitative easing measures that might have come out of that. Now that the meeting has come and gone with little consequence, the relationship between these two assets has strengthened substantially and EUR has rallied in line with equities over the last couple of days.

The main point of this exercise in knowing how we got here is realizing where one should be positioned in case of a reversal in the optimism-driven jump in global shares. For those who, like us, believe that the current "risk on" rally is overdone, establishing short positions in EUR/USD and AUD/USD and going long USD/CAD makes the most sense. Gold and USD/JPY should be approached with caution and with the knowledge in hand that these two move against each other most of the time. Bottom line: Any reversal in current risk appetites will undoubtedly see a revival in the US dollar.

ECB Shifts Policy in Light of Economic Severity

Both the ECB and the BOE surprised the market last week. The BOE announced that it would extend its asset-buying plan by GBP50 billion to GBP125 billion and the ECB announced that it would buy EUR60 billion in euro-denominated covered bonds.

The move into quantitative easing by the ECB was in addition to its expected 25 bp rate cut and the anticipated extension in its money market credit facility. A major reason why the central banks were able to surprise the markets is that recent economic data have been coming in better than expected, dampening fears about the extent of the economic downturn. The actions of the central banks clearly make the point that both the UK and the euro zone have a long way to go before recovery is firmly established. ECB president Trichet acknowledges tentative signs of stabilization in the economy, but describes Q1 as being significantly worse than expected and warns that the world economy, including that in the euro zone, is still undergoing a severe downturn. Trichet forecasts economic activity as likely to be very weak for the remainder of this year before gradually recovering during the course of 2010.

Proponents of the Taylor rule (which indicates how far rates should move to address the imbalance between actual and potential GDP) are still arguing that monetary policy in the euro zone has more work to do. Trichet was keen to make the point last week that the market should not view the present 1% level of the refinance rate as representing the floor, a clear counter to recent market speculation. It therefore seems possible that rates may be reduced further. Equally there is no reason to expect that the ECB will not announce further quantitative easing measures if soft economic conditions keep inflation potential benign. EUR 60 billion is a very measured amount by comparison to the equivalent measures announced by the BOE and the Fed. Granted, according to ECB data, money market interventions have increased the balance sheet of the euro system by around 16% of GDP, more than the 14% of GDP increase seen in the Fed's balance sheet. However, the tone of the ECB last week suggested that the ground has been laid for more easing.

MORE: Key Data and Events to Watch This Week |pagebreak|

The US economic calendar is relatively busy this week and kicks off on Monday with Fed chairman Bernanke speaking on the stress tests. Tuesday sees the trade balance, while Wednesday has import prices, retail sales, and business inventories lined up. Thursday has producer prices and the usual jobless claims data. Friday is busy with consumer prices, NY Empire manufacturing, international capital flows, industrial production, and the University of Michigan consumer sentiment index. In sum, plenty for the risk trades to chew on.

It is similarly busy in the euro zone. Monday starts off the week with industrial production. This is followed by French business confidence and German consumer prices on Tuesday. Euro zone industrial production is up Wednesday, and Thursday has the ECB monthly economic report. Euro zone consumer prices, euro zone GDP, French nonfarm payrolls, French GDP and German GDP are all on tap Friday. We would expect EUR to give up recent gains if the data come in materially worse than anticipated.

It is also eventful in the UK. Monday sees the BRC retail sales monitor and the RICS home price report. Tuesday has the trade balance, industrial production, and the NIESR GDP estimate due. The all-important employment report is up on Wednesday, and Thursday closes out the action with the Bank of England quarterly inflation report.

Japan's week is busier than usual. Machine tool orders on Monday kick off the action. Tuesday is busy with the leading index, current account, trade balance and bank lending statistics lined up. On Wednesday, we see the Eco watchers economic surveys and Thursday has domestic corporate goods prices.

Canada is characteristically light. Monday has new home prices, while Tuesday sees the highlight for the week, international trade. Wednesday brings new motor vehicle sales data and Thursday closes things out with manufacturing shipments.

Last but not least, it is a modest data week down under. Sunday brings New Zealand home prices, and Monday has Australian business confidence on deck. The RBNZ financial stability report is up on Tuesday along with Australian home loans and investment lending. Australian consumer confidence is on tap Wednesday, while New Zealand retail sales and Australian consumer expectations round out the week on Thursday.

By Brian Dolan, chief currency strategist,

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