The Greenback Gets Smoked

05/26/2009 10:49 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The US dollar took a beating this past week as safe-haven USD and US Treasury long positions continued to be unwound. The dollar's slide was exceptionally rapid and no doubt was exacerbated by relatively thinner liquidity conditions ahead of long holiday weekends in the US and UK. The last phase of USD weakness occurred on Thursday after the Treasury market was caught long and wrong after smaller-than-expected Fed purchases and the announcement of a larger-than-expected Treasury debt issuance next week. USD weakness was widely attributed to fears over the fate of the US AAA sovereign credit rating, after S&P lowered its outlook for UK credit ratings. If you're perplexed why GBP should strengthen after its credit outlook is downgraded, and the USD weakens even as ratings agencies downplayed the prospects of any change to the US ratings, you're not alone. The only consistent theme behind USD weakness is the overall improvement in economic data suggesting that the global downturn is stabilizing, lessening the safe-haven demand for the USD and for US Treasuries. Accompanying themes, such as inflation fears, Chinese machinations, credit rating downgrades, and quantitative easing all provide background noise and fortify what has emerged as a nascent trend.

The USD has been steadily weakening since around April 22 as data has increasingly suggested the worst is behind us, though we remain pessimistic on the prospects for a V-shaped recovery. Over the same time frame, the CRB commodity index saw gains based on the improving global outlook, but topped out on May 12 and has since moved mostly sideways, even as the USD decline accelerated. The topping in commodities, as well as in stock markets, suggest that much of the good news has been priced in, while the sharper slide in the USD suggests there is still an overhang of long USD positions. That prospect further suggests that the USD may have some more room on the downside, but also that the USD could find new demand if the tide of data begins to soften again. As well, the USD decline has brought it to levels that are likely to elicit official concerns over USD weakness/EUR strength/JPY strength. Japan's Vice Fin. Min. Sugimoto sounded the alarm over JPY strength earlier last week, and on Friday, euro zone finance chief Juncker said that further EUR strength could hamper the euro zone recovery, which he also said was a long way off. We would expect additional verbal intervention in the weeks ahead, with US Treasury Secretary Geithner likely to re-introduce the strong dollar mantra after his attempt at re-formulating it fell rather flat this past week. Also, we will be closely watching the results of next week's US Treasury debt auctions (see below) and if healthy demand surfaces yet again, we would look for the USD to stabilize and potentially recover. If, however, demand is weak, look out below on the USD!

On the technical front, the USD decline has brought it near several important psychological price levels, namely 1.40 in EUR/USD, 1.60 in GBP/USD, and 80.00 in the USD index. The cable level was never tested, while EUR/USD and the USD index breached their levels, but later closed back below/above. In light of the prominence of these levels and the excessive speed of the USD selloff, we won't be chasing the USD lower and will be alert for significant reversal signals. In particular, given holiday-thinned conditions on Monday, we think there is strong potential for a short-term speculative push lower in the USD, which if quickly reversed, especially in response to official comments, would strongly suggest that the USD has found a near-term bottom.

Poor US Note Auctions Could Exacerbate Dollar Weakness

The US Treasury will auction a monumental $101 billion in government debt notes this week. The amounts are in line with the prior month's offering and we will see $40 billion in two-year, $35 billion in five-year, and $26 billion in seven-year paper. Given the recent chatter about the risk to the United States' AAA credit rating, the auctions could have significant implications for the US dollar and will likely have a hand in either stemming the buck's decline or exacerbating it. For traders following the auctions, the most important statistics will be the bid/cover ratio and the market tail.

The bid/cover measure is a ratio of the number of bids submitted (total interest in the auction) to the amount of paper on offer. Thus, if the bids for a two-year auction totaled $100 billion and the amount offered was $40 billion, the result would be a 2.5 bid/cover. This would suggest a well-subscribed auction, and thus, confidence in the ability of the US to repay this debt. For reference, the average bid/cover over the last three months for next week's auctions are 2.69 for the two-year, 2.15 for the five-year, and 2.30 for the seven-year. Should these come in significantly below the recent averages, we would look for USD weakness to continue and even accelerate. Better bid/cover results would not necessarily be a positive for the buck, but would help stop the recent assault on the greenback.

The market tail, though less advertised, will also be important in gauging the health of the auction. The tail measures the distance between the interest rate traded at market for that particular security right before the offering and the rate that the auction settles on. This is measured in basis points. For example, if the two-year were trading at 0.85% in the market right before the offering and the auction settled on a 0.90% yield, this would represent a five basis point tail and overall lack of interest from the investment community. Seven to ten basis point tails would represent a problem for the five- and seven-year note auctions. By bidding a higher rate, the participants are really saying that they would only be willing to buy the bonds at a price well below the prevailing market price (higher yield = lower price). We would think that large market tails coupled with disappointing bid/cover ratios would be a perfect storm and fuel further dollar declines.

MORE: Budget Deficits, Credit Ratings, and European Banking Issues |pagebreak|

Using EIU data, the UK and US will be the only major economies this year to suffer double-digit budget deficits. That the respective governments had little option but to spend their way out of this downturn is not in dispute, but the focus has now turned to how quickly these governments can start to repair the damage done to their national debts.

As a ballpark figure, a budget deficit below 3% of GDP can be considered to be consistent with stable national accounts. The EIU estimate that the UK budget deficit this year will rise to 12.3% of GDP, and the US deficit will be 13.1% of GDP. On May 21, S&P revised their UK debt-rating outlook from stable to negative. This has not been followed by other agencies and there is no serious fear that the UK government is in real risk of defaulting on their bond obligations, but the market's attention has been drawn to the risk, albeit a slim one, that an upward spiral in deficits may leave the US and UK governments with little option but to print money to meet their obligations. The latter scenario is clearly currency negative.

Despite the news from S&P, sterling ended the week stronger versus the USD and little changed versus the EUR. There is no getting away from the fact that the news on the UK national accounts is bad. However, this is not new news and sterling still has a lot of bad news pertaining to the poor economic backdrop reflected in its price. Sterling is still about 30% weaker versus the EUR than before the Northern Rock banking crisis in September 2007. By contrast, the EUR has seen little downward pressure from economic news even though according to the IMF, non-UK European banks face more write downs than US banks over the next two years. Already, Spain's Caja Madrid has announced it will skip a coupon payment on bonds as sharply rising unemployment (17.7%) has prevented many consumers from making mortgage payments. Dire Q1 GDP data from the euro zone have increased the risk that more bad news will emerge from its banks this summer. As a consequence, there is potential for EUR/GBP to move back toward its lows for the year around EUR/GBP 0.8640 and then to edge lower from there.

Key Data and Events to Watch This Week

The US economic calendar is moderately busy in the week ahead. Memorial Day was Monday, of course, and thus the action kicks off on Tuesday with the Case-Shiller home price index and consumer confidence. Existing home sales is up Wednesday, while Thursday is busy with durable goods, initial jobless claims, new home sales, and crude oil inventories. The second cut of 1Q GDP is up on Friday along with the Chicago PMI and University of Michigan consumer confidence index.

The euro zone calendar is a touch busier. Monday had the German IFO index on tap. On Tuesday, we see euro zone current account, euro zone industrial orders, French consumer spending, German GDP, and German consumer confidence. Wednesday brings French consumer confidence, French business confidence, and German consumer prices. Thursday has euro zone consumer confidence and German employment, while Friday rounds out the week with euro zone consumer prices, French producer prices, and German retail sales.

Japan sees a pretty busy week ahead as well. The all industry activity index starts things off on Sunday, while the Bank of Japan monthly report is due Monday. International trade is one of the week's highlights on Tuesday. Small business confidence and retail trade are on deck Wednesday, while employment, household spending, and industrial production make for a busy Thursday. Housing starts finish off the week on Friday.

It is a light one in the UK and starts off on Wednesday with home loan data. Thursday sees the other noteworthy data with the quarterly distributive trades report (retail sales) and consumer confidence due.

The calendar in Canada is almost not worth mentioning as only the current account on Friday is scheduled.

Last but not least, the action down under is pretty normal. Monday had the New Zealand trade balance lined up, while Tuesday sees New Zealand inflation expectations. On Wednesday, we will see Australia's leading index and New Zealand business confidence. Thursday brings Australian new home sales and New Zealand building permits, while Friday closes things out with Australian private sector credit data.

By Brian Dolan, chief currency strategist,

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