The Worst Looks to Be Over for the US Dollar

06/08/2009 10:28 am EST


Brian Dolan

Chief Currency Strategist,

We may be jumping the gun by sounding the "all clear" for the USD at this stage, but we feel more comfortable now buying USD weakness going forward. We are mindful, however, that several currency pairs are still above key trend lines in the prior USD down move (see below), and that this past week's USD rebound may just be a correction. But the messages from central bankers/reserve managers greatly allay fears of a USD implosion and we think the USD short-covering rally has more room to run.

The USD came storming back last week, with the most impressive moves coming after a "less worse" May non-farm payrolls (NFP) report on Friday suggested the worst of the job cuts are over in the US (see below). But the USD actually bottomed out earlier in the week after finance officials from China, Japan, South Korea, and India indicated their belief that the USD would remain the global reserve currency for the foreseeable future. Those comments followed Treasury secretary Geithner's trip to Beijing, during which he managed to allay Chinese concerns over US deficits and voice support for the USD, presumably also securing Chinese commitments to keep buying US debt. Fed chairman Bernanke followed that theme in testimony on Wednesday, during which he encouraged Congress to begin to act now to address long-term deficits. On Thursday, both ECB president Trichet and Bank of Canada governor Carney voiced concern over USD weakness, with Trichet solemnly noting the US Treasury's support for a strong USD. These developments removed the pall that had been hanging over the greenback. The icing on the cake was the May NFP report, which initially saw the USD weaken, but massive USD short-covering flows then dominated.

Risky Assets Remain Buoyant, Threatening Correlations

Another major driver of the USD rebound was the sharp run-up in US Treasury yields, with the yield on the two-year bill rising 35 basis points to 1.30% on Friday alone. Ten-year yields came close to 3.9%. The backup in yields reflects the market more aggressively pricing in a US economic recovery later this year. Fed fund futures traders even began to bet on Fed rate hikes as soon as this autumn. While we think those expectations are wildly premature, the NFP report was sufficiently rosy to keep the reflation/recovery trade alive. This had the effect of seeing at least a temporary breakdown in many of the recent FX correlations, with the USD rallying sharply, stocks trading nearer to recent highs, and commodities (with the exception of gold, which collapsed on USD strength) generally maintaining recent gains. This suggests that much of the week's rebound in the USD was more about removing excessive USD fears and consequent short USD positioning than about a major revision to the near-term outlook. The theme of a sooner-than-expected US recovery may drive the USD higher in the weeks ahead, while also keeping stocks and commodities better supported. However, in light of the ongoing global recession, which we still expect to persist well into 2010, crimping overall demand, the risks are that commodity prices come off the boil, aided partly by a higher USD.

Another development that suggests the 'risk-on' trade remains in effect is that carry trades (JPY crosses) held on to most of their recent gains. A sharp rise in USD/JPY was largely responsible for this, driven both by USD buying and higher US yields. USD/JPY managed to break through the Ichimoku cloud top at 98.07 and to surpass key daily trend line resistance at 98.30, drawn off the April 101.40/50 highs. This may see potential for another week dominated by carry trades grinding higher, as USD/JPY remains firm and EUR/USD, AUD/USD, USD/CAD, and GBP/USD may consolidate after Friday's sharp losses. The USD has come a long way quickly and has some further immediate upside. But for the USD to see an even larger recovery against other currencies, we will be watching the following price levels: EUR/USD below 1.3776 Kijun line/1.3800 head and shoulders top minimum measured move objective; GBP/USD below 1.5700/20 Kijun line/daily trend line from 1.4500; AUD/USD below daily channel support at 0.7900/10, then Kijun line at 0.7753; USD/CAD above daily channel top at 1.1300/Kijun line 1.1370. Looking ahead, we would look to be buyers of USD on dips and sellers of those currencies on strength. We would also prefer to be buyers of JPY crosses on weakness, while US yields remain firm and the S&P 500 holds above 915/920, keeping the risk-on/reflation trade alive.

NEXT: Is the Bottom in for US Employment? |pagebreak|

The May employment report showed a much better than anticipated -345K decline in non-farm payrolls, with the prior two months being revised up by a net +82K to boot. The details of the report were encouraging as job shedding decelerated across most major sectors. Private employment losses eased to -338K from -596K the prior month and a near -750K loss in January. Services jumped to -120K from -230K, while business services increased to -51K from -111K. Education and health returned to the pre-crisis trend and printed a booming +44K increase after averaging a meager +15K over the prior three months. The fact that the unemployment rate jumped to 9.4% from 8.9% is ignored as a "baked in the cake" event as everyone expects this number to breach 10.0% in the very near future. The pace of employment declines is what matters and other indicators buried in this report, along with other recent statistics, suggest the worst of the declines are behind us.

The most important leading indicators within the May employment report have clearly carved out a bottom. Improvements in aggregate employee hours and temporary employment suggest a turn is in the works. The three-month annual rate for aggregate hours was steady at -8.6% and has been on an upward trend since bottoming in January at -9.0%. Hours lead bodies in the employment cycle and the slowing here suggests employers are now nearing the limit for layoffs. Temporary employment is also an excellent leading indicator and the three-month annual rate here jumped to -31.0% from -35.7% the prior month and the cycle low of -37.5% in March. Temporary employment on the mend is also a sign that employers are likely done in terms of major cuts.

Other indicators of late also point to a trough in employment losses. The somewhat obscure Challenger employment report released this past week showed that the annual rate of announced job cuts fell to the lowest since May 2008 and is at 7.4%, down from 47.0% prior. This metric has done a great job of predicting the path of initial jobless claims in recent years, with a lead time of about three months. The relationship suggests we put in the peak for initial jobless claims in the month of March and could be on our way to a sharp correction in terms of the job shedding rate towards 400K by mid-summer (from a current initial jobless claims rate well above 600K). Another metric flashing a bottom is the employment trend index from the Conference Board. The index is composed of eight indicators that have historically led employment cycles. This number rose to a three-month annual run rate of -26.3% in April from -29.0% in March.

Should historical correlations of better US data leading to a higher US dollar return to the fore, we could be poised for a sharp reversal in the recent dollar weakness. Economic problems in Europe are at least as large, if not larger than in the US, while Canada tends to lag the states by roughly one to two quarters in terms of economic activity. In other words, long USD/CAD and short EUR/USD could be attractive places to be in the medium term.

Sterling Reels Under Political Uncertainty

The forthcoming week could be another long one in UK politics, particularly for PM Brown. The crisis had been growing for days fed by talk that the Chancellor of the Exchequer Darling was about to be ousted by the PM and then by rumors that PM Brown himself may have resigned. Four cabinet ministers had resigned ahead of Friday's cabinet reshuffle. While these resignations helped the Chancellor to keep his job, the PM's position has definitely been shaken.

The pound was hit hard by Thursday's rumors that the PM may have resigned. While the rumors were denied, the pound remained on the back foot through the Friday morning session in London on fears that events may yet bring about his resignation. His cabinet reshuffle was read as having bought some time for the PM since Brown appears to have surrounded himself with supporters, and in doing so, has slowed the pace of calls demanding that he go. But cable's recovery was short-lived, and the uncertainty continues, meaning the next few days will be telling. Party rules require at least 70 labor MPs calling for a leadership contest before one has to be called. However, even if Brown survives the next couple of weeks or so, it seems that his days at the helm are still numbered.

The opposition continues to call for a general election, but the PM would not be serving his interests by conceding to these calls. Projections that the Labor government would suffer heavy losses at an election have been supported by the results of the June 4 local elections. An early election may still happen, but the government will try and struggle on until May 2010.

It is interesting that sterling largely ignored the UK political crisis until the rumors of Brown's resignation surfaced on Thursday. Extreme political uncertainty, it seems, is still a currency negative factor. Looking ahead, sterling is not likely to react well to the likelihood that Brown's position as leader has been weakened by the events last week. Sterling will also be undermined by the current uncertainty about who would be most likely to replace Brown.

The bigger picture provides some solace. It has been well known for months that the present government is unlikely to make it past the next general election and sterling has hardly reacted to this. The conservative opposition is expected to takes the reins of government sooner or later. Essentially, the gap between the conservative and labor parties has closed over the past 15 years or so, limiting perceived political uncertainty associated with a change of government. Pledges of budget austerity made by the opposition and the perception that their house is in better order than the labor party mean that an election, when it eventually happens, could be positive for the pound.

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

The economic calendar in the United States has some top-tier events lined up. Tuesday kicks it off with wholesale inventories. On Wednesday, we have the trade balance, weekly oil inventories, the monthly budget statement, and Fed's Beige Book due. Retail sales is the highlight for the week on Thursday, and we'll also see the usual weekly jobless claims numbers and business inventories that day. Friday rounds out the week with import prices and the University of Michigan consumer sentiment index. Look for Treasury secretary Geithner on Friday as well, who will be speaking at a G8 news conference.

It is also pretty busy in the euro zone. German factory orders start off the action on Monday, and there is also a meeting of the euro zone finance ministers that day, which could prove market moving. Tuesday is busy with French business sentiment, German and French trade, and German industrial production on tap. Wednesday brings French industrial production and German consumer prices, while Friday closes out the week with euro zone industrial production and German wholesale prices. Notable as well on Friday is a speech by ECB President Trichet.

The UK is on the light side. The BRC retail sales monitor and home prices are on Monday. Trade numbers and industrial production are due Wednesday, and the Bank of England releases its quarterly inflation attitudes survey on Thursday.

Japan has a modest week ahead. The current account leads the way on Sunday, while the leading index and machine tool orders are up Tuesday. The final 1Q GDP numbers are due Wednesday. The data week finishes out with industrial production and consumer confidence on Friday.

Canada's calendar is characteristically light. Housing starts kick off the week on Monday, while international trade and new home prices are due Wednesday.

It is a bit busier down under. New Zealand home prices start things off on Sunday. On Tuesday, we have Australian business conditions and New Zealand credit card spending. The highlight of the week comes Wednesday with the RBNZ interest rate decision (market looking for no change to 2.50% target), and Australian consumer confidence and home loans are also up that day. Thursday is also very top-tier with New Zealand retail sales, Australian inflation expectations, and Australian employment on deck.

Last but not least, while we don't cover it on a routine basis, we would be remiss not to mention the important data due out of China in the week ahead. Thursday has the trade numbers lined up, while Friday sees retail sales and industrial production. With China deemed to be one of the beacons of hope in terms of a global recovery, the data could indeed be market moving. Look for weaker numbers to elicit a relapse in any preceding "risk on" rally, while better results would likely make for a strong market into the weekend.

By Brian Dolan, chief currency strategist,

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