USD Consolidation as Recovery Optimism Wavers

06/15/2009 10:49 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The greenback largely consolidated this past week in a highly volatile fashion as optimism over the prospects of an imminent economic recovery wavered. Stocks remained elevated, but could not make any significant upside progress, while commodities also gained, but showed signs of stalling late in the week. In a paradox, the very optimism that led speculators to ramp up commodity purchases may end up hampering the recovery, as higher food and energy prices are seen to be a major headwind for any consumer-led recovery. In bonds, government yields continued to head higher, posing yet another circuit breaker to economic recovery, as higher credit costs will restrain consumer and corporate borrowing, and hence spending and investment. Yet another obstacle to recovery is USD weakness driving up currencies in other major economies. RBNZ governor Bollard joined a growing list of finance chiefs and central bankers when he noted this past week that NZD strength undermined an export-led rebound. Incoming data also points to an ongoing contraction in global economic activity, with China's May exports dropping to a new cycle low of -26.4% YoY, April euro zone industrial production falling to a new cycle low at -21.6% YoY, and Japanese April machine orders unexpectedly slipping -5.4% MoM.

Against this backdrop, G8 finance ministers met this weekend in Lecce, Italy. Currencies were not slated to be a subject of formal discussion as central bank chiefs were not present for the meeting, but we will be alert for any sideline comments from participants. Instead, the G8 communique is expected to address financial regulatory issues and government plans to withdraw fiscal stimulus as economies stabilize. Most importantly, though, the G8 will provide its view on the global economic outlook, with most talk centering on a cautious assessment of stabilization, but with a healthy dose of realism that growth prospects remain distant and that many risks remain. Rising unemployment is most frequently cited as the greatest risk to any recovery. How markets react to the G8 view will be an important indication of the sustainability of the current rally. Traders are just now beginning to second guess the prospects for an early recovery, and a more cautionary, somber tone from the G8 may speed that process and lead to a more rapid unwinding of positions. Should commodities and stocks begin to falter on a more pessimistic G8 view, we would look for the USD to begin to strengthen.

The USD remains plagued by concerns over the high levels of deficit spending (see below), providing many with an easy excuse to sell the USD on any rebounds. While we think the near-term concerns are overblown, the longer-term prospects cast serious doubt on any significant trend toward USD strength, barring a financial cataclysm of sorts. What we can see, however, is a modest recovery in the dollar after May's steep losses, and, more likely, a near-term differentiation of other currencies' strength against the USD. Here, we think the EUR is the most likely candidate to weaken after the USD, making the EUR a sale on strength on the crosses, especially against AUD, GBP, and CAD. The European banking system is widely perceived to be the most vulnerable to a protracted downturn and national governments in Europe are widely viewed as largely ignoring the situation, in contrast to more aggressive capitalization efforts by the US and UK. Given the reliance of European firms on the banking sector for financing, in contrast to US firms' heavy utilization of capital markets to borrow, a serious crisis among Europe's banks would have quick spillover effects on the real economy.

Based on the expectation of deteriorating economic data out of the euro zone over the rest of the year and the prospects for significant further credit losses in European banks, we will look to use any rebounds to sell EUR/AUD, EUR/GBP, and EUR/CAD. Against the USD, EUR/USD looks to have sustained the key support at 1.3750/3800, but weakness below this level will be a strong indication that a medium-term high has been seen. On the topside, EUR/USD appears to be faltering below the 1.4150/4200 area, potentially tracing out a head and shoulders topping pattern. We would need to see the recent high at 1.4330 surpassed on a daily closing basis to become bullish.

Sterling Recovers, but Could Be Sensitive to Poor Data Near-Term

Sterling has made good progress since the start of May in winning back ground versus both the USD and the EUR. Concerns that PM Brown may have lost his job have, for the time being, subsided, allowing the market to turn its focus back to the relative prospects for the UK economy. On balance, UK macroeconomic data has surprised on the upside in recent weeks. In particular, the combination of an expansionary services PMI number and two monthly upticks in manufacturing output have convinced some economists that the recession is over. Many others, however, prefer to remain cautious. Concerns that many firms and consumers are still finding access to credit difficult and fears that the ongoing uptrend in unemployment will continue to hinder confidence remain valid. The next round of economic data will be a test of the theory that the UK is already emerging from recession.

The release of the May CPI data is expected to show CPI finally falling back to the BoE's 2.0% target. The BoE is forecasting a significant period of below-target inflation, which is the justification of the heavy-handed approach to monetary policy adopted as a result of the financial crisis. One more set of inflation data is unlikely to alter the view that rates will be on hold until next year. Similarly, the minutes of the June MPC meeting, while closely watched, are unlikely to have a strong impact on policy expectations or the pound. The unemployment data are unlikely to bring outright good news. The best possible outcome would be a slowing in the rate of layoffs, though this is not being forecasted for May. Retail sales data for May is expected to post a moderate 0.3% m/m gain. Following recent gains, sterling will be sensitive on a bad number. Similarly, following the May warning from S&P over UK debt, the market will be sensitive to bad news on the public finances. The PSNCR is forecast to be as much as GBP16.0 billion in May. Sterling could find it difficult to forge ahead under the weight of a larger number. Given that EUR/GBP is still about 26% higher than its September 2007 level (pre Northern Rock), there remains significant downside potential (medium-term, particularly) given the likelihood that the euro zone economy will emerge from recession at a slower pace than the UK. However, given last week's sizeable move lower in EUR/GBP, the risk is for a near-term pullback before the downtrend is re-established, and upcoming data could be a trigger for such a pullback. A break above the EUR/GBP 0.8560 area could trigger a move back as far as 0.8660/70. Such a move should be viewed as an opportunity to establish new EUR/GBP shorts.

MORE: US Funding Concerns Overblown, but Risks Loom |pagebreak|

The US Treasury auctions this past week suggest demand for US paper remains extremely robust and that talk of a US funding problem are overblown at this point. The most compelling results came at the longer end of the maturity curve. The Treasury offered $11 billion in 30-year bonds and the bid/cover (the demand relative to what was on offer) came in at 2.68 and well above the 2.29 six-auction average. Better still, foreign demand was very strong, with 49% of the offering taken by indirect bidders, compared to a six-auction average of 31%. The three-year and ten-year auctions were also quite healthy, but the fact that the long bond saw the best results suggests the long-term confidence in the ability of the US to pay its debts remains intact.

This past week, we also witnessed some more vocal intervention that was decidedly dollar bullish. One of the bigger factors in the buck's late week recovery was Japanese Finance Minister Kaoru Yosano, who said confidence in US government debt remains "unshakable" while reaffirming the dollar's status as the premier global reserve currency. On the flipside, Russia announced that they would be diversifying away from some of its US Treasury holdings. The good news is that more recently they seem to be alone in the dollar bear camp.

Russia owns about $140 billion in US Treasury paper and is the fifth largest holder. Now, the Fed has embarked on a mission to purchase up to $300 billion and the market has actually taken rates higher, fighting the Fed all the way. So even if Russia sold all of their Treasury holdings, this would merely get soaked up by the market, in our view. Recent auctions suggest the appetite for US paper has not waned, and if anything, it has gotten bigger. With Treasury supply expected to be around $2 trillion in 2009, Russia's decision to unload some US debt seems insignificant in the grand scheme of things.

Meanwhile, China has offered little in the way of support to Russia's claim that the world needs to diversify its reserves away from the USD and into a broader IMF basket of currencies. Given that China holds a massive $768 billion in US Treasury paper, we think they will be pretty hard-pressed to offer up negative musings with regards to the buck. Throw in the fact that Chinese exports were declining at a record -26.4% rate in May and we see even less incentive for them to create tension with their biggest customer, the United States.

Deficit worries remain, however, and the just released US Flow of Funds report for the first quarter suggests that while it is clear that consumers and businesses continue to cut back, the federal government's appetite for spending and borrowing remains voracious. Credit market liabilities held at the federal level grew at a staggering annual rate of 29%, up from a 24% run rate in 4Q08 and 6% in 1Q08. This is likely to accelerate as we muddle through 2009 and into 2010.

Health care reform plans currently being bandied about are estimated to come with a $1.5 trillion price tag in the face of an already massive $7 trillion in federal liabilities. Continuing on the path of unsustainable borrowing suggests we will be headed towards a debt-to-GDP ratio of more than 100% from a current 70% sooner rather than later. This seems to be the threshold that would knock down the US credit rating from the coveted AAA perch. The negative implications for the USD from this are obvious. So while in the short term, the US fiscal position is likely to remain on firm ground, the pieces are in place for potential problems not too far down the road. At this point, we remain cautiously optimistic.

Key Data and Events to Watch This Week

The US data docket is jam-packed this week and kicks off with NY Empire manufacturing, international capital flows, and the NAHB homebuilder sentiment index, all due out on Monday. Producer prices, housing starts, and industrial production are up on Tuesday, while Wednesday brings consumer prices, the current account, and weekly oil inventories. Thursday rounds out the week with the usual weekly jobless claims, leading economic indicators, and the Philly Fed manufacturing index.

Euro zone action is on the light side. Euro zone employment gets the ball rolling on Monday, while consumer prices and the ZEW economic sentiment survey are up on Tuesday. The trade balance is on deck Wednesday, while German producer prices are scheduled for Friday.

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

The UK has a modest week lined up. Consumer prices start things off on Tuesday. On Wednesday, look for the Bank of England meeting minutes along with the all-important employment report. Thursday ends the data week with retail sales, CBI industrial trends, and public sector borrowing.

Japan will see very little action. The Bank of Japan rate decision is on Tuesday and is likely to be a non-event yet again. That day also sees nationwide department store sales, and machine tool orders on Wednesday is the only other data point of note.

Canada has a busy week lined up for a change. Manufacturing shipments and new motor vehicle sales start things off on Monday, while labor productivity is due Tuesday. Wholesale sales and leading indicators are due Wednesday, while consumer prices are on deck Thursday. The top-tier retail sales report closes out the week on Friday.

It is ultra-light down under. New Zealand manufacturing activity on Sunday and the Australian leading economic index on Wednesday are the only noteworthy releases.

By Brian Dolan, chief currency strategist,

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