What if the G-8 Discusses the USD This Week?

07/06/2009 10:57 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

We got some mixed news out of China this past week with regards to the US dollar's reserve status and the potential for it to be discussed at the upcoming G-8 Summit July 8-10. On Wednesday we saw headlines that China has asked the group of eight to discuss potential reserve alternatives to the USD. China and Russia have been the most outspoken in terms of calling for an IMF-backed super-sovereign reserve currency. These comments were promptly denied one day later when China announced that they do not plan any near-term adjustments to their reserve portfolio. The comments sent the buck for a ride, mainly through EUR/USD—the most liquid vehicle when one wants to voice an opinion about the greenback. EUR/USD promptly squeezed up to the week's highs just above the 1.42 mark only to dip back towards the 1.40 area one day later. Thus making it clear that the market's sensitivity to any commentary regarding the USD losing its prominent reserve status remains at an all-time high.

The meeting in question is scheduled for this week and we would be remiss not to mention the importance of this event. Should headlines emerge that the group is indeed discussing potential diversification away from the dollar, we would expect the weakness in the buck to resemble and exceed the reaction from the China musings earlier. We would not be surprised to see EUR/USD trade well above the 1.4200 mark and potentially make a bid for the 1.4340 June highs. However, the dollar comments could also be on the positive side, with the group reaffirming its reserve status. In this case a move towards the nearby lows of 1.3750/40 would likely be in the cards.

Focus back on risk as US earnings season kicks off:

This week kicks off the 2Q earnings reporting season in the US and the month of July will likely see FX move in tandem with the risk on/risk off dynamic. While the first week is light with only four S&P 500 companies reporting earnings, the weeks of July 13 and 20 see a whooping 193 companies slated to report. The market is looking for earnings in 2Q to be down -34% from the same quarter last year, with declines broadly based across pretty much all industries. The key will not be the earnings themselves but how the earnings come in relative to the consensus. For example, in 1Q nearly 68% of companies reported positive surprises to earnings as EPS estimates looked to have been "low-balled" on the back of horrid economic conditions. Should earnings surprise mostly to the upside once again, the implications for FX could be significant.

If we look at the correlations between FX and other asset classes for 2009 thus far, a clear picture emerges on what better corporate earnings and the subsequent rally in stocks could bring. The biggest loser in the big picture would be the US dollar. The buck has benefited from risk aversion flows and has seen a near 90% negative correlation with the stock market this year thus far. Should equities rally hard on the back of better EPS reports, the greenback would undoubtedly take it on the chin.

The jump in shares is also likely to see a significant pick-up in commodity prices, with these two asset classes very strongly correlated as well of late. This would be great news for the currencies of the resource-based economies like Australia and Canada whose terms of trade would instantly improve on more favorable commodity values. Thus any pick-up in equities would be bullish for AUD/USD and negative for USD/CAD on the follow. AUD/USD 0.85-0.87 and USD/CAD 1.07-1.05 would likely be up for grabs if the S&P decided to make an attempt towards the 1000 mark. Finally, gold looks likely to gain from a run-up in stocks as well. The precious metal has benefited both from the rally in the commodity space as a whole and from USD selling as investors seek out an alternative to holding dollars. A move above 950/970 would target the psychologically important 1000 mark next.

The opposite scenario, while less likely, is also possible. If earnings come in worse than anticipated overall, this could see equity marts retrench with the S&P's 800 level a potential target under a more negative scenario. This then would be decidedly positive for the buck and a trip in EUR/USD towards the 1.35/1.33 area would not be ruled out. The bottom line is that with earnings likely to be at the forefront for the better part of July, expect risk to provide direction.

Steady rates expected from the Bank of England (BoE); risk for a step up in the asset-purchase plan:

Rates are expected to remain unchanged at 0.5% following the July 9 BoE policy meeting, though there is a risk that the MPC members will vote to increase the size of its asset purchasing plan. The Chancellor has authorized the purchase of £150 billion. In March the BoE decided to buy £75 billion and this was extended to a total of £125 billion in the June meeting. In June the BoE cited that it would probably take another two months for these purchases to be completed, suggesting the possibility of a step up in the amount of either in July or August if economic weakness persists.

While there is evidence that the pace of the downturn in the UK economy is abating, the tone of most economic data is weak. Ahead of the BoE policy meeting, May manufacturing data and June consumer confidence are expected to show further signs of stabilization but recent BoE data for April has shown the weakest flow of net lending to businesses since June 2000. The BoE also cited last month that major UK lenders continued to see weak conditions in May. On balance, it seems that monetary policy measures have yet been insufficient to normalize the availability of credit. This implies the focus of BoE policy is likely to remain on stimulus and talk of exiting these policies is premature. Having rallied significantly since March, the sterling rally has lost steam. Poor economic data next week could increase the downside pressure, a break below the £/USD 1.6190/1.6200 support could see losses accelerate.

By Brian Dolan, chief currency strategist, Forex.com

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