US Dollar: Following in the Footsteps of China?

08/19/2009 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

Risk aversion has dominated trading in the currency market the past few days with the US dollar rising against every major currency except for the Japanese yen. Economic data was better than expected, but concerns have grown about the strength of the recovery and whether the economy has improved enough to warrant the recent gains in US equities. Since the beginning of the month, investors had grown increasingly uncomfortable with the green shoots theory despite improvements in economic data, which was why the S&P 500 struggled to extend its gains for the past two weeks. However, even though currency traders were already risk averse, the liquidation has now expanded to equities, and if that continues (and we believe it will), it should lead to more losses for the dollar against the Japanese yen and further gains for the greenback against the euro and British pound.

Taking a Cue from China

Towards the end of last week, the price action in the currency market indicated that investors were skeptical about the strength of the recovery, but it was not until the sharp selloff in equities on Monday that stock market investors jumped onboard, exacerbating risk aversion across the financial markets. The liquidation began in Asia when investors sent the Shanghai Composite Index down 5.8%, the biggest decline in nine months. This nervousness among investors in China translated into nervousness in the US because problems in one country will undoubtedly lead to problems in the other.

The concern in China right now is that the market has gotten ahead of itself. Yes, the Chinese government has funded a massive stimulus package, but so far, it is businesses and not consumers that are benefitting. Interestingly enough, one could argue that we have the same problems here in the US where it has been a business and not a consumer-led recovery. Therefore, without another stimulus, it will be a long and hard recovery that the average Joe and Jane will not feel until months later. So if the US follows in the footsteps of China, we could see a steeper slide in equities and more risk aversion in the currency market. The VIX index has also jumped sharply, which confirms our belief that the odds favor more weakness.

Economic Data: Preview and Review

Inflation and housing market data are due for release on Tuesday. With import and consumer prices released before the PPI number, the impact of any surprises or disappointments in producer prices should be minimal. Therefore, the market will be paying closer attention to the housing starts and building permits numbers. We have seen a series of positive surprises in both reports over the past few months, and with the NAHB index of builder confidence rising to the highest level since June 2008, there is a decent chance that the numbers will be positive once again. As for the other reports, the Empire State manufacturing survey also rose to a 20-month high, while foreign demand for US dollars rose by the strongest amount in 16 months.

The details of the report indicate that foreign investors moved out of short-term Treasury bills and other instruments and into longer-term Treasury and government bonds. This is a reversal of the previous month's trend where demand was skewed towards the short end of the curve. Interestingly enough, demand was particularly strong among private investors, but a similar pattern of demand was also seen in foreign central banks. Including short-term TIC flows, total purchases of dollar-denominated assets fell by $31.2 billion in June. Part of the reason why demand was skewed towards the long end of the curve was because long-term bond yields skyrocketed in June. Ten-year yields, for example, climbed to a seven-month high of 3.948% on June 10th, while 30-year yields climbed to a high of 4.763%. Short-term rates, on the other hand, have remained low.

The Federal Reserve also extended their Term Asset-Backed Securities Loan Facility (TALF) program to June 30th for commercial mortgage-backed securities and to March 31st for newly issued asset-backed securities and already issued, or "legacy," commercial mortgage-backed securities. Both programs were set to expire at the end of the year. Although expanding the TALF program provides more support for the economy, it also reflects their degree of concern about the commercial real estate industry, which has been struggling to recover.

By Kathy Lien, Director of Currency Research at GFTForex.com

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