Traders Remain Nervous About US Dollar

08/18/2010 12:01 am EST

Focus: FOREX

Kathy Lien

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

We are moving into the heart of the dog days of summer, and today’s price action across the financial markets suggests that consolidation, rather than continuation, could be the theme of trading this week. After an exceptionally strong performance last week where there was not one day that the dollar did not appreciate against the euro, British pound, and New Zealand dollar, the greenback has finally given back some of its recent gains. However, the selloff was extremely modest, implying that investors remain nervous and are simply waiting for another good reason to bail out of risky currencies. In fact, the dollar’s more significant selloff against the Japanese yen and Swiss franc confirms that investors are still seeking safety in lower-yielding currencies. 

Diversification Concerns Weigh on US Dollar

Concern about central banks diversifying out of US dollars is the main reason why the greenback was sold.  Bloomberg news reported early this morning that China has bought "quite a lot" of European bonds, according to a former adviser to the People's Bank of China who was part of a foreign policy advisory committee that visited France, Spain, and Germany from June 20 to July 2. Based upon this morning's Treasury International Capital flow report, which showed total demand for dollar-denominated securities falling by $6.7 billion in June, buying US dollars has become increasingly unfashionable. Although long-term Treasuries remain in demand, China and oil-exporting countries were net sellers of dollars in June. Luxembourg, Japan, Switzerland, and the UK were the biggest buyers, but demand has primarily been for long-term US Treasuries. China sold $24 billion in the month of June, a sign that diversification has become a growing priority. Between May and June, China sold more than $55 billion worth of dollar-denominated securities. During that same time, China bought more than $13 billion worth of Japanese yen. China has been an aggressive buyer of Japanese yen throughout 2010, as well as a big buyer of euro. Last month, the trade chief of the European Union said that “China’s presence in Europe is visible across the board whether in China’s recent purchase of several hundreds of millions of euro of government bonds in the euro zone, particularly Spain or Greece, or in other large-scale investments too, such as the acquisition of Volvo by the carmaker Geely.” Due to their increasing diversification out of dollars, China has reduced their holdings to just $40 billion more than Japanese levels.

Turning to Housing and Inflation

Any possibility of continuation would be contingent upon Tuesday’s economic reports because the rest of the week is relatively quiet. Producer prices, housing starts, and building permits are scheduled for release tomorrow. Inflationary pressures are expected to be muted following a very modest rise in import and consumer prices. The National Association of Home Builders (NAHB) index showed that homebuilder confidence fell to a 17-month low in August, and if builders are worried about demand, then the chance of a meaningful pickup in housing starts and building permits is slim. Recent data shows that the pace of the recovery in housing has slowed significantly, and we believe that the clouds still hang over the housing market. According to the Chairman of the NAHB, "Builders are expressing the same concerns that they are hearing from consumers right now, particularly the sense that the overall economy and job market aren't gaining any traction.” “Meanwhile, many continue to report that problems with inaccurate appraisals, competition from the large number of distressed properties on the market, and tight consumer lending conditions are causing them to lose potential sales." 
The housing market is not the only sector of the US economy that is struggling to sustain its recovery.  The latest Empire State manufacturing survey also showed a tepid increase in activity with the index rising from 5.08 to only 7.10 in August after a very steep drop in July. Therefore, we do not expect tomorrow’s economic reports to provide much support for the US dollar. 

EUR: Greek and Portuguese Banks Still Tapping ECB

The euro rebounded against the US dollar despite a round of negative economic data and news that banks are still aggressively tapping the European Central Bank (ECB) for funding. According to the Bank of Portugal, Portuguese banks borrowed 21% more from the ECB in the month July compared to June. This indicates that despite the relief the stress tests have brought to investors, financial institutions in Portugal are still struggling to raise money in the capital markets. The Central Bank of Greece also said that borrowings from the ECB increased 2.5%. Like Ireland, none of the Portuguese banks failed the stress tests and ATEbank was the only Greek bank to fail the tests. Theoretically, the stress tests helped to restore confidence in the European financial markets, but practically, it failed to help the weaker countries in the euro zone get financing, which serves as a harsh reminder that the sovereign debt problems in Europe are not behind us. Meanwhile, inflationary pressures in the euro zone remain tepid. Consumer prices fell 0.3% in July, but on an annualized basis, prices rose 1.7%, the most in 20 months due to soaring energy costs. Stripping out energy prices, CPI rose 1.0% in July. 

Oil prices have fallen quite a bit from their August highs, but if they rise once again, it may hit the central bank’s radar, forcing them to err on the side of inflation when determining monetary policy changes. Current account figures are scheduled for release tomorrow, and good numbers could lend additional support to the euro. Germany’s current account surplus ballooned in June after shrinking substantially in May, while the French trade deficit improved, which should bode well for the euro zone’s report.  The ZEW survey of analyst sentiment is also scheduled for release and the market expects a sharp improvement in current conditions, but a weaker outlook for future economic activity. 

NEXT: What's Ahead for GBP, AUD, JPY


GBP: Sharp Decline in House Prices

Like the euro, the British pound rebounded against the US dollar, shrugging off news of a steep 1.7% decline in house prices in the month of August. This drop wiped out the year-to-date gains and is a sign that the UK housing market continues to suffer from tight credit. Bank of England governor Mervyn King said earlier this month that the “badly damaged” banking system is keeping the funding costs for lenders extremely high. With buyers unable to come up with hefty deposits, homeowners have had to reduce prices to attract any interest.  Prices will continue to be a focus tomorrow with the consumer price report scheduled for release. CPI has been running above the central bank’s target and the rate at which a plan of action needs to be submitted to the Chancellor for the past six months, and chances are it will continue to be above 3%. The central bank stubbornly believes that inflation will automatically decline as consumers and businesses respond to the government’s austerity measures. There is a good possibility that tomorrow’s CPI report will confirm that inflationary pressures subsided in July. BRC shop prices decreased slightly last month, while producer prices eased. It is a big week in the UK, and the action should begin with Tuesday’s report.

AUD: Leadership Battle in Australia

The Australian and New Zealand dollars rebounded against the greenback while the Canadian dollar sold off modestly. Aside from Australian new motor vehicle sales, which dropped 2.6% in July, no major economic reports were released from the three commodity-producing countries. Volatility should pick up over the next 24 hours with the minutes from the most recent Reserve Bank of Australia meeting scheduled for release, along with economic data from Canada. The RBA decided to leave rates on hold earlier this month and the tone of the monetary policy statement was very neutral. Therefore, traders will be looking to the minutes for clues on whether the door remains open for additional tightening this year. Aside from economics, politics is also on the minds of Aussie traders with the general election scheduled for Saturday. This election will determine whether Prime Minister Gillard will be nation’s the shortest-serving leader. Neither Gillard nor Tony Abbott is a particularly inspiring pick as both candidates have their flaws. The important thing for currency traders to remember is that political uncertainty is never good for a country’s currency, and the tight race between Abbott and Gillard should limit the upside potential for the aussie this week. Regardless of who wins, there will be a wait-and-see period before they actually clarify their policies. In the long term, investors are more focused on economics than politics, and regardless of the winner, growth in Australia is more reliant on the performance of Australia’s trade partners than on the Prime Minister. Over in Canada, manufacturing sales and international securities transactions are scheduled for release on Tuesday.

JPY: China Overtakes Japan as Second-Largest Economy

The Japanese yen rose against all of the major currencies despite disappointing GDP numbers. As our colleague Boris Schlossberg pointed out, “Japanese GDP data printed markedly worse than expected coming in at 0.1% versus 0.6% eyed as growth in the world’s third-largest economy cooled on the back of lackluster consumer demand. Japanese domestic demand declined at -0.2% while external demand rose 0.3%, both missing expectations of 0.1% and 0.5% increases, respectively. After recovering from the largest contraction in post-war history, consumer demand in Japan appears to have stalled once again as government incentives fade away, while private capital expenditure have been sluggish and unable to propel growth in the overall Japanese economy.”

Meanwhile, the sluggish GDP growth helped China overtake Japan as the world’s second-largest economy with a second quarter nominal GDP of $1.337 trillion, compared to Japan’s $1.288 trillion. Also from Japan, the July tertiary industry activity index declined for the second straight month. Disappointing economic data from the United States has caused US yields to decline significantly, driving investors to put their money in safer, yen-denominated assets since both currencies yield extremely little. Concerns over the yen’s recent rally and the lack of action by the government to prevent further strength have kept investors on edge. Over the past three months, the yen has risen over 8% against the dollar, posing a major threat to exporters’ profits. In addition to numerous comments by government and central bank officials, Prime Minister Naoto Kan told reporters yesterday that he is closely watching the economy and forex market. Japan’s Economy Minister, Satoshi Arai, stated today that, “As the yen has risen unexpectedly while US economic growth fell short of expectations and the European economy lacked strength, we need to work with the BOJ to respond to the yen’s rise and watch whether it may prevent a self-sustaining economic recovery.” He added “We are discussing quite a lot with the Bank of Japan what to do about the yen’s rise, and I hear the finance ministry is also exchanging various opinions with the BOJ at a working level.” Speculation continues to rise that Japanese officials are edging closer to action to stem further yen strength. There are many worrying signs about Japan’s economy that fuel this speculation, such as holding the world’s largest public debt, little to no growth, record-low interest rates, and crippling deflation.

By Kathy Lien of

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