The Dollar: Takes a beating, Can it Keep on Ticking

The market has been inundated with a steady stream of dollar negative news. The Federal Reserve has slashed its funds rate target by 125 bp over the past ten days or so. Fourth quarter growth was about half of what the consensus expected. The New Year has begun poorly with the US actually shedding jobs for the first time in over four years. In fact the combination of the decline in non-farm payrolls and the first drop in the work week since last July warns of risk that the US economy is contracting.

The US dollar has been surprisingly resilient. To be sure, it has slipped against most of the major currencies thus far this year, but it has not fallen as much as one would have intuitively expected given the news stream.

Euro

The euro reached a record high on November 23 near $1.4967 (according to Bloomberg) and despite the news and a few ill-fated challenges, it has not managed to rise above that high water mark. The $1.50 level has taken on extra significance. Not only is it a round psychological number, but there is widespread talk in the market of option structures struck near there and large buy orders above. For three months now it has been confined to a band roughly between $1.4300 and $1.4950.

On 29 January, the five-day moving average crossed above the 20-day moving average, which we find to be a useful short-term trend indicator. The euro closed that day at $1.4776 and there has been follow through euro gains. However, this is the fourth crossover since late-November and in a sideways market, moving averages get whipsawed. And the inability of the euro to sustain gains through the $1.49 level despite the dismal employment report reinforces the upper end of the bans. Important support is seen near $1.4720-30 and then the $1.4580-$1.4600 area.

The ECB meets next week and with inflation in the euro-zone ticking up further away from the 2% target, the ongoing wage round and the stronger than expected purchasing managers survey for the manufacturing sector, a recalcitrant stance is likely. While downside risks to growth will likely be recognized, ECB Trichet will likely strut his hawkish plume. Yet, the market is unlikely to bite. The threat of a rate hike is not to be taken seriously. Although survey data suggests sentiment shifting toward a late Q2 ECB rate cut, which is what we forecast in our last quarterly publication, the June Euribor is not there yet.

Yen

The Japanese yen has been the strongest major currency against the US dollar over the past one, three and six months (5.1%, 8% and 12% respectively). Its strength does not reflect enthusiasm for the Japanese economy or Japanese assets. The Japanese economy, the world’s second largest, is slowing. Recall that its economy contracted in Q2 and staged a halfhearted, export led recovery in Q3 and appears to have largely stagnated in Q4. The preliminary estimate for Q4 GDP is coming in at a little more than half that of the disappointing US 0.6% annualized pace. That said, because there still is a bit more than a whiff of deflation in Japan, nominal GDP might have actually stagnated.

Falling equity markets, risk aversion, elevated volatility, and the dramatic reduction of the US interest rate premium over Japan lie behind the recovery of the yen. It appears to have gone beyond the unwinding of the yen carry trades. At the IMM, speculators have amassed their largest long yen position in several years.

The five day moving average for the dollar against the yen broke below the 20 day moving average on 2 January and has not looked back. However, the dollar’s down side momentum against the yen has faded since the middle of January. It did briefly dip below the JPY105 level on Jan 23, but for the most part the greenback is finding good bids near JPY105.75. On the upside, the dollar faces resistance in JPY107.40 and JPY108 area. A move above JPY108 would immediately target JPY110.

Sterling

Sterling has enjoyed a bit of a short-covering rally since reaching its January low just below $1.9340. It had peaked in early November near $2.1160. The five-day moving average crossed below the twenty-day average on November 14 and crossed back above on January 28. The short-covering bounce ran out of steam in the $1.9950 area, unable to even meet the minimum retracement objective of the two-month downtrend, which is found just above $2.00. Support now pegged near $1.9650 and a break would signal at least another cent decline and possibly a return toward the recent low.

The Bank of England’s Monetary Policy Committee meets on 7 February. There is as near as these things get to being universal opinion in favor of a 25 bp rate cut, which would bring the bank rate down to 5.25%. In the subsequent statement the MPC is likely to signal that additional rate cuts will be forthcoming. Economic data has generally come in below expectations and the housing market slowdown continues to unfold.

If there were to a be a surprise from the BOE, where Governor King was just reappointed, it would be a 50 bp rate cut rather than standing pat. The odds would seem low, but then again that is what makes it a surprise. The economy to be sure is not contracting, but the central bank and the unelected Prime Minister can ill-afford to wait until then to ease monetary conditions.