The last several weeks have been particularly difficult for short-term players in the foreign exchange market. Many have been chopped up as narrow ranges have prevailed—selling lows and buying the highs betting on a breakout which did not materialize. The US dollar appeared to break higher after a knee-jerk drop after news the job creation in September was less than half what the consensus expected. The greenback’s gains pushed the euro to its lowest level since late July and recorded its best level against the Japanese yen since mid-March. The next key levels are seen near $1.2560 and JPY120. A convincing break of these areas warns of near-term scope for another big figure dollar advance—toward $1.2450 and JPY121. That said, the greater risk to traders is betting now that a convincing break has taken place, and instead, when the dust settles, the dollar may still be stuck in a range, even if frayed.
The fundamental case for the US dollar to strengthen is predicated on something that has been a concern of ours for some time now. We have argued that the US economy is more resilient than many appreciate and that the market was getting ahead of itself in pricing a good chance of a Fed rate cut in Q1 07.
Numerous Federal Reserve officials have spoken in recent days. The comments by the Vice Chairman Donald Kohn were especially pointed. His comments take on extra significance when one appreciates that there has been a great deal of turnover at the Federal Reserve and Kohn has more experience at the Fed than every one else on the Board combined. In addition, Kohn is in charge of a task force working on making Fed communication more effective. Although Kohn recognized the risk that the economy would weaken too much, which is what lies behind the market discussing a rate cut within the next six months, he argued, as we have, that the decline in energy prices and the low long-term interest rates will cushion growth. To this we would add the strength of personal income in the US which has risen 9.4% in the 12-months through August.
Kohn, along with several other Fed officials, indicated that they were more concerned about price pressures than about the risk the economy falls into a recession. Kohn specifically cited the 7.75% year-over-year increase in labor costs as a cause of concern. He won’t draw any comfort from the average hourly earnings data contained in the September employment report. Hourly earnings ticked up and are now rising at a new cyclical high of 4.0% on a year-over-year basis.
These Fed comments helped begin a swing the pendulum of market psychology and this is reflected clearly in the short-term interest rate futures market. Consider the Fed funds futures strip, The March contract sold off 10 ticks from Wed, Oct 4 through Friday Oct 6. Admittedly the March contract is not very liquid at the present, but the same general pattern is evident in the March 07 Eurodollar futures. It has dropped 15 ticks in the same period.
There appears to be potential more additional adjustment. Assuming that the Fed is on hold for the next several months and then cuts rates at the 21 March 2007 meeting, fair value for the Fed funds futures is 94.83. Even with the sell-off in recent days, the contract is trading near 94.81, implying that the market is still pricing in a good chance of a cut. When expanding our analysis to the April 07 contract, the market appears to be pricing in just about a 50% chance of a cut. This still seems to high, by our reckoning. We still recognize a reasonable chance of a Fed hike and even if we are wrong about that, a protracted period of steady policy seems a more likely scenario than a cut. As has been the case through most of the current cycle, we remain more hawkish than the market.
Meanwhile there has also been a complimentary move in Europe. Following the ECB’s decision to hike rates on October 5, many participants read ECB President Trichet’s comments as somewhat less hawkish than expected. This saw the March Euribor futures contract rally almost 10 ticks in 24 hours. We suspect the market misunderstood Trichet. Previously, Trichet and the Bundesbank President Weber both cautioned the market against thinking its monetary tightening cycle would be completed this year. Trichet neither repeated nor contradicted this guidance. The market may have read too much into the fact that he did not address the topic.
In any event perceptions that the Fed is more hawkish and the ECB is less hawkish helped push out the interest rate differential by more than 10 points, possibly signaling the end of the narrowing trend that began in earnest in mid-June. At its peak, the US offered almost 200 bp more than the euro-zone. By October 4th, the spread stood at 131 bp and finished after the Fed comments and employment data at 142 bp.
Yet one reason that we are reluctant to pronounce the end of the trading range and the beginning of a new trend in the dollar is that there is likely to be some more poor US data in the week’s ahead. The main mitigating factor in the US jobs report was the sharp 60k upward revision to the August data and the indication by the BLS (Bureau of Labor) that there will be substantial upward revisions to back month data through March 2006 when the annual benchmark revisions are made in January 2007. While this raises the issue about reliability of the data, make no mistake about it, the September data itself was weak.
Output (GDP) is a function of how many hours are worked and the productivity of each hour of labor. The index of hours worked in September fell 0.1%, the same as in August, leaving the 3-month annualized rate up a mere 0.9%. This contrasts with a 2.6% rate in June, the end of Q2 and points to the likelihood of another sub-trend GDP figure when it is released on October 27. The manufacturing sector shed 19k jobs in September, more than expected, and has lost jobs in each month of Q3. This warns of another lackluster industrial production figure, which will be released on Oct 7.
There is another source of support for the euro below $1.26. While speculators have been trimming their long euro exposures in recent weeks, since reaching a record in August, our proprietary data indicates that real investors—asset managers and mutual funds—have been steadily taking advantage of pullbacks to buy euros. In addition, reserve managers at a number of central banks still appear to be engaged in a diversification program and also likely to have an appetite for the euro.
For its part, the yen has been undermined by its low interest rates, Japanese institutional demand for foreign bonds and stocks, and most recently fear that North Korea will shortly conduct a nuclear test. The most recent weekly Ministry of Finance data showed the first net inflow into Japan in several weeks. Some of the outflow in recent weeks likely reflects a seasonal demand for foreign assets linked to the start of the second half of the fiscal year. Several Japanese life insurance companies, which traditionally are big buyers of foreign bonds, have indicated their intention on keeping more money in Japan. Lastly, with the yen weakening while its current account surplus grows and it appears that China is allowing a modestly quicker appreciation of the yuan, the risk is that international jawboning increases.
The fundamental case for the US dollar to strengthen is predicated on something that has been a concern of ours for some time now. We have argued that the US economy is more resilient than many appreciate and that the market was getting ahead of itself in pricing a good chance of a Fed rate cut in Q1 07.
Numerous Federal Reserve officials have spoken in recent days. The comments by the Vice Chairman Donald Kohn were especially pointed. His comments take on extra significance when one appreciates that there has been a great deal of turnover at the Federal Reserve and Kohn has more experience at the Fed than every one else on the Board combined. In addition, Kohn is in charge of a task force working on making Fed communication more effective. Although Kohn recognized the risk that the economy would weaken too much, which is what lies behind the market discussing a rate cut within the next six months, he argued, as we have, that the decline in energy prices and the low long-term interest rates will cushion growth. To this we would add the strength of personal income in the US which has risen 9.4% in the 12-months through August.
Kohn, along with several other Fed officials, indicated that they were more concerned about price pressures than about the risk the economy falls into a recession. Kohn specifically cited the 7.75% year-over-year increase in labor costs as a cause of concern. He won’t draw any comfort from the average hourly earnings data contained in the September employment report. Hourly earnings ticked up and are now rising at a new cyclical high of 4.0% on a year-over-year basis.
These Fed comments helped begin a swing the pendulum of market psychology and this is reflected clearly in the short-term interest rate futures market. Consider the Fed funds futures strip, The March contract sold off 10 ticks from Wed, Oct 4 through Friday Oct 6. Admittedly the March contract is not very liquid at the present, but the same general pattern is evident in the March 07 Eurodollar futures. It has dropped 15 ticks in the same period.
There appears to be potential more additional adjustment. Assuming that the Fed is on hold for the next several months and then cuts rates at the 21 March 2007 meeting, fair value for the Fed funds futures is 94.83. Even with the sell-off in recent days, the contract is trading near 94.81, implying that the market is still pricing in a good chance of a cut. When expanding our analysis to the April 07 contract, the market appears to be pricing in just about a 50% chance of a cut. This still seems to high, by our reckoning. We still recognize a reasonable chance of a Fed hike and even if we are wrong about that, a protracted period of steady policy seems a more likely scenario than a cut. As has been the case through most of the current cycle, we remain more hawkish than the market.
Meanwhile there has also been a complimentary move in Europe. Following the ECB’s decision to hike rates on October 5, many participants read ECB President Trichet’s comments as somewhat less hawkish than expected. This saw the March Euribor futures contract rally almost 10 ticks in 24 hours. We suspect the market misunderstood Trichet. Previously, Trichet and the Bundesbank President Weber both cautioned the market against thinking its monetary tightening cycle would be completed this year. Trichet neither repeated nor contradicted this guidance. The market may have read too much into the fact that he did not address the topic.
In any event perceptions that the Fed is more hawkish and the ECB is less hawkish helped push out the interest rate differential by more than 10 points, possibly signaling the end of the narrowing trend that began in earnest in mid-June. At its peak, the US offered almost 200 bp more than the euro-zone. By October 4th, the spread stood at 131 bp and finished after the Fed comments and employment data at 142 bp.
Yet one reason that we are reluctant to pronounce the end of the trading range and the beginning of a new trend in the dollar is that there is likely to be some more poor US data in the week’s ahead. The main mitigating factor in the US jobs report was the sharp 60k upward revision to the August data and the indication by the BLS (Bureau of Labor) that there will be substantial upward revisions to back month data through March 2006 when the annual benchmark revisions are made in January 2007. While this raises the issue about reliability of the data, make no mistake about it, the September data itself was weak.
Output (GDP) is a function of how many hours are worked and the productivity of each hour of labor. The index of hours worked in September fell 0.1%, the same as in August, leaving the 3-month annualized rate up a mere 0.9%. This contrasts with a 2.6% rate in June, the end of Q2 and points to the likelihood of another sub-trend GDP figure when it is released on October 27. The manufacturing sector shed 19k jobs in September, more than expected, and has lost jobs in each month of Q3. This warns of another lackluster industrial production figure, which will be released on Oct 7.
There is another source of support for the euro below $1.26. While speculators have been trimming their long euro exposures in recent weeks, since reaching a record in August, our proprietary data indicates that real investors—asset managers and mutual funds—have been steadily taking advantage of pullbacks to buy euros. In addition, reserve managers at a number of central banks still appear to be engaged in a diversification program and also likely to have an appetite for the euro.
For its part, the yen has been undermined by its low interest rates, Japanese institutional demand for foreign bonds and stocks, and most recently fear that North Korea will shortly conduct a nuclear test. The most recent weekly Ministry of Finance data showed the first net inflow into Japan in several weeks. Some of the outflow in recent weeks likely reflects a seasonal demand for foreign assets linked to the start of the second half of the fiscal year. Several Japanese life insurance companies, which traditionally are big buyers of foreign bonds, have indicated their intention on keeping more money in Japan. Lastly, with the yen weakening while its current account surplus grows and it appears that China is allowing a modestly quicker appreciation of the yuan, the risk is that international jawboning increases.
Is the Dollar Still Range Bound?
![Is the Dollar Still Range Bound?]()
Reviewed by magonomics
on
October 06, 2006
Rating:
