Ahead of the Fed’s interest rate decision later Wednesday, and just one week after the dollar hit its lowest level for 10 months, forex markets and currency analysts are now talking about whether the US currency is reaching a turning point.
As the FT’s currency correspondent Peter Garnham notes, the change of sentiment was largely triggered by last week’s upbeat US payrolls report, which saw far fewer job losses in July than expected. This strengthened the view that the US is past the worst of its recession and that its economic recovery could precede that of Europe and Japan.
Buoyed by such views, the dollar last Friday gained more than 2 per cent against the yen and more than 1 per cent against the euro and the pound. The currency’s climb – continuing more or less this week – comes as analysts of various descriptions are converging on the view that the US economy has responded positively to the massive US fiscal and monetary stimulus, thus reducing the risk premium for holding US assets.
The Fed’s introduction of quantitative easing in March has let the dollar’s performance “diverge from the guidance of real interest rate differentials,” Hans Reddeker, of BNP Paribas, told the FT. “Now, as the economic outlook has stabilised, the relative yield and interest rate differentials should regain their impact on currency markets.”
Others, however, are hesitant to call an end to the trend of dollar weakness, given that the currency’s rebound has been based on its reaction to a single piece of economic data, notes the FT’s Garnham, quoting Neil Mellor at Bank of New York Mellon saying, “if there is a shift, it’s at a very embryonic stage”.
But if the dollar does continue to rise, Garnham adds, it would mark “a very significant development given the pattern of trading that has tended to characterise the currency markets since the onset of the financial crisis”.
Currency movements are notoriously tricky to forecast, as Lex noted last week. But Deutsche Bank research focuses on three indicators that all suggest that dollar weakness since March is overdone. On a trade-weighted basis, versus historical trading bands, the dollar is 12 per cent below ‘fair value’. It is even more undervalued against the euro and commodity currencies such as the Australian dollar, according to Deutsche.
The dollar also tends to move with changes in the sum of the US current account deficit plus portfolio flows, and by this measure, the dollar is slightly cheap, it adds. It is also undervalued when comparing interest rate differentials, especially if America is first to emerge from recession and yields on 10-year Treasuries march higher. Of course, adds Lex, “plenty of things move currencies in the short-term”; for example:In the past three months, the dollar’s changes against the euro… have moved most closely with the oil price — a higher oil price worsens the current account deficit and is, therefore, bad for the dollar; or risk indictors such as the CBOE’s Vix index — because traders flock to the dollar whenever there is a peep of bad economic news.
Still, it concludes, the dollar now looks a good bet, enabling “those in the ‘normal’ camp to buy it on fundamental grounds, while the hell-in-a-handcart crew knows it’s a safety play”.
Among currency strategists worth noting, Richard Grace at CBA sees the case building for a higher dollar, though warns it may be premature to conclude the upswing has begun in earnest, before any indication that the Fed will begin again to hike interest rates.
The US labour market report is highly important, says Grace. “But one-month’s numbers are unlikely to be game changer”. He continues:Further firming in US economic data will be required to offset the strong depreciation forces on the dollar, and while the currency may strengthen a little more, it is unlikely to significantly appreciate until the Fed lifts rates.
The best way to ride out a potentially short-term period of dollar strength is to remain long AUD cross rates (AUD/EUR and to a lesser extent, AUD/JPY), because these exchange rates should appreciate whether the USD firms or not, given they reflect a better global growth environment. The AUD/USD exchange rate will be impacted less than the EUR/USD and arguably USD/JPY during a period of USD firmness
On Wednesday, the FOMC will present its monetary case and on Friday, comes the July US industrial production report, notes Grace:
The consensus is capacity utilisation will post its first monthly rise since December 2007. Over at least the past four decades, the first monthly rise in capacity utilisation has signalled the US has unofficially exited the recession. If the data continues to improve and the USD closes this week higher, then we will begin to re-assess the USD outlook.
On most occasions when capacity utilisation has turned higher, it has been USD positive. But the degree of appreciation varies considerably with different economic cycles and capacity utilisation has never been a trend changer for the USD. Further confirmation is needed (and probably Fed rate hikes) to change the trend in the USD.
As for Fed rate hikes: these “still appear a long way off”, he adds, with H2 2010 being a more likely timetable than the current market pricing of Fed rate hikes by March 2010:
The depreciation and diversification forces weighing on the USD appear dominant, and even further mild improvement in US economic data will not lead the Fed to lift interest rates anytime soon. Real yields (adjusted for core CPI) remain low and are less encouraging of USD appreciation. The US current account deficit has narrowed courtesy of the US trade balance, but not enough to offset reduced net capital inflows.
Ashraf Laidi, of CMC Markets, meanwhile is looking also at the yen, and concludes:
Emerging signs of economic stabilization in Japan may have in the past been accompanied by subsequent declines in JPY as improved Japanese investor appetite encouraged outflows into foreign equities. But with Japanese equity indices outperforming their G7 counterparts (Nikkei-225 and Topix-20 +19% and 15% respectively YTD), the usual capital bleed from Japan is not happening. And with the Bank of Japan maintaining its economic assessment unchanged, indicating a bottom in the pace of deteriorating, the case for the yen is far from over.
Despite Friday’s aggressive snapback in USD/JPY to 3-week highs, the trend remains that of a generally strong yen and a declining USD/JPY. Due to the yen’s persistent role as a safe haven currency, USD/JPY continues to act as the exception to the general USD pairs. Thus, while EUR, GBP, CHF, AUD and CAD tend to move in tandem against the USD, JPY has often moved the opposite direction, depending on the intensity of prevailing risk aversion or risk appetite.
Related links:
Online Q&A: The many faces of the dollar – FT
Fed under the spotlight on interest rates - FT
Dollar stays strong even as risk shifts - FT