Dollar Ends Monday Remarkably Unchanged after Morning Risk Rally

Dollar Ends Monday Remarkably Unchanged after Morning Risk Rally

Does every trader in the market make rational decisions when placing a position? Absolutely not. In fact, it is arguable that speculation distorts the view of the masses – pushing us more often towards the extremes of fear or greed. However, there is a sort of ‘fundamental mean’ that we inevitably return to that is defined by the necessity of capital flows rather than the volatile hope to make outsized gains or avoid leveraged losses. These are the different lenses we need to view the dollar through. We have a larger bull trend that has developed over the past month alongside the S&P 500’s slide; but this new trading week has opened with a distinctive correction and risk trend and reserve currency. Following the remarkable run through last week (a period historically hollowed out by holiday liquidity), the Dow Jones FXCM Dollar Index opened Monday with a tumble back below 10,000. A correction after such an aggressive, low participation drive is to be expected; but where do we go from here?

To gather our bearings for the return of liquidity, we need to return to the underlying trends. A quick market correction due to exhausted speculation is natural; but it rarely generates new trends when the fundamentals aren’t already in place to support the change of direction. For underlying sentiment, there was no missing the strong rebound in equities across the board Monday; but this correction is far from moving into a full-blown trend status. We need to take stock of global economic, financial and yield conditions. For yields (the foundation of returns), we note that the central banks are easing rates at the fastest pace since the 2008 financial crisis – with the Fed vowing to sit pat with a virtual Zero Interest Rate Policy (ZIRP) until mid 2013. The OECD would remind us of the expectations we should maintain for economic activity with a GDP estimate for its 34-member group of 1.9 percent this year and 1.6 percent in 2012 (from previous estimates of 2.3 and 2.8 percent respectively). Yet, where the risk is most pressing is financial stability. Whether we are looking at the cost of short-term funding, dependence on stimulus or the risk of a liquidity crisis chain reaction at the bank level; a threat to normal market functioning overwhelms any speculation arguments.

Despite the risks we face, there are still those out there that will expect the ‘Santa Claus’ rally and the best retail ‘Black Friday’ sales performance on record to return us to historical norms. These hold outs will can sustain short-term deviations; but without market-wide support; such moves will inevitably fall apart. For the dollar, that translates into a constant risk of a rally as the trading environment deteriorates. The greenback’s extreme safe haven appeal will be a constant draw as risk aversion builds. Yet, we need to be aware of the short-term shifts in the winds of sentiment as well as the risk that the Fed may pursue another large-scale intervention (QE3) – a concern gaining more traction.

Euro Stability Belies a Collapsing Fundamental Backdrop

The fundamental picture of the euro deteriorated appreciably last week. At one extreme, we were met with Fitch’s downgrade of Portugal to ‘junk’ status; while closer to the core, Germany came up short on a bond auction. Without a focal point of stability for Europe, the slide into crisis will be unstoppable. Starting out this new week, the negative fundamentals would pick up under the same tenacity that they closed on for the weekend. Moody’s issued a warning that a “rapid escalation” of the region’s crisis threatened downgrade to all sovereigns. More tangible were the disappointing Belgium and Italian bond auctions. The latter was particularly disturbing as the inflation-linked bonds drew a yield above the 7 percent threshold (the level that usually ushers in a bailout). Tomorrow we have a more important 8 billion euro auction from the country.

Japanese Yen Sliding a Function of GDP Downgrade or Speculative Souring?

Policy officials at the BoJ and Ministry of Finance must be pleased. The yen has taken a sharp turn lower to start the week and has shown more consistent bearish effort against the US dollar. Consistency in this move, however, depends on its driver. The OECD projected a contraction for the economy this year; but growth has little influence here. Intervention fears hardly carry weight as officials have not acted. Instead, we may be seeing the true influence of capital flows towards deeper pools of liquidity – supported by one-month USDJPY risk reversals at 7 year highs.

British Pound Undermined by BoE King’s Warning of Contagion, OECD Recession View

According to the OECD, the United Kingdom is facing an economic contraction this quarter and through the first quarter of 2012. Depending on what economic school of thought you prescribe to, that is the very definition of recession. And, to ensure that sterling traders are sufficiently frightened, BoE Governor King made another go at warning us that the UK is dangerously exposed to a spreading Euro Zone crisis.

Australian Dollar Leads the Risk Appetite Rally but Advance Dependent on Risk

There are few exceptions to global winds; and Australia is losing ground as one of the hold outs. Adding fuel to the dovish rate outlook, Australian Treasurer Swan lowered his GDP forecast (to 3.25 percent); though projections of cutting the deficit smacked of optimism while their assumption of a 1.0100 AUDUSD exchange rate felt bullish. If the S&P 500 stalls and revives its bearish drive; expect the same for the Aussie.

New Zealand Dollar Finds Modest Optimism from Key Reelection, Asset Sale Promise

Politics in Europe matter little in the bigger scheme of market stability in the region (as the countries have extremely limited options to change their current predicament); but they can carry more tout in countries that aren’t under immediate crisis. New Zealand for example has reelected Prime Minister John Key; and his vow for furthering free markets and asset sales speaks to FX traders looking for an investment currency.