Dollar Is As Strong As EUR/USD, USD/JPY Says It Is

A growing voice of support is being made for the dollar as an investment currency on the rise. While this may be the case months down the line; for now, the dollar’s strength is a product of the euro and yen’s weakness. The short-fall for the greenback is its exceptionally low benchmark yield that will be held at basement levels by the Fed until unemployment is seen back at 6.5 percent and / or inflation crests 2.5 percent. Furthermore, market-based rates – based on low-risk Treasury and Libor – are also at lows and can drop further with the central bank’s aggressive stimulus program. This would be the issue that would hold the dollar back if there were indeed a strong drive behind risk and carry trade appetite. On that point, global yields / rates are just off record lows and investor participation (measured in volume and open interest) shows little interest in chasing such thin returns when stimulus-targeted assets are the only position showing capital gains.

What does this mean? Speculation that the dollar will eventually enjoy higher rates than counterparts and local assets could outperform due to abundant stimulus is premature. There are two things that can meaningfully drive the dollar materially higher in the near-term: strong risk aversion that short-circuits investors’ appetite for yield and sends them fleeing to the safety of US markets, or the greenback’s counterparts lose significant fundamental ground of their own. The Dow Jones Industrial Average nudged out a second record consecutive high this past session, which some accept as evidence that the greenback is rising alongside risk appetite. However, looking at something like the Risk-Reward Index, we find sentiment is not as robust as equity indexes suggest. Instead, the side-by-side advance between stocks and the Dow Jones FXCM Dollar Index (USDollar) is sustained by acute dollar strength against the Euro, Japanese yen and British pound. And, those are moves that more the responsibility of the counter currency rather than the benchmark dollar.

Euro: Laying out the Scenarios for EUR/USD, EURJPY on ECB
Of the heavy round of event risk through Thursday’s session, the European Central Bank (ECB) rate decision carries the greatest potential. The shared currency has dropped this past month against the dollar and other major counterparts as the ongoing recession starts to overlap with a return of financial instability. The latest bout of trouble for Europe’s debt-borne crisis is Italy’s election – which now finds Democratic Party leader Bersani threatening to abandon the deficit cutting agenda in order to win a workable government. If stability starts to breakdown in the region, there is little that can be done through the regular political channels to forestall the return to crisis. One of the few variables: the ECB.

Heading into the event, there is considerable evidence in the euro’s performance to suggest that the market has positioned for an expected softening of the central bank’s policy bearing. Though the Open Market Transactions (OMT) program is a standing threat of action, it lacks action to offset the receding balance sheet on LTRO repayments – which reduces banks’ access to liquidity and boosts market rates. The most bearish scenario for the euro would be a rate cut as it lowers return for the currency and is unlikely to support financial stability should conditions continue to deteriorate. The more prolific, bearish move by the ECB would be to introduce a stimulus program that is intended to build with time – competing with the Fed and the BoJ. Joining the ‘open-ended’ program would present a mounting weight as the balance sheet bloats. Most likely and least effective for volatility would be simple guidance that offered vague threats of chance in the near future. And, of course, the ECB’s refusal to adopt any additional stimulus policy would present a euro relief rally.

British Pound: GBP/USD His New Multi-Year Low Before BoE
While the euro has room to recover should the ECB not meet the market’s expectations for easing, the British pound has been forced to a far greater extreme on clear assumptions of stimulus. We can point to the more than 1300-pip drop in the GBPUSD over the past few months as evidence that the market believes the Bank of England (BoE) will play catch up to its global counterparts via stimulus, but we can look at more fundamental elements as well. We have seen the 10-year Gilt (government bond) yield drop as much as 18 percent over the span of a few weeks while overnight index swaps are pricing in 19 bps of easing over the coming 12 months. It is unlikely that the BoE cutsrates as it would be ineffective in spurring growth – though if it does happen, it could one of the few sparks that keeps the sterling diving. Instead, the more likely outcome from an expanded stimulus effort from the Monetary Policy Committee (MPC) is an increase in thebond purchasing program. Of course, the market is priced for much more than the standard 25 billion pound clip of yore. A fixed, ‘small’ stimulus move could spark a recovery. To really spur the pound’s rally though, no change in policy and impotent vows for more would likely see a tremendous retracement.

Japanese Yen Slow Depreciation Will Continue Unless This Happens…
The Bank of Japan maintained its steady course – as expected – this morning. This was the last policy meeting to be helmed by outgoing Governor Shirawaka, and he didn’t want to rock the boat. Now, we move on to a new regime. However, the next BoJ meeting isn’t until April 4. In the meantime, all we have is threatens by the new central bankers. We have seen a modest advance in yen crosses on the heightened jawboning, but we have lacked for a full-blown return to rally. This is a steady trend, unless risk appetite collapses and takes carry with it.

Canadian Dollar as Bank of Canada Moves Further Away from Rate Hike
There was considerable opportunity for the Bank of Canada to spark volatility this past session as the fundamentally-inclined FX traders were weighing the possibility that the group would abandon its quest for an eventual rate hike. This is no doubt a contributing factor to the USDCAD’s advance through recent weeks. However, when the statement hit the wires, Governor Carney maintained that ‘higher rates’ would likely be needed after a ‘pause’. Yet, the language would still, subtly eased the hawkish rhetoric – enough to satisfy to justify the loonie’s recent decline.