By Peter Garnham
Published: August 11 2009 19:31
Just a week after the dollar hit its lowest level for 10 months, the main talking point in FX markets is whether the US currency is about to strengthen.
The change of sentiment has been sparked by last week’s 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.
“Markets are in a flurry of debate about whether Friday’s US payrolls data marks an inflection point for FX, whereby good US economic news starts to benefit rather than hurt the dollar,” says Ray Farris at Credit Suisse.
Hans Redeker at BNP Paribas says there are signs that the US economy has responded positively to the massive US fiscal and monetary stimulus, thus reducing the risk premium for holding US assets.
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“The introduction of quantitative easing in March has let the performance of the dollar diverge from the guidance of real interest rate differentials,” he says.
“Now, as the economic outlook has stabilised, the relative yield and interest rate differentials should regain their impact on currency markets.”
Others 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.
“If there is a shift, it’s at a very embryonic stage,” says Neil Mellor at Bank of New York Mellon.
But if the dollar does continue to rise, 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.
This has seen the dollar benefit from haven demand when equities, and hence risk appetite, have fallen.
In contrast, the dollar has lost ground when stocks and investor confidence have risen as investors abandon the relative safety of the US currency in search of higher returns elsewhere.
Thus as equities hit their highest level of the year last week, the dollar index, which tracks its progress against a basket of six major currencies, fell to its lowest level since October.
This correlation has led to the perverse situation where the dollar has fallen on better US economic data and rallied when news from the US has disappointed.
This pattern seemed to break down last Friday after the US employment report. The positive surprise generated a predictable rise in equity markets and a surge in US Treasury yields. The dollar also strengthened.
Todd Elmer at Citigroup says this was a rare event indeed, since over the past 18 months, S&P gains of 1.7 per cent or more were associated with moves higher in the dollar index of 1 per cent or more on fewer than four occasions.
One key reason for the dollar rebound was that US interest rate expectations surged on the jobs data, moving to price in 130 basis points of monetary tightening over the next 12 months.
But the question for investors now is whether this is the start of a more concerted trend in which a rebound in US growth supports the dollar.
“We have argued for some time that higher US bond yields, as long as they are associated with stronger growth rather than increasing worries about the US fiscal position and potential for the monetisation of debt, were good for the dollar,” says Adarsh Sinha at Barclays Capital. Several factors will determine whether this happens, he says.
First, the dollar’s rise last week came at a time when oil prices were moving sideways. Mr Sinha says the dollar remains vulnerable to any rise in the price of oil.
Second, the outcome of Wednesday’s Federal Reserve meeting will be crucial to the dollar’s fate.
If the Fed remains dovish, the strength of the dollar may prove temporary, says Mr Sinha.
Conversely, it might continue to strengthen if the central bank announces no extension to its asset purchase programme and sounds more upbeat on the US economy.
“This would likely be dollar positive and may herald a period where positive news for US yields continues to support the dollar as long as it is associated with stronger activity data and a muted response in commodity markets,” he says.
But not all analysts are convinced of the significance of Friday’s move, especially since it was not the first time in recent months that the dollar had rallied following a stronger-than-expected US jobs report. Indeed, it last occurred following the release of the US employment report for May, which was released on June 5.
On that occasion the dollar’s gains proved short-lived, partly because talk of an early increase in Fed interest rates quickly faded.
Callum Henderson at Standard Chartered believes the move this time is just a short-term phenomenon reflecting stretched positioning prior to the figures.
Bets on further dollar weakness – short dollar positions – were at their highest level since June 2008, according to positioning data from the Chicago Mercantile Exchange, going into the jobs report. Thus when the dollar pushed higher, the move was exaggerated as traders were forced to cover their losses and buy dollars.
“Clearly, the market was short of dollars going into the figures, but there is no case for the Federal Reserve to raise interest rates,” says Mr Henderson.
He says the fact that the present crisis started in the US means the US economy is likely to emerge last from the present downturn and the Fed the last to tighten monetary policy.
Mr Henderson believes US interest rates are likely to remain on hold until 2011, keeping the dollar under pressure in a repeat of the price action that followed aggressive Fed easing in 2001.
“The dollar fell sharply from 2002 to 2004,” says Mr Henderson. “The dollar is going to grind painfully lower over the next couple of years.”
Copyright The Financial Times Limited 2009
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