Interactive Brokers FX Summary

The dollar is heading into Thanksgiving Thursday, which marks the onset of the holiday season in the United States, on a firm footing snapping back losses incurred on the back of additional quantitative easing earlier in the week. Each additional remedy dished up by the Federal Reserve and Treasury team is met with a short-lived bout of dollar weakness. The reason is that fickle currency investors dread a reversal of the entrenched longer-term trend, which has favored the dollar since March. What investors keep missing is the fact that incremental remedies represent a growing need to address deepening issues. It’s possibly very likely that government is feeding investors plans that might stem the blood letting and create some semblance of order. In turn, myopic investors mistake the situation for a total solution, which of course it is not.

The dollar is likely to continue to rebound from periodic bouts of unpopularity between these announcements. Crucial will remain the unfolding economic scenario, which as suggested by this week’s quarterly 0.5% growth contraction, is unlikely to rebound anytime soon. We keep hearing about a resurgent appetite for risk as the dollar authorities announce remedial measures, but can’t help but feel that this is a very misplaced perspective. It would likely be more accurate to state that such measures represent a jumping point for dollar longs to bail out of profitable positions in the short term. Note the resilience of the dollar 24-hours post just about any initiative this year.

Another key to understanding the plight of the dollar is to recognize that the U.S. authorities often fail to achieve their goals and as a consequence have created temporary safe havens, which has created further troubles. For example, bailing out housing behemoths Fannie and Freddie has not cured the housing market. By dithering on dealing with delinquent mortgages it has created an incentive to default. By securing money market funds, it has created a rush to cash helping freeze already log-jammed waters. We don’t envy the authorities with their role but we do recognize that every time they are required to act, they seem to be faced with devising a plan that has unintended consequences at every turn.

Slashing monetary policy to virtually zero has not harmed the dollar one iota and as observed in prior columns we have suggested that central banks are on a race to zero in their domestic economies. The next clue to understanding the likely performance of the dollar lies in a reading of yields. Many economists have suggested that the avalanche of debt soon to be issued by the U.S. government, and the cause of the mother of all budget deficits, will be difficult for primary dealers to digest. Surely the demand from overseas central banks and sovereign wealth funds is no bottomless pit they argued. As such they forecast two things. One is inflation through a simple monetarist mechanism. Second is an extremely steep yield curve, by which we mean the slope between the two and 10-year yields.

It’s too early to say whether inflation will be the result and given the fact that much of the debt issuance will be to couch lending rather than to rebuild the nation’s power grid for example, there is a strong likelihood that inflation won’t emerge. Also given the fact that current policy is aimed at stopping the freefall in housing markets, it’s likely that future regulatory measures won’t allow a stabilized housing market to ever revisit the boom that we just lived through. That kind of inflation creates consumer-led price rises, which could easily spiral. Simply put, for now deflation remains a larger threat in the near term.

The yield curve and the predictions of debt indigestion have been decimated in the past few days. 10 year treasury note yields have entered freefall as they declined from 3.75% to 3.00% by midweek. That move is simply monumental and in part has been led by the nose by surges in the price (lower yields) of the 30 year bond. The fact that the government stated that it would seek to purchase agency mortgages has somehow poked a spanner in those economists’ estimates of higher yields. The surge in note and bond prices has reduced the slope of the curve from 260 basis points two weeks ago to around 185 points today. Predictions less than a month ago would have you believe that the curve would steepen to more than 400 basis points. That kind of move would devastate government plans to stimulate lending.

Lower yields tell us something that can’t be ignored. It tells us that the problem is far from over and to that extent there will be no return to risk appetite across emerging markets other than what we read in the newspapers whenever the dollar rally falters. It also tells us that demand for such fixed income assets is healthy and in order to park money there, the demand for dollars is very much alive. We should expect the dollar rally to continue through at least year end. We’ve noted before that this American sneeze has become highly contagious. In other words, America might have the mother of all budget deficits, but her sisters have powerful printing presses too.

Over the course of the last week with the exception of the Canadian and Aussie dollars, all major units have steadied against the greenback. The perception of rising risk appetite will help draw a line in the sand in support of currencies as their underlying economies slowdown. In line with currency direction there was greater demand for CME calls over puts except for the commodity dollars. Open interest in the Canadian dollar declined by 7% over the course of the week as its southern neighbor swelled to almost $1.3000, which likely helped liquidate a few positions.

Implied currency option volatility has certainly steadied over the recent sessions, which ought to be expected given how the falling knife appears to have been successfully caught. Implied volatility on the euro rose the most during the week reaching 23.2% today, which is 16% higher than last week’s sub-20 reading.

A cut in Swiss interest rates last week helped cheapen the franc against both dollar and core European units proving it’s not the safe haven it once was. The U.S. unit reached $1.23 against the franc helping restore implied volatility from 14 to 18%.

In option activity during the last week investors got most bullish on the Australian dollar. Looking at the put/call open interest ratio for CME options, you can see that the reading of 0.6 indicates more calls in play than puts. During the week call buyers added positions to the January 70 strike calls, while the most notable addition came in the March contract where investors added substantially to existing positions at strike between 65.0 and 70.0. We can only conclude that some call buying interest may have been spurred by prospects for the Aussie to benefit from a coincidental deflationary stampede into gold.

At the other end of the spectrum the most bearish option positioning exists on the British pound – still seen as the “high yielding” European currency with rates now at 3%. It seems to us that the transparency of dire events on the British economy seems to take greater precedence over European country news. For what reason, we know not. Sure things are bad, but we doubt they are much worse than for the entire Eurozone. The pound rebounded sharply earlier in the week against the dollar only to feel the weight of weaker than anticipated consumer spending mid week. In the December contract investors have increased put positioning at the 140 and 145 strikes while larger positions were established in January at the 148 strike and in February as low as the 135 strike.

Comments

[crafty1:]

I am at a loss to explain the reason for the dramatic weakness in the Australian Dollar against many major currencies

2008 Nov 27 08:47 AM