Forex: Why the Dollar Is Staying Strong

Last week as we wrapped up our analysis for the year, we noted that with the euro buying $1.40 at the time, its reversal from $1.4719 signaled a drop to $1.35 “for the first week of January.” The ensuing slide to as low as $1.3317 ushered in by a New Year dollar buying frenzy proved the point that the fat lady hasn’t yet inhaled. Once again there has been a minor revision of the thought process surrounding prospects of the dollar, but suffice it to say that while the healing process has begun, the patient might display further signs of illness first. The dollar rose against the yen, the euro and the Swiss franc to begin the year while longer term currency option plays indicate less bearish prospects for the euro than just a week ago.

Click on link for updated table throughout the week at http://www.interactivebrokers.com/en/general/education/FX-View.php?ib_entity=llc

One might have argued that the arrival of a stimulus package here in the United States would be dollar negative. After all, that same sentiment initially weighed on the dollar when the FOMC finally arrived at zero percent for the fed funds rate. And with bounding fiscal laxity setting the tone, one might assume that with the medication firmly in place investors can rest assured that the economic future of America and therefore the global economy is on the mend. That would presumably leave investors punishing the explosive debt issuance through a negative outlook on the dollar.

We have made the point before that this is an entirely wrong approach. Currency trading has a strong underlying current of the here and now. Sentiment changes on a dime and it’s very difficult to marry a medium to long term picture to intraday gyrations. Standing on the sidelines and commenting on what we observe certainly has its merits.

When soon-to-be President Obama commented on the approximately $750 billion stimulus package, we found his accompanying comments salient when he told reporters that the situation was worsening and that a serious response was required. Many investors misplace price discovery with economic misfortune. In other words they believe that the low point of the equity markets in late November probably marked the low-point of the recession. As we have warned before, this isn’t like any other recession before. The low point so far for stocks may indeed be tested before the end of the first quarter, driven by weakness in sales and employment. Try finding anyone who will tell you today that unemployment will be lower by the middle of 2009 than it is today. This week we are likely to see a 7%-plus handle in Friday’s employment report for the final month of 2008.

So with worse to come, we still would argue that not only have other economies got worse to come too but that the dollar’s role as a safe haven or as a preferred liquidity tool will remain a feature throughout the first half of 2009. That very likely means a fresh low for the euro under $1.2317.

There was also a sharp reversal of the thought process in what the ECB might do. For those of you with short memories, we’d remind you that now marks the six month anniversary of when the ECB last raised interest rates. Talk about not having a grip on reality, but we’d point to this as a serious blunder that will likely lengthen the European recession.

This week, the announcement of weaker than expected consumer price inflation has allegedly given the ECB a green light to relax its benchmark repo rate next week. That has caused investors to ditch euros in favor of the strengthening dollar. The additional rumor that the European fiscal policy-makers are secretly discussing a tall-order tax plan ought to be worrisome to euro bulls. They always felt that the yield differential that the euro commanded would remain intact since the ECB always felt that there was some kind of trade off between fiscal and monetary policy tools. If both tools were ever needed, it is now.

America is showing that and slowly other nations are adopting that thought process. This philosophy will hinder the argument going forward that the dollar will be undermined by a deteriorating budget balance. At a time when public money is fast replacing private money across global economies ask yourself who won’t have a serious fiscal problem. America’s might be the largest, but it won’t be isolated.

Over the duration of the week put open interest on the yen declined across the PHLX World Currency Options series. Investors bailed out of profitable bearish positions as the Japanese currency fell to its weakest in a month against the dollar. What’s happening here is that government and central bank response around the world has made investors less pessimistic that equity markets will reach new lows. The intraday gyrations have indeed stopped for now at least and that’s detracting from implied options volatility levels. Some investors have even ventured back into Australian and Canadian dollar plays as they ease their way back into markets.

The Russian standoff with Ukraine, which has shut off gas pipelines to the rest of Europe accompanied by ongoing Middle East tensions, has created a positive yet unwelcome rebound in energy prices. Investors need to be careful not to mistake this rise with a sustainable bull market for commodity prices predicated on rising demand.

When the President-elect speaks and sends a chilling message, it’s worth listening despite the fact that he is still a couple of weeks shy of inauguration. When he finally gets to the White House, much might not have improved for the economy. That tells us that a stronger dollar rather than a weaker one will likely greet him on Pennsylvania Avenue.

Comments

[Chris B:]

Good analysis. Can anyone predict the 2009 yield on FXA or FXC?

Jan 07 12:43 PM

[silverwood:]

Andrew Wilkinson says
"When the President-elect speaks and sends a chilling message, it’s worth listening despite the fact that he is still a couple of weeks shy of inauguration. When he finally gets to the White House, much might not have improved for the economy. That tells us that a stronger dollar rather than a weaker one will likely greet him on Pennsylvania Avenue."

So I gather that a weak or sick economy spells a strong dollar, then as the economy improves the dollar should weaken, right? There is just something intuitively wrong with this picture. I could understand the deleveraging effect as traders unwound positions and covered loans causing a demand for the dollar. So are we to expect another round of this?

Jan 07 01:27 PM

[jrs87sch:]

Good article. I still feel like the US dollar is going to tumble quickly because it has stayed this strong in these times.

Jan 07 01:28 PM

[RomanFinancial:]

I very much agree with this analysis. Deflationary period will reverse end of Q2.

Jan 07 01:33 PM

[RomanFinancial:]

Well this is because we are not having a strong dollar, we are in a deflationary period, plus historically the dollar has been stable when currencies like the Yen and Jakarta are suffering.


On Jan 07 01:27 PM silverwood wrote:

> Andrew Wilkinson says
> "When the President-elect speaks and sends a chilling message, it’s
> worth listening despite the fact that he is still a couple of weeks
> shy of inauguration. When he finally gets to the White House, much
> might not have improved for the economy. That tells us that a stronger
> dollar rather than a weaker one will likely greet him on Pennsylvania
> Avenue."
>
> So I gather that a weak or sick economy spells a strong dollar, then
> as the economy improves the dollar should weaken, right? There is
> just something intuitively wrong with this picture. I could understand
> the deleveraging effect as traders unwound positions and covered
> loans causing a demand for the dollar. So are we to expect another
> round of this?

Jan 07 01:35 PM

[nmelendez:]

This article forgot one item:China. If the chinese pick up the pace to an 8%

Jan 07 01:42 PM

[nmelendez:]

then investors will be bailing out of dollars and into Yuans. I believe this is already being set up. I do not, however see a devaluation of the dollar beyond 70%.
I believe the Fed or treasury holds 4.5 Trillion of the 8 trillion dollar defecit. So if investors want their money back, we don't print it, we just pull it outta the Fed and leaves us broke but with only half the debt, which we basically owe ourselves. nice tactic, if this is true.

Jan 07 01:48 PM

[Costard:]

"We have made the point before that this is an entirely wrong approach. Currency trading has a strong underlying current of the here and now. Sentiment changes on a dime and it’s very difficult to marry a medium to long term picture to intraday gyrations. Standing on the sidelines and commenting on what we observe certainly has its merits."

Larger players like foreign cb's cannot shift their holdings on a dime. For the moment panic is keeping them in dollars, but a secular diversification from USD is only just beginning. A "strong dollar" means nothing if it, and the currencies it is measured against, are all falling in real value. For the moment this is weighed against asset deflation and lower spending, and with no clear winner I would agree that relative currrency stability is the order of 2009; however at some point a move that defies your "here and now" theory will take place, and wealth will resume its transition towards a medium that retains its value. Jury's out on what this will be... my guess is scarcer commodities, gold for its value or oil for its utility. Timeline is uncertain, but too short in any event to be cavalier about.

Jan 07 02:02 PM

[Reinko:]

We have to take into account that dollar moves these years are often not good to explain, for example lately European inflation was reported at 1.6% instead of 1.8% (while core inflation still above 2%).

That gave an intraday swing of 2% on the €/$ pair.

Later Obama stated that trillion deficits will be there for a couple of years and almost nothing happens...

There simply is no economical theory that explains such weird behavior; one thing is clear:

Those who have the deep pockets to steer the value of the dollar neglect large parts of what the real value should be.
Don't forget: In the 600 trillion nominal value in the OTC derivative markets a tremendous amount is bounded to currencies; if we would have more insights who has what kind of derivatives you might better understand the weird weird behavior of the US dollar.

It might very well be that if the dollar gets too weak, a few trillions must be paid in the derivative markets...

That is not unreasonable.

Jan 07 03:47 PM

[mplaut:]

Costard wrote:

" and wealth will resume its transition towards a medium that retains its value. Jury's out on what this will be... my guess is scarcer commodities, gold for its value or oil for its utility. "

The problem is that neither gold nor oil has the sheer scale that is necessary to store the value that is residing in dollars.

There is no single thing, not a commodity nor a currency, that is large enough to even seriously compete with the dollar. What we can have is just a general move towards more "risky" assets like equities, bonds, commodities, etc. But this will probably happen later rather than sooner.

Jan 07 04:30 PM

[nmelendez:]

I read recently the various asian markets are trading with the yuan, bypassing the dollar and the IMF. If this catches on and the UAE start accepting the Yuan, the dollar is going down.

Jan 07 05:29 PM

[scotty1560:]

tend to agree with the author...

one of the theories is Europe is playing catch up with rate cuts and policies...
so the dollar stays strong...

many would agree that long term the dollar gets weaker...the question is
3 months...6 months...two years? that's the harder question..

Jan 08 12:03 AM

[Kunst:]

Yes, anyone can predict those. Oh, you meant accurately! No.


On Jan 07 12:43 PM Chris B wrote:

> Good analysis. Can anyone predict the 2009 yield on FXA or FXC?

Jan 08 01:01 AM

[ralph_909:]

good analysis..

Jan 16 02:38 AM