Dollar Damaged As the Fed Goes Shopping

Today's serious case of dollar damage was once again made courtesy of the nation's central bank. The Fed's purchase of $7.7 bln in 7 and 10-year treasuries in the morning, followed by purchases of $3.08 bln in Agency securities in the afternoon accelerated the dollar decline and the resulting rally in commodities --as was the case on March 18 when the Fed first announced purchases of long term treasuries. Today's dollar sell-off stood out from previous declines by the fact that EURUSD knifed through the key resistance of $1.3740 (failed 4 times this year) to $1.3830, and even sterling finally managed to break above its 200-day moving average vs USD--something that all majors currencies had achieved in previous weeks surging to a 7-month high of $1.5794.

Contrary to what some media concerns have stated, the dollar selling emerged well before the release of the FOMC minutes, which did accelerate the selling.

Improved risk appetite has never helped the dollar, but this time around, the yen (which is usually the broadest loser during rising equities) has in fact soared against USD. Unless US Treasury Secretary Tim Geithner reiterates the strong dollar being in US interest (which could work temporarily), or equities come under severe pressure, the turnaround for the greenback is unlikely to emerge, to the benefit of commodities and equities. We long warned about the day of reckoning for the dollar emerging at the next economic recovery (a la 2004-5) where real demand for commodities combined with improved risk appetite seeks yield in emerging markets, commodity currencies, away from the fiscal deficiencies of the US economy and the excess reflationary build up accumulated by the Fed--all of which is accompanied by uninterrupted weakness in US labour and housing markets.

We reiterate the only viable driver for renewed USD strength would be a fresh bout of selling in US and world equities prompting safe haven flows into cash (which remains denominated in USD treasuries), and/or news of failed banks in the Eurozone and/or the UK. Meanwhile, the case for metals (with a preference for silver over gold) remains evident as central banks rush to buy bonds that their very governments are rushing to issue.

VIX: From Fear to Greed?

Much talk about the VIX breaking below 30 for the first time since the week of Lehman's downfall. Although the inverse relation between the VIX and equities is well documented, it is worth noting a few changes. The VIX rose to only 52 when stocks tumbled to 12-year lows in the first week of March, compared to a record high of 90 (some measures at 96) in late October, when stocks were at 5-year lows. Said differently, the element of fear and volatility was less pronounced in early March when equities reached lower lows than it was in October-November. Thus, renewed selling can emerge without panic of a systemic breakdown, which can be a reflection of speculative shorts (March) rather than panic redemptions (October-November).

The above chart compares proxy measures of confidence/fear as expressed by interbank market, equities and currencies. The upper panel in the chart below shows the VIX (volatility in equities) versus USD 3-month LIBOR (confidence among banks), illustrating a fairly positive correlation. The sudden decline in LIBOR between Aug 07 and Mar 08 resulted from the Feds about turn from an inflation-centric monetary policy to aggressive interest rate cuts. While such a shift helped ease the interbank cost of short-term money in summer-fall 07, it failed to prevent the VIX from creeping higher.

The sharp decline in LIBOR since mid Q4 08 reflected the Fed's zero interest policy, accelerating liquidity-injection measures and its purchase of mortgage-backed and agency securities. The recurring bounce in the VIX from its January low of 39 to the March high of 53 resulted from renewed selling in the S&P500 and the rest of global equity indices. Despite the fact that equities fell as far as 12-year lows, the VIX rebounded to half the level reached in October because the selling was more of a proactive strategies rather than reflexive trades. The subsequent tumble in the VIX below 30 is a combination of improved equity markets, reduced fears of a breakdown in the financial system and increased signs of a bottom in the economic data.

The risk view from Forex markets is shown in the lower panel of the above chart via USDJPY vs EURJPY, both measures of the yen's continued tracking of risk appetite (falling yen pairs indicate stronger yen vs USD and EUR, which is in line with reduced appetite). But note how both EURJPY and USDJPY proved volatile over the past 2 months, with frequent bouts of yen strength occurring despite falling VIX, falling LIBOR and rising equities.

On the EUR and USD sides of the coin, weak EURJPY and USDJPY re-emerged partly due to conflicting ECB remarks about bonds purchases and broadening worries over the rising cost of US treasuries. The JPY side of the coin has not only reflected prolonged pre-occupation over the sustainability of the equity rally from the currency community, but also rumblings about Tokyo's desire to further internationalize the value of the yen as well as requesting the US to issue Samurai bonds (yen-denominated bonds). Those claims were initiated by the leader of Japan's opposition Party, but happen to be shared by bureaucrats of the ruling establishment. One valid argument opposing the view of ongoing risk aversion in Forex is that of sterling strength. The currency is now trading at its highest level this year on dissipating signs of event risk from UK banks as well as prolonged signs of bottoming in property and equity markets (both key targets of vital capital flows).

EURUSD and GBPUSD may have broken on the upside, but GBPJPY, EURJPY, NZDJPY and CADJPY point to renewed selling (as early as Thursday's Asian session), suggesting prolonged erosion for USDJPY. This is in line with our long held belief that sub-85 USD/JPY remains inevitable, and may not be seen until 2010.

Comments

[spald_fr:]

Please, will one person cite an instance when the federal government spent its way into an overall market prosperity?

May 20 05:14 PM

[doubleguns:]

Fiat currencies in a race over the clift and to the bottom.

Looks like US is winning.

May 20 05:16 PM

[Between The...:]

Two decades of economic stagnation, huge deficits, and 150%+ gov't debt/GDP, yet the yen is still very strong. Does this mean the US is headed for the dollar strengthening in the next two decades?

May 20 06:45 PM

[Jeff Nielson:]

I liked the part about suggesting Tim-the-tax-cheat "reiterates the strong dollar being in US interest..."

If the dollar isn't devalued by 1/2 to 2/3, in order to reduce the REAL value of $100 TRILLION in total U.S. public and private debt, then the U.S. will go bankrupt in less than 3 years.

So I don't think anyone is buying that old, "strong dollar" line any more!

May 20 06:59 PM

[user396040:]

WW2.


On May 20 05:14 PM spald_fr wrote:

> Please, will one person cite an instance when the federal government
> spent its way into an overall market prosperity?

May 20 07:13 PM

[Market Sniper:]

Sorry, doublegun, Zimbabwe already won that race. Only question now is which fiat comes in second.


On May 20 05:16 PM doubleguns wrote:

> Fiat currencies in a race over the clift and to the bottom.
>
> Looks like US is winning.

May 20 07:16 PM

[conceptwizard:]

Never has any empire Ever spent its way out of debt. The Roman Empire failed, Spain failed, Russia failed, Britain failed, the USA will fail, its just a matter of time. They start wars, pillage countries seize their wealth just to maintain, and still self destruct. Why would it be any different thiis time? Is their some self serving special reason that the USA can squander generations of wealth, live well beyond their earnings and give away jobs, free uncontrolled medicare, Social security with tax revenues falling 30%, Committed national debt at 60 trillion. the Banks are raping what is left of the weath of the Americas as we know it.
Today, the rich are getting richer while millions of Americans struggle daily to get by and live perilously from paycheck to paycheck, a mere one away from insolvent disaster.

Given where we're heading, Warren Buffett warns that America is changing from an "ownership society" to a "sharecroppers' " one, no different than feudal serfdom. Economist Paul Krugman calls it "debt peonage," much like the post-Civil War South that forced debtors to work for their creditors.

Make no mistake, it's a corporate America scheme for a plentiful reserve army of labor no better off than in developing countries - at low wages, no benefits, weak unions if any, and government engineering the whole scheme. Even personal bankruptcy protection eroded under the Bankruptcy Abuse Prevention and Consumer Protection of 2005 - benefitting lenders at the expense of borrowers by keeping them chained to their debts.

It requires many more people "to file under Chapter 13, which does not eliminate debts but mandates that they be repaid under a court-ordered payment schedule over a three to five year period." Homes, in some cases, may be seized and even owe a "deficiency, or balance due" if its sales price doesn't cover it. This Act "eroded the protection the government once provided against (various) unexpected catastrophes (like job loss and high medical expenses) ensuring that working people (henceforth) are kept on a treadmill of personal debt."

May 20 09:41 PM

[Moon Kil Woong:]

The dollar is certainly not being helped by the Fed's expansive dabbling in te market nor the disembowling of the free market system. If GMAC gets support and offers GM and Chrysler cars with low interest rate loans that Ford can not match what does that say about fair and free competition. The winner is the loser and the loser is the one who doesn't beg and kiss up to the government be it Republican or Democrat.

Considering this, it is no wonder the dollar is falling. It is shortable on principal alone, not because of too much debt or easy money (although we know these are not good for it), but because if you gut the free market system you gut any hope for a healthy recovery. The premise that we will recover this year or next is eroding every time the Fed or Treasury propose another misbegotten government solution.

May 20 10:29 PM

[Dave Wrixon:]

Which incidentally would make the Euro the "World's Reserve Currency" even without any increase in foreign holdings which would of course increase rapidly.


On May 20 06:59 PM Jeff Nielson wrote:

> I liked the part about suggesting Tim-the-tax-cheat "reiterates the
> strong dollar being in US interest..."
>
> If the dollar isn't devalued by 1/2 to 2/3, in order to reduce the
> REAL value of $100 TRILLION in total U.S. public and private debt,
> then the U.S. will go bankrupt in less than 3 years.
>
> So I don't think anyone is buying that old, "strong dollar" line
> any more!

May 21 01:12 AM

[Cliff Wachtel:]

Unclear if US gov spending did it. Remember, after WWII much of the non-US industrial capacity had been destroyed, and the US was producing about HALF of the world's goods and services. A nice advantage in addition to being the prime occupying power of axis countries and sole military protector of the free world (suffice to say these conditions open a few doors).


On May 20 07:13 PM user396040 wrote:

> WW2.

May 21 03:35 AM

[Clive Corcoran:]

Very perceptive article.
Looks like the dollar is entering a no-win situation if the reflation trade continues and unless there's another major leg down in confidence. However that would not be good for paying off all the national debt which would itself not be good for faith in the US currency.
The US is between a rock and a hard place.

May 21 04:15 AM

[User 357705:]

Quite agree. This time its spending on its corporate masters. Will you agree that is even crazier?


On May 20 05:14 PM spald_fr wrote:

> Please, will one person cite an instance when the federal government
> spent its way into an overall market prosperity?

May 21 05:10 AM

[Bjarne Jensen:]

Cliff, the difference between then and now: Then, when Europe's industry and economy were in shambles we funded the Marshall Plan to rebuild their industry and restart their economy. Now, with our industry gone and our economy in shambles, I don't expect that China is going to help us out.

May 21 03:21 PM