Tuesday FX View: Currency Traders Take a Beating as Dollar Rally Gives Way

Today’s exchange rate movements are a little tough to decipher. Broadly speaking the dollar was well bid earlier, while the price of gold also jumped and is clearly mulling over the notion of making a thunderous bolt to the upside towards a record high. But a mid-morning event, that we are yet to isolate, has sent the dollar careening. Weakness in equity markets once again brings focus back onto the aftermath of the financial crisis. Further British government injections to the banking system are stirring the mix, reminding investors that stability does not necessarily encompass recovery.

There was good news from the European Commission for the prospects for Eurozone growth earlier. However, the euro has slumped to $1.4650 and stands lower by more than a cent on the overnight close. Against the Japanese yen it’s also weaker and buys ¥132.41 while the euro is also weaker against the British pound at 89.50 pennies.

EC executives raised their projection for European growth in 2010 lifting it from a minor contraction to 0.7% growth. That rate will more than double by the time 2011 is at an end. However, the recovery comes at a cost and highlights the strains predicted by key economists at the time the notion of the single currency was dreamed up. EU member nations are supposed to maintain a budget deficit of no more than 3% of GDP. That of Germany next year will be 8% while that of France will be 10.5% - and those are the best there are.

Peripheral nations such as Spain, Greece and Ireland are expected to continue contracting into 2010 leaving the core Franco-German industrial heartland to drag the Eurozone back to life. Budget deficits within peripheral nations will contribute to create a 14% average deficit to GDP statistic for the entire economic area. We doubt that it’s this news that’s weighing on the euro today when the broader theme is an increase in risk aversion. It’s more likely that euro bulls are finding it hard to maintain such sharp horns in light of positive news butting heads with a strengthening dollar.

All of this makes for higher implied volatility on the major crosses. Most dollar pairings on the six majors have added 200 basis points or between 11 and 18% to their implied volatility readings since last Tuesday. Implied volatility on the euro has gained from 11% to 12.7% for example. Aussie dollar implied volatility reads 18% from 15.8% during that time.

The Australians did raise interest rates by one quarter of a percentage point as most analysts had expected in the Asian session. The Australian dollar declined and today buys 89.88 U.S. cents after the Reserve Bank was a little less hawkish in its statement. There was also a rather sharp rally in interest rate futures as money markets revised down its expectation on the scale of more rate rises.

The RBA stated that the two quarter point interest rate increases over the recent two months would help put the economy back onto a path of sustainable growth yet maintain the rate of inflation consistent with its target. To most investors this was taken to mean that the RBA is now in pause mode through year end and that the threat of more stringent rate increases is off the table. Future meetings will consider the merits of recent data points rather than the RBA walking in with its mind already made up.

After a sloppy start the British pound is gaining against the dollar and buys $1.6405. Earlier it fell to $1.6262 as the British government announced the additional injection to RBS and Lloyds Banking Group. Again the aftermath of the financial meltdown continues to be felt and investors’ mettle is being tested.

The Canadian dollar was in the majority earlier in the session as it failed to decline relative to the greenback. Subsequently the Canadian unit is back to 93.22 U.S. cents.

Comments

[Mr. G:]

The dollar index recently made a major breakout from its downtrend. Was this a headfake or a signal for future upside movement? The ADP and ISM nonmfg reports do not support the upside, but an unexpected move in the unemployment rate on friday may have a more pronounced affect.
The dollar breakout may have been short covering as the demand for the dollar increases. It seems the US is just bumping along the bottom and if the unemployment rate is flat, I do not expect more upside to the dollar.GI

Nov 04 10:12 AM

[UK farmer:]

How undervalued is the Yuan on currency market data- what would be the true value if it floated like every other curency ? A guess will do

Nov 04 12:23 PM

[Mr. G:]

The question concerning the Yuan is interesting. The most important point is that the value of any currency is how the universe of traders see it on the spot market, not any true value. For example, for the US to have a strong dollar policy is a worthless statement if the universe of traders do not perceive the dollars fair market value as strong.
A better question is what causes a currency to be perceived as strong? In my opinion, the value of any currency is determined by the set of economic indicators affecting the countries GDP. It is the constant ebb and flow of these indicators that traders perceive at any one time that ultimatley measures a currency value. Said another way, look at currencies as being a stock in a country.

At present China may be artifically depressing its currency to make its exports more competitive on the global export market. Considering Chinas economic growth rate, I believe the universe of traders would see its value higher than its current pegged rate. How much higher is a guess at best, but I would like to watch it trade once unpegged and my position would be long. GI

Nov 04 08:14 PM