Yield Implosion Muddies Currency Waters

Wednesday’s U.S. CPI data was a sight for sore eyes for investors amid a worsening background for fixed income trading around the world. Surging commodity prices, partially compounded by a weakening dollar but coupled with a rock-solid fundamental demand story, have conspired to deliver the threat of stagflation.

Rising prices at a time of slowing economic growth leave central banks in a bind. But only one of them – the Fed – has done the hard work first. By slashing rates in response to clear systemic financial fallout, it’s now the envy of global central banks worried about addressing clear signs of weakness but accompanied by accelerating prices unlikely to reverse anytime soon.

US dollar

When money moves in and out of any commodity, it tends to do so at breakneck speed. Currency trading got off to a brisk start this week with dealers finely composed awaiting an all-too perfect dollar rebound episode. Everything seemed to be in place. U.S. economic recovery was back on the cards thanks in no small part to the deep interest rate cuts from the Federal Reserve. The market conclusion that the Fed is on hold has served to underscore that theory.

On the other side of the monetary coin, conditions in the Eurozone are responding to an inevitable unintended tightening of monetary conditions courtesy of a strong euro and dissipation of collective economic confidence.

Just to ice the cake for dollar bulls, the latest CFTC data from Washington last week showed the first weekly net short position in euro currency futures contracts. The stock markets around the globe began to perk up, indicating confidence in emergence from recession, while volatility as measured by the VIX index has been below 20 for several days now. Money rates continue to decline pointing to lower credit pressures in the funding market.

The stage was set for a dollar rebound when some pretty hefty dollar sales appeared right across the board sending the dollar index lower and even sending the unit lower against the Japanese and Swiss units where risk aversion typically shows up.

The move was pretty much like a depth charge. We didn’t see any collateral damage, but it was hard to miss the above-sea-level impact from the activity. It was as if a player was almost testing the waters to see exactly how sentiment now fared in the face of a realignment of dollar sentiment. In that regard, the dollar spent the rest of the session defending its stance before a full-blown Tuesday recovery.

But the driving force behind currency movement this week is to be found in a deteriorating framework for interest rates. The movements have been dramatic, and largely explain why the dollar’s rebound is taking shape. We’re not sure we agree with the dramatic selling in Eurodollar futures, but it’s a global theme that can’t be ignored.

A full cast of Fed members took center stage around global forums on Tuesday. Mr. Bernanke pulled the rug from beneath Treasury Secretary Paulson’s feet by denying that the storm clouds surrounding financial institutions had lifted. But he was clear in his message surrounding the relative success of global central banks' open market operations in alleviating credit market stresses.

Putting their best foot forward, futures markets accelerated losses as U.S. retail sales data showed that consumers were far from broken by an average $3.70 per gallon gasoline at the pumps. And while they did reduce their spending on fuel as a direct result, they still found room to keep activity at the malls alive.

The price of the December Eurodollar contract has risen from an effective yield of 2.68% to 3.10% over the past couple of days. That’s why this activity is extremely important to the sentiment behind the greenback. Slowly but surely as more and more investors parse the data, they arrive at the fretful conclusion that the Fed won’t ease rates - but they yet might raise them.

Euro

Euro option traders continue to build a stake in the bullish euro call option positions in the December contract at the 155 strike. Current open interest of 11,178 contracts was added to Tuesday by around 10%, while the euro closed at 154.75 on the PHLX euro index basis. On the other side of the options page, bear positions were taken in July at the 152.50 and 158 strikes, while in June the heavily populated 154 strike was again active.

British pound

The immediate reaction to a surge in producer input prices to an annualized 7.6% this week saw a rather odd rally in the pound. The misplaced conclusion was that a slowing housing market, which looms large over the economy, would not be addressed anytime soon by easier monetary policy given the rampant cost of goods leaving the factory gate. Sure, that puts the Bank of England in a bind, but the lofty yields that sterling carries are clearly set to be eroded by inflation.

In other words Britain is arriving at the nastiest bout of stagflation, which will likely undermine rather than support the currency. The June 196.0 puts were best trafficked Tuesday accounting for around half of the day’s trade. Investors paid a 3.3 premium for the right to sell sterling at $1.96 by expiration in five weeks time.

Option implied volatility on the PHLX pound options rose from 8.9% to 9.1% this morning. There is fresh put buying activity in the September contract between $1.85 and $1.87 strikes. On the September contract there is some activity in $2.02 calls and $2.00 puts, which could be straddle posturing.

Canadian dollar

We dare say it must be oil related, but demand for the loonie (it’s a bird and it’s on the Canadian coin) has seen it push below parity this week. The greenback has weakened from C$1.0170 to C$0.9965 since last Thursday. We think this strength has its underpinnings in the reversal of the psychology that brought us here in the first place. The U.S. economy is stronger than first thought, which means that the export prospects for Canadian companies is a little brighter. This was also evidenced by stronger payroll growth just a few sessions ago. Ergo, the Canadians are faced with a lesser need to reduce rates to save the economy.

Aussie dollar

To test our theory on the resurgence in demand for the Canadian dollar, look down under to see that the Aussie is suffering. With a rather juicy 7.25% benchmark rate, the Aussie has been an attractive haven for carry traders. But now there are visible signs of cooling across the economy, and investors fear that the RBA will be trapped along with other central banks who would like to address easier economic times but might feel the heat from stagflationary price pressures.

Whichever way you look at it, the rationale for holding Aussie dollars is past, and traders seem to be selling in anticipation of cheaper credit and therefore lower rewards from a carry trade in times ahead. Monday’s Aussie rally as far as $0.9480 now marks resistance while the unit has slipped to close to $0.9300 midweek.

Japanese yen

As stock markets rebound across the globe, risk aversion dissipates, while risk appetite returns. The yen is therefore weakening and is currently at a one-week low against the dollar at Y105.07. Option premiums feel some slight pressure as traders continue to sell volatility, with PHLX yen implied volatility down to 11.1% from 12.5% earlier this week with the dollar at Y102.50.

Swiss franc

The same reason for weakness exists in the Swiss franc relative to the dollar. We note that implied volatility is on the wane, but less noticeably in this case with a reading of 12.1% today. Both the Swiss and the yen “suffer from” low interest rates and act as safe haven units in a climate of risk-aversion. We’re surprised to see implied volatility on the Swiss remain relatively high as equity strengths resumes. We’re pretty sure there must be an arbitrage opportunity between the two somewhere, whatever your view is!

Rebecca Engmann Darst contributed to this report.

Comments

[User 143167]

Have you ever seen a SA CPI factor of this big (-1.4 accumulatively in four months) in the past? We will have one more month in May to have a negative SA adjustment factor down the road and then,..., man it's gonna be UGLY afterwards if food and energy prices don't drop substantially.

[syruppy]

What to make of this: "When money moves in and out of any commodity, it tends to do so at breakneck speed," from the article? What's happening here? Are you saying liquidity is so tight, the velocity of money is being kicked in the rear, harder and with more desparation than a company's controller squeezing A/Ps down to 31 days because the company's line of credit is tight? Is so, then the global economy needs more greenbacks. If you saying people with options choose "short" the dollar by exchanging for bank balances in other currencies ... then, at this point, I would call that nothing but speculation--perhaps a well-financed speculation--but likely as prescient as investing in Global Crossings at the top of the Dot.Com.

[Whidbey]

The Fed's enviable position at having cut rates early on and now having options to tighten when others must fight recessions - is a little short sighted. The Fed's position is complicated by politics that will not allow tightening sooner, or later, without a recovery in clear view. USA growth is export oriented today and when exports slow things will slow in the USA as well. But, I suspect the dollar may be seen as attractive due to the Fed's apparent prescience.