Although many market participants are on summer holiday, this has not prevented some interesting market moves in the wake of yet more improvement in economic data and earnings. The most noteworthy release was the July US jobs report, which revealed a better than forecast 247,000 job losses and a surprise decline in the unemployment rate to 9.4%. Moreover, past revisions added 43,000 to the tally.
Although it is difficult to get too optimistic given that job losses since December 2007 have totaled 6.7 million, the biggest drop since WWII, the direction is clearly one of improvement. Nonetheless, markets were given a dose of reality by the drop in US consumer credit in June, which gives further reason to doubt the ability of the US consumer to contribute significantly to recovery.
The data spurred a further rally in stocks and a selloff in Treasuries. Such a reaction was unsurprising, but the more intriguing move was seen in the US dollar, which after some initial slippage managed a broad-based appreciation in contrast to the usual selloff in the wake of better data and improved risk appetite.
It is too early to draw conclusions, but the dollar reaction suggests that yield considerations are perhaps beginning to show renewed signs of influencing currencies following a long period where the FX/interest rate relationship was practically non-existent. Indeed, the strengthening in the dollar corresponded with a hawkish move in interest rate futures as the market probability of a rate hike by the beginning of next year increased.
Since the crisis began, the biggest driver of currencies has been risk aversion, a factor that relegated most other influences including the historically strong driver, interest rate differentials, to the background. More specifically, much of the strengthening in the dollar during the crisis was driven by US investor repatriation from foreign asset markets as deleveraging intensified. This repatriation far outweighed foreign selling of US assets and in turn boosted the dollar.
Over the past few months this reversed as risk appetite improved and the pace of deleveraging lessened. Ultra easy US monetary policy also put the dollar in the unfamiliar position of becoming a funding currency for higher yielding assets and currencies, though admittedly this was all relative as yields globally dropped. The dollar also suffered from concerns about its role as a reserve currency but failed to weaken dramatically as much of the concern expressed by central banks was mere rhetoric.
Where does this leave the dollar now? Risk will remain a key driver of the dollar but already its influence is waning, as reflected in the fact that the dollar has remained rangebound over recent weeks despite an improvement in risk appetite. As for interest rates, their influence is set to grow as markets price in rate hikes and, as in the past, more aggressive expectations of relative interest rate hikes will play the most positive for the respective currency.
It is still premature for interest rates to overtake risk as the principal FX driver. Even if rate increases are important, I still believe that interest rate markets are overly hawkish in the timing of rate hikes. A reversal in tightening expectations could yet push the dollar lower. This is highly possible given the benign inflationary environment and massive excess capacity in the US economy.
Eventually the dollar will benefit from the shift in interest rate expectations as markets look for the Fed to be more aggressive than other central banks in reversing policy, but this could take some time. Until then, the dollar is a long way from a real recovery and will remain vulnerable for several months to come as risk appetite improves further.