Hint of U.S. Economic Recovery Fuels Increased Demand Risk

By: Brewer Futures Group | Mon, May 4, 2009
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May 04, 2009

The key story this week affecting the Forex markets turned out to be the global economy rather than the U.S. Treasury auction and the Fed's preliminary bank stress test report. If you had asked me last week if a report indicating that Citigroup and Bank of America were on the top of the Fed's list as being undercapitalized, or that six out of 19 major banks were facing banking problems, I would have thought the Dollar was going through the roof. Investors decided to ignore these stories and focus instead on the better than expected news sweeping the global economy.

The week started with the report of an outbreak of Swine Flu. The immediate reaction by traders was to sell risky assets and ask questions later. Well they must have asked the right questions and received the answers they were looking for because the Dollar never looked back after an initial decline on Sunday night/Monday morning.

Early in the week a bearish U.S. GDP report was released. The pre-report estimate was for a decline of 4.7% but the actual report showed a contraction of 6.1%. Under normal trading conditions this report would have sent the Dollar higher, but investors found a silver-lining in the low inventories indicated in the report. Their thought is that the economy has room to grow.

Later in the week it was reported that U.S. initial claims were less than expected. This was another sign that the economy may be bottoming and investors responded by selling Dollars. Additional signs that the recession was slowing came in the form of improved manufacturing and an increase in consumer sentiment.

The Fed concluded a two-day FOMC meeting on Wednesday by leaving interest rates unchanged and hinting that the pace of the decline in the U.S. economy was slowing. They contributed to the Dollar's weakness in a big way when they refrained from increasing the amount of money available for quantitative easing.

On Friday, China announced improvement in its April manufacturing sector. This marked the second consecutive month of better production. The U.K. also showed signs of bottoming action by posting better than expected production numbers. Both of these friendly reports fueled weakness in the Dollar to finish the week.

The Treasury's $100 billion auction the first three days of the week was orderly as demand was about average. Yields climbed slightly but this was expected because of the widening U.S. budget deficit. With the economy turning better and yields creeping up, it is probably time to begin debate on the Fed's exit strategy from this current mountain of debt. We know it won't start next week because the Treasury has another auction planned.

Although the Dollar trended lower for most of the week, I wouldn't call it a bear market yet. One sign that trader appetite for risk was increasing was the surge in the stock market to nearly new highs for the year. But some feel that the market has gone up too far, too fast and is ripe for a correction. If stock market sentiment begins to shift to the downside next week then profit-taking could hit the major Forex pairs. The news that Treasury yields were climbing may also begin to draw money out of the stock market which could trigger an increase in risk aversion.

The Euro rose this week but next week's European Central Bank interest rate decision could pressure the EUR USD if it slashes rates by more than expected. Most investors are looking for a cut to 1.0%. If the interest rate cut doesn't rattle traders then there is still the possibility that the ECB's new quantitative easing plan will not be accepted by traders.

The GBP USD posted a big gain for the week. Strong equity markets provided most of the support but the market surged on Friday following news that U.K. production was better than expected. This is all good news over the short-run, but the U.K. economy is still going through a contraction while the budget deficit is widening. Traders may ask for more evidence of a bottom in the economy before beginning a new uptrend.

News that Japan's unemployment rose was not a good sign its the economy. Chrysler declaring bankruptcy put even more pressure on the Japanese Yen. Many Japanese companies will be affected by this financial disaster.

Signs that the U.S. economy was beginning a recovery triggered a rally in the USD JPY. Traders were also buying Dollars to capture the higher yields in the U.S. The strong rally in the equity markets triggered renewed interest in the carry trade.

The U.S. Dollar closed lower versus the Swiss Franc. Once again increased appetite for risk sent Swiss investors out of the Dollar seeking better returns elsewhere. The threat of an intervention by the Swiss National Bank triggered a mild rally in the USD CHF late in the week, but the lack of follow-through to the downside negated the signal. The threat wasn't even confirmed but keep in mind that the SNB will do all it can to prevent deflation and that does include an intervention among other weapons at its disposal.

The USD CAD fell sharply lower for the week. The Canadian Dollar is locked onto the rally in the equity markets. Higher commodity prices including crude oil and copper also helped support the strong rally in the Canadian Dollar. Traders have to avoid getting too bullish at current levels because the stock market looks overpriced and toppy.

The AUD USD followed the stock market higher most of the week as traders sought the higher yield in exchange for more risk. The pace of the rally in the Aussie began to slow late in the week because of the possibility of an overpriced equity market. Australian Dollar traders should also be concerned about the Swine Flu outbreak. If this virus lingers and spreads globally then the economy is likely to suffer because of a slowdown in tourist traffic.

Selling pressure hit the NZD USD late in the week as the Reserve Bank of New Zealand cut its benchmark interest rate by 50 basis points. This cut was already priced into the market but the statement by the RBNZ following the rate cut was not. The RBNZ is forecasting that interest rates should continue to fall throughout this year as the economy declines, and that it doesn't see a bottom until 2010. This announcement kept the downside pressure on the market. Like Australia, New Zealand is susceptible to the Swine Flu. As this disease spreads globally, travel could be limited which would cause a slowdown in tourism. This would interfere with the economy's ability to recover from its recession.

 


 

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