US Dollar’s Critical Breakout Fades Along with Risk Aversion

US Dollar’s Critical Breakout Fades Along with Risk Aversion
It was a mixed day for investor sentiment and subsequently the US dollar. Through the Asian and European session, risk appetite was generally muted; but there was a notable bearish bias among the various asset classes. Big ticket events helped to feed this drift including the commentary following the RBA’s rate decision and the announcement of a second record-breaking bailout of two UK banks (read more about these two events below). In the early morning hours, the provisional rise in risk aversion was influential enough to push EURUSD to what could be described as a meaningful breakout. The currency market’s most liquid pair fell below 1.4650 and tentatively breeched the rising trendline that has defined its dominant bull trend since its inception back in March. In turn, the trade-weighted dollar index (which is heavily influenced by the euro-based pair) would produce a similar break. However, without a market-wide reversal in risk appetite or meaningful dissolution of the currency’s role as a safe haven, this inciting dollar rally would ultimately fall back into line.

Outside the influence of risk currents, the economic activity behind the US dollar was relatively light. The only remarkable economic indicator on the docket was the factory orders report for September. For market-moving potential, this report’s impact is usurped by the durable goods orders data that was released last week. However, this Commerce Department report is arguably more detailed than its predecessor. The 0.9 percent pickup in new orders marked a correction from the modest correction in the August report and modestly beat expectations. Set into the bigger fundamental picture, this data supports the strong ISM manufacturing survey from yesterday (which hit a three-and-a-half year high yesterday). There is growing debate that the US economy is not doomed to a ‘new normal’ that would set average growth much lower than it has been in the past five to ten years; but instead there will be a different dynamics for GDP – that depends more heavily on manufacturing and export. This is far-fetched for long-term growth; but a short-term boost could help hasten the recovery of employment and consumer spending.

Another event that wasn’t heavily rotated in the media was an announcement from the Treasury that said it had matched six new deals for the Public-Private Investment Fund valued at $3.58 billion. The financial authority further said that it put up $14.34 billion in total funds. Considering the focus on central banks efforts to reign in stimulus and work down deficits, this is another positive step for the US financial system and the US dollar. No doubt, a more meaningful reaction to policy changes will likely follow the Federal Open Market Committee’s (FOMC) rate decision tomorrow. Scheduled for 14:15 EST, this event will not yield any change to the benchmark lending rate (there is a token 1 percent probability of a hike priced into overnight index swaps). Instead, market participants will be watching the commentary that follows. Traders have become language aficionados in their attempts to interpret and derive a timetable for when the Board of Governors will finally deliver the long-awaited hike and whether there will be efforts to unwind abnormal stimulus efforts in the meantime.

British Pound Response to Second Round Bailout for UK Banks Mixed
The British pound’s position in the risk appetite spectrum made for an unusual reaction to an otherwise surprising event. Early in the European session, the Treasury announced it would inject further capital into two of the economy’s largest banks to put them back on stable ground and potentially prevent another financial seizure in the meantime. Details show the government will provide the Royal Bank of Scotland with 25.5 billion pounds (in addition to the 20 billion received in the first bailout) for the largest single capital infusion on record. Lloyds Banking Group’s aid will amount to approximately a quarter of their expected 21 billion pound fundraising. This is unquestioningly discouraging for the United Kingdom as it implies that not only is the economy struggling to pull itself out of recession, but the nation’s financial position is still highly unstable. However, with all of the background volatility in risk appetite, the pound would ultimately develop a mixed reaction to this news.

As we approach Thursday’s BoE rate decision though, we can expect this government bailout to be rehashed. Looking at overnight index swaps, there is a 20 percent chance of a 25bps rate hike priced in; but in reality the MPC will not likely ease rates (it would do them little good from an economic perspective). Instead, expectations for a loosening of monetary policy surrounds the quantitative easing program. Commentary and data released over the past few weeks have turned this upcoming announcement into the most highly anticipated event risk for the week. Two weeks ago, 3Q GDP data revealed the economy’s recession was extended to its worst pace on record, overshadowing commentary from officials lower on the policy totem pole that said a pause was still likely. If this warning proves valid and the central bank does pause or end its QE, it could inadvertently elicit fears that efforts to revive the economy will fall short and put the UK in an even worse position than it is in now.

Euro Finds Little Support from the EU Commission’s Economic Forecasts
Where does the Euro-region economy stand in the global recovery? This is a question that has turned the euro into a second class citizen when it comes to fundamental trends. With the IMF’s last projections, the Euro area was projected to contract 4.2 percent this year and grow a sparse 0.2 percent in 2010. This lags the US, Japan and even the UK among others. Combined with a timetable for monetary policy that sees little to no probability of hikes until the middle of next year; the euro ultimately turns into a foil for currencies that have more extreme projections for economic activity and interest rates. With the release of the European Commission’s semi-annual economic forecasts, there was some hope that positive revisions could perhaps push the currency out of its speculative funk. Looking at the data, the report did offer better forecasts, looking for 0.7 percent expansion through 2010 and 1.5 percent in 2011 for those sharing the euro. However, projections for the average deficit to hit 6.9 percent of GDP, unemployment to peak at 10.9 percent in 2011 and the dour outlook for some member economies offsets the headline read.

Australian Dollar Stabilizes as the RBA Throttles Back on the Rhetoric
The Reserve Bank of Australia’s rate decision would end up as one of the top market moving events for the past 24 hours. However, the impact wasn’t exactly what economists and speculators were perhaps looking for. While the central bank would meet expectations for a second hike (the only authority in the world that done so) to 3.50 percent; the pace for policy – arguably the more important factor in this equation – was tempered. RBA Governor Glenn Stevens said that going forward it would be “prudent to lessen gradually” the stimulus that is still in the system. This is a dramatic reversal in the intensity of previous commentary. Nonetheless, from an economic perspective, this was a logical stance.

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Written by: John Kicklighter, Currency Strategist for DailyFX.com
E-mail: jkicklighter@dailyfx.com