Dollar’s Appeal Rising as Threat of Another Financial Crisis Builds

• Dollar’s Appeal Rising as Threat of another Financial Crisis Builds
• Euro Funding Troubles on Sovereign and Bank Level, ECB is Struggling
• British Pound Traders Much More Sensitive to EU Spread after King’s Warning
• New Zealand Dollar on the Verge of a Much Larger Trend Reversal
• Japanese Yen Marks its Second Lowest, Non-Holiday USDJPY Range in Over Seven Years
• Gold Collapses Alongside the S&P 500 – A Sign of Liquidity Trouble

Dollar’s Appeal Rising as Threat of another Financial Crisis Builds

Global growth trends are slowing, benchmark rates are lowering the floor on expected returns and market sentiment is sobering after the bullish charge that began back in the first quarter of 2009. However, in this shift; we have yet to hit the fever pitch that triggers a true financial crisis. That may soon change. As we frequently reiterate, we need a strong and straightforward reason to go long the US dollar. When we take stock of the individual currency’s fundamental strength (in a vacuum), the greenback is plagued by: a benchmark rate that will remain at virtually zero through the middle of 2013 (so vowed by the Fed); the Fed’s effort to flood the system with dollars; an effort to diversify reserves away from the currency to reduce exposure; and a shift away from the United States as the center for economic activity. This is a significant burden to overcome; but it can be accomplished in one fell swoop when the market’s singular focus is on liquidity.

Back in September of 2008, the credit markets began to seize when news that Lehman Brothers had lost access to its credit lines and thereby would be forced to close shop made the headlines. The normal operation of the capital markets depends on the availability and circulation of credit. Banks frequently require short-term funds to cover obligations for overnight up to a few months when there is not enough cash on hand to cover liabilities or they are unable to liquidate positions to raise the necessary capital. Normally, it isn’t difficult to raise this capital through the open market at very low cost; but when there is a risk of falling short of mandated reserves, banks will generally hold cash rather than lend it out. For those that come up short, such a situation can spell a quick end.

These are the financial dynamics that we need to watch for now. We are already seeing the signs of real trouble building up. The most pressing concerns are still across the Atlantic as European banks are attempting to cut their holdings in Euro Zone government debt to shore up their balance sheets and meet reserve ratios that have been pushed up to 9 percent by regulators and have to be met by the middle of next year. Yet, we are seeing the strain spread to the US and the rest of the world. Gauging the global strain, the demand from European banks for funds in the US (struggling to find it in the EU), the Fed reported today that its swap lines to the region rose to $2.25 billion. Domestically, the Libor-Overnight Index Spread (a favored gauge for the cost of short-term money) rose to its highest since June of 2009. The kindling has been stacked. If there is a spark - like an influential bank failing (perhaps on the same level as MF Global) – credit markets could freeze and leverage dollar liquidity.

Related: Discuss the Dollar in the DailyFX Forum, John’s Video: EURUSD, NZDUSD and USDJPY Setups for a Financial Crisis

Euro Funding Troubles on Sovereign and Bank Level, ECB is Struggling

The fire fight in Europe is quickly growing out of control. On the sovereign level, we see that Euro Zone members that are one ring outside the ‘core’ are in bailout territory. In a Spanish 10-year bond auction, the government raised 3.56 billion euros in funds at an incredible rate of 6.98 percent. It is generally believed that crossing the 7 percent threshold and holding above this level draws an inevitable conclusion that a country will need to ask for a bailout. In this particular auction, we can see how bad conditions truly are. In the secondary market, tradable 10-year bonds were trading at a yield of 6.5 percent. Yields on auctions should not be higher than tradable bonds. The fact that they are highlights the ECB’s pained effort to keep the yield below the bailout threshold. Italy is in the same boat with its benchmark rate hovering just below 7 percent (supposedly thanks to heavy central bank effort). However, ratings agency Fitch has released a warning that if the country is unable to access the markets, it could lower the sovereign rating to low investment grade. However, the real trouble comes when the sovereign issues spread to the market level. We can already see this strain through Greece’s haircut (discussions of which are expected to take place tomorrow), Unicredit’s CEO asking the ECB for access to funds using lower rated collateral and the general effort to unwind sovereign exposure to boost reserve requirements that have been imposed by officials to actually prevent a crisis.

British Pound Traders Much More Sensitive to EU Spread after King’s Warning

Fundamental conditions are deteriorating for the UK just as surely as they are falling apart for Europe. There are economic, financial and political benefits in the UK’s relationship to the EU; but that also draws in the same troubles. Bank of England Governor Mervyn King put voice to this trouble when he recently said that there was persistent risk to his economy’s stability through the spillover of the Euro Zone crisis. When we compare the health of the sterling to the Euro; the buffers will be clear. But, when the comparison is made to a currency outside of Europe; the trouble will be plain to see. Add to that the BoE’s propensity for further stimulus against government austerity, and we have a messy situation.

New Zealand Dollar on the Verge of a Much Larger Trend Reversal

While our focus is fundamentals in this report, we have to pay respects to the technical boundaries that can define shifts in sentiment. Looking at NZDUSD, we note that that a channel floor going back to May of 2009 was once again tested this past session. Alone, a break here could trigger a quick sense of panic. What can really facilitate a bear trend though would be the S&P 500 futures sliding below 1,210 / 1,200, caving risk.

Japanese Yen Marks its Second Lowest, Non-Holiday USDJPY Range in Over Seven Years

The range on the USDJPY was a mere 17 pips. We saw an instance of a 16-pip range as recently as October 11th; but before that, the last time we had this low a level of market activity was back in February of 2004 (excluding New Years day activity). A breakout is a high probability. A move upward would likely fizzle very quickly. A move lower though could trigger the Bank of Japan’s panic and generate a bigger overall move.

Gold Collapses Alongside the S&P 500 – A Sign of Liquidity Trouble

The correlation between gold and the S&P 500 received a big, positive boost this past session. A serious break lower for equities led to a similar move for the precious metal. Once again, we are reminded that this is a safe haven asset; but when liquidity is in demand, its cost is a burden. Should the credit market seize, this reality will be far more prominent – and the metal’s losses will be far more aggressive.

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--- Written by: John Kicklighter, Senior Currency Strategist for DailyFX.com

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