Dollar Weakness: The Biggest Story in the Currency Market

This past week, traders and investors alike have seen how powerful of an impact interest rates can have on currencies.  Since the middle of last month, the dollar has been on a one way downtrend and this downtrend was spurred by the market’s expectation of 25 to 50bp of easing by the Federal Reserve.  When the Fed cut both the Fed Funds and Discount rate by 50bp, the market realized two things.  The first is that Bernanke’s new policy will lean towards being proactive and the second is that the outlook for US economy may be worse than most people may have thought.  As a result, the interest rate curve is still pricing in another 50bp of easing by the end of year which has triggered the dollar’s weakness.

The only currencies that were weaker than the US dollar today were the Japanese Yen and Swiss Franc.  It is not a coincidence that both of these currencies are also funding currencies for carry trades.  The divergent performance of the US dollar signals that risk appetite is quietly creeping back into the market as traders cautiously pile back into carry trades.  Dollar weakness is getting overextended however and each further pip drop increases the risk of a reversal.

There was no US economic data released today.  Although there were a number of Fed officials speaking, they simply defended the central bank’s recent interest rate cut.  Fed President Warsh said that the “Fed action has not incurred moral hazard” while Plosser blamed credit innovations on creating the excesses that we have seen thus far.  Over in Europe, there seems to be no major concern about the impact of a stronger Euro.  In his speech today, ECB President Trichet simply touted the success of the Euro and reiterated the need for the central bank to be independent.  Although today’s comments from ECB officials Bini-Smaghi and Constancio can be interpreted as slightly critical of the Euro, it is also not clear that this is their intention.  Bini Smaghi simply said that there are times when FX rates will deviate from fundamentals and the currency cannot be a policy instrument. Constancio on the other hand said that the strength of the Euro dampens inflation.  The reason why we are paying so close attention to ECB comments is because if the ECB becomes concerned about Euro strength, verbal intervention could trigger the top in the Euro. 

Next week, housing market data dominates the calendar with existing and new home sales due for release.  In addition we are also expecting consumer confidence, durable goods, personal spending, personal income, final Q2 GDP and Chicago PMI.

After Thursday’s mild setback, US equities have regained strength.  Positive earnings by Oracle and Nike have helped to lift optimism on an unusually high volume trading day in the stock market.  Today is the quarterly expiration of both futures and option contracts and it is worth noting that Google shares also hit an all time high.  Treasury yields are softer however which indicates that not everyone is buying into the growth story.

Written by Kathy Lien, Chief Strategist of DailyFX.com