FOREX TREND MONITOR: Dollar Roars Back as EU Debt Crisis Compounds Risk Aversion
Major Currencies vs. US Dollar (% change)
16 May 2011 – 20 May 2011
Dollar Roars Back as EU Debt Crisis Compounds Risk Aversion
The US Dollar pulled back last week while aggressive selling across the spectrum of risky assets took a breather as the risk-averse trend that began to take place at the beginning of May ran into short-term bargain hunters, producing a correction. Risky assets came under pressure after the Fed announced in late April that it would allow its QE2 program to expire in June, closing investors’ access to cheap funding that had propped them up.
The respite proved to be short-lived, with sentiment quickly turning defensive once again as Euro Zone sovereign risk fears re-emerged amid a deluge of negative news-flow out of the currency bloc: S&P lowered its credit outlook for Italy to “negative”; Fitch cut its rating of Greece; and Spain’s ruling Socialist party suffered a defeat in local elections as the public lashed out at the budget cuts that had kept the region’s fourth-largest economy off crisis watch until now.Needless to say, traders now fear this is a sign of things to come, with a national-level electoral turnaround that undoes austerity in Spain or an outright rating cut in Italy threatening to unleash a crisis in a country too big to be rescued within the context of the EFSF bailout fund as it stands.
On balance, this paves the way for a Dollar-supportive theme this week. The Fed’s final QE2 bond purchase is a mere three weeks away –raising the urgency of unwinding USD-funded bets across the spectrum of risky assets – while the return of sovereign stress has met with little push-back from the EU so far, with policymakers seemingly content to allow it to rage on unchecked. An upward revision to first-quarter US GDP figures promises to reinforce this trajectory, with any meaningful signs of strength in the world’s top economy naturally tipping the scales in favor of faster monetary policy normalization in the minds of investors.
EUR/USD: Debt Fears Return as Crisis Threatens Italy and Spain
The Euro finds itself in the worst of possible scenarios this week as selling pressure transmitted via its correlation with the S&P 500 amid returning risk aversion is compounded by homegrown headwinds by way of a resurging debt crisis. Worse still, leading economic indicators are painting a dour picture: May’s early set of PMI figures proved disappointing, German business confidence fell for third month (albeit less than expected), and Industrial Orders well for the first time since September 2010. Further signs of economic weakness against a backdrop of sovereign risk fears will weigh on the ECB rate hike outlook – already in retreat over the past three days – promising further losses. The preliminary set of May’s German CPI figures rounds out scheduled event risk for the week. A pullback to 2.3 percent on the annualized reading is expected, bolstering the case for an overall downside scenario.
GBP/USD: Interest Rate Outlook Takes Center Stage, GDP on Tap
The British Pound has broken with the rest of the majors, looking away from the overall risk on/off dynamic guiding other currencies to look inward. Indeed, prices are tracking short term UK-US yield spreads, putting monetary policy expectations in focus. This points the spotlight on a revised set of first-quarter GDP figures. On balance, only an aggressive upward reduction is likely to reignite bets on near-term BOE rate hikes, but such an outcome seems unlikely given the mixed tone of recent economic data. May’s Nationwide House Prices report rounds out scheduled event risk on Friday.
Relative borrowing costs remain in focus with USDJPY tracking the US – Japan 10-year Treasury bond yield spread. Given the markets’ underlying focus on QE2 expiry over recent weeks, the path of least resistance appears to point higher as expectations of higher US borrowing costs in the second half of the year sized up a static (at best) stance from the Bank of Japan underpin the currency pair. A somewhat light US Treasury issuance calendar over the near term may keep yield gains slow-moving for now, but given the forces at work concern rate expectations rather than their absolute levels, the upside remains the most plausible scenario and we will stay long USDJPY for now.
The commodity bloc remains firmly anchored to stock markets, pointing to renewed losses as risk aversion returns after last week’s brief respite. With that in mind, day-to-day volatility is likely given the introduction of the Euro Zone debt crisis into the mix, with any move to stymie the outbreak by the region’s policymakers likely offering a bit a lift to risky assets and commodity bloc currencies alike. Australia’s first-quarter Private Capital Expenditure figures amount to the only bit of significant event risk left on the calendar.
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