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Dollar Holds Up Well Despite EU Lifeline’s Implications for Risk Trends

Dollar Holds Up Well Despite EU Lifeline’s Implications for Risk Trends

2010-05-10 23:00:00
John Kicklighter, Chief Currency Strategist
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Dollar Holds Up Well Despite EU Lifeline’s Implications for Risk Trends
No currency or asset class would escape the news that the European Union had drafted up a 750 billion euro rescue plan in an effort to banish any doubts over the stability and cohesiveness of one of the world’s largest economies. However, the reaction from the speculative markets was less consistent than one would expect from such a colossal effort. From the simple bearings of the equity market, the announcement would strike a clear and loud bullish tone. The benchmark S&P 500 would mark its largest single-day advance in a year; but the proximity of the relief would derive far greater response from the European indexes. The Spanish IBEX 35 Index rallied over 14 percent, the Italian FTSE MIB climbed 11 percent, the French CAC 40 rose 10 percent and the German DAX would enjoy its own 5 percent advance. However, in contrast, the market’s favorite safe havens would surprisingly maintain their strength. The US dollar fell as much as 1.8 percent through the early morning trading hours. Though, by the time US liquidity would join the mix, the benchmark currency was already on pace to recover lost ground; and by the session close, it had recovered nearly all of its lost ground. If this remarkable reversal were unique, it could be assigned to the unique fundamental strength of the greenback itself. Yet, the dollar isn’t the only security to have recovered through the day. Gold – a barometer for sovereign debt risk and speculative uncertainty – would similarly find its footing in the early European session.

In the volatility of the day, the divergence of asset classes may have been lost on many market participants; but understanding the reasoning for this deviation is critical to gauging what the masses are most concerned about. Looking to the currency market for answers first, we see that both the dollar and the Japanese yen would recover lost ground. This shows an inherent value for safety through what seemed like a clear speculative buy signal for investors in so many other asset classes. One possible reason for this divergence (beyond skepticism that the plan will actually work, which we discuss below) is that the issue in the European Union was just one threat to stability and unchecked capital appreciation. Even if the risk of a Euro region-born crisis dissipated, there are still concerns that valuations for different assets are still far greater than what growth and yield forecasts would suggest. What’s more, there is a list of follow catalysts (like China throwing the breaks on its economy and market) that could upset the flimsy speculative build later down the line.

Another reason for the dollar’s performance through the end of the day is that there is a fundamental strength beyond the currency itself that runs deeper than mere safe haven. It is true that the currency is backed by the market’s preferred speculative refuge (Treasuries); but the economy itself has seen a consistent improvement in its own right. ‘Consistent’ is the crucial concept to this assessment. While there are other economies that are enjoying a faster rate of recovery than the United States, the world’s largest nation is seeing the engine for its growth shift to consumption (the largest segment of GDP); which lifts the burden off temporary government stimulus. Another source of strength for the dollar is interest rate expectations – the foundation of return for a currency. Given the troubles in the European Union and UK, the Fed looks like it will return to hikes well before the ECB and BoE are able to act. Oddly enough, this boosts both the greenback’s safe haven and carry status.

Related: Discuss the US Dollar in the DailyFX Forum, EU Crafts 750 Billion Euro Life Line, EURUSD Advance Likely to be Limited

Euro Still Hesitant on the Future Despite 750 Billion Euro Rescue
After weeks of infighting and false promises, European officials seem to finally have met the immense problem that it faces with a plan of equivalent proportion. A 750 billion euro rescue plan calls on funds from EU member contributions (440 billion euros), the IMF (250 billion euros) and the Union’s own budget (60 billion euros). This size of this effort recalls the endeavor that the US took at the peak of the 2007-2008 subprime crisis in its own 700 billion backstop – and that plan seemed to do the trick. However, the US injection of capital was not just a promise of funds. This money was actually put to work to stabilize the economy and markets. This is where doubt starts to come in for the Euro-area. Such an incredible amount of money from individual nations that are already stretched and heading towards financial consolidation is hard to imagine. What’s more, those that actually look for assistance will have to bear the costs of this aid. This could include a dramatic change to the spending and tax systems in these economies as well as significant short-term recessions. Few will tolerate this burden willingly. On the other hand, the euro has a second component to this plan. The ECB will act as a backup by reviving the unlimited 3 and 6 month loans, opening swap lines and purchasing government bonds in the secondary market. It will be a long, hard road; but this is a strong first step.

Related: Discuss the Euro in the DailyFX Forum, Euro Future Bleak Regardless of ECB or EU Bailout Efforts

British Pound Still Caught in the Political Current as PM Brown Resigns
Things were already complicated for sterling traders with the political situation still in flux. Though the vote from last week has already been tallied; there has yet to be a clear coalition to come out of the jockeying; therefore, there is no clear direction on policy initiatives. With the Liberal Democrats seemingly near an alliance with the Conservatives (which would create a majority in Parliament), Prime Minister Gordon Brown announced his resignation to pull the Liberals back to Labor’s side. Looking ahead, there is a lot of event risk on deck.

Australian Dollar Outlook Defined by Domestic Health as Much as Risk Appetite
The Australian dollar was one of the outperformers on today’s EU bailout announcement. As a high-yield currency, the benefits of stability and revived speculation were obvious. However, the currency’s own interest rate and growth advantages would certainly leverage the situation. Looking ahead to tomorrow, the 2010-2011 budget could significantly diminish the currency’s own strength. Watch it carefully.

Japanese Yen Crosses Advance with a Clear Sigh of Relief from Speculators
There was clear difference in the performance of the Japanese yen and the US dollar Monday. The latter would almost completely retrace its early morning losses while the yen would only recovery a fraction of its losses. This difference can partially be attributed to the Japanese currency’s permanence as a carry currency. A year from now when these risks have diminished, the yen will still be a funding currency.`

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**For a full list of upcoming event risk and past releases, go to www.dailyfx.com/calendar

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

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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