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Dollar Advances as Temporary Boost in Risk Appetite from EU Bailout Passes

Dollar Advances as Temporary Boost in Risk Appetite from EU Bailout Passes

2010-05-12 01:25:00
John Kicklighter, Chief Currency Strategist
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Dollar Advances as Temporary Boost in Risk Appetite from EU Bailout Passes
That didn’t take very long. Only a day after the market is able to respond to news that the European Union had crafted a 750 billion euro bailout program for its financially strapped members, activity levels have returned to normal and risk premiums built into the currency market have been worked off. Was this a sign that doubt is seeping back into the market? Perhaps the investment community is convinced that one of the largest regional economies in the world will falter regardless of the possible efforts officials can muster. Or, maybe concern over the prevailing level of risk appetite runs deeper than the issues in the EU. Establishing what is the primary fundamental catalyst for the greenback is the first step to gauging its direction. The second is predicting the bearing of that particular driver. For our purposes, the issue of sentiment is relatively straightforward. The outlook for the European Union is gloomy regardless of the proposal of financial assistance because the austerity cuts, recession and lack of funds are practical problems with the plan. With global asset valuations already inflated beyond what growth and yields would in imply by government stimulus (that is in the process of being removed), the market is merely looking for a catalyst to reconcile speculative appetites to fundamental reality. Furthermore, concern for the euro translates into opportunity for the dollar. Given EURUSD is the most liquid currency pair in the market (by far), a flight of capital away from European assets naturally directs a significant bulk of the capital flow into the US. Another aspect of this uncertainty is that regardless of whether the package staves off crisis; the ECB will not likely turn to a hawkish policy regime for an extended period. This naturally bolsters the expected yield advantage that the dollar is seen holding over the euro three, six, twelve months down the line.

Yet, on the topic of interest rate forecasts; while the relative level of yields is still slanted in the US dollar’s favor, the absolute level itself has declined substantially over the past month. Through the end of the day, overnight index swaps from Credit Suisse were pricing in a mere 55 basis points worth of tightening from the Federal Open Market Committee (FOMC) over the coming 12 months. This is the most dovish forecast for the benchmark lending rate in six months and approximately half of what was projected just a month ago. What was the foundation for such a significant tempering of speculative forecasts? The rumblings of a second financial crisis from across the Atlantic is no doubt a factor; but economic performance may be the underpinning of this adjustment. In recent data readings, we have seen the pace of growth cool through the first quarter, unemployment tick back up to 9.9 percent and core inflation pressures level off around 1.1 percent. There is little in this mix to suggest that policy officials would take the aggressive step of lifting the Federal Funds rate. However, a hike wouldn’t be the only hawkish step the central bank could take. Selling off assets from its bloated balance sheet would be a clear step towards such a regime. That being said, should we believe there is a risk to this time table in the Fed reopening its swap lines with the ECB, BoE, BoC and BoJ? If a full-blown crisis develops, expect stimulus measures to be held in place. On the other hand, if the problem remains isolated to Europe or it is an orderly tumble in risk trends, then the Board is likely still on schedule to remove these extraordinary measures.

Related: Discuss the US Dollar in the DailyFX Forum, Technical Implications from Last Week’s Equity Plunge

Euro Confidence Less Remarkable than 750 Billion Euros would Imply
What does 750 billion euros buy you? European policymakers were hoping its vast rescue package would at least buy investors piece of mind. Yet the sting of the last financial crisis and concern in the group’s ability to raise funds for Greece when the single economy was still the extent of the region’s threat are reason enough to doubt the commitment. It is fair to question whether officials are simply trying to shock the market’s into confidence with the size of the program that has been suggested. Thinking critically of the hurdles that would exist to such a plan leads to clear holes that still need to be filled in. The first concern is where would the capital come from. The EU member governments are on the line for 440 billion euros; and yet every single member seems financially strapped and most are supporting deficits that are greater than the Union’s allowable shortfall-to-GDP ratio. The next question is whether money is the answer to the region’s problems. Stimulus has already been pumped into the system; and yet conditions have still progressed to their current state. More specific to the EU’s situation, those members that tap the rescue funds will have to cut spending as directed and likely steer their economies into recession. This is a necessary step; but one that will be difficult to bear. A critical estimate for whether Europe can recover from its predicament is growth. Should a recovery prove robust, tax revenue and investor confidence could close the gap. For this reason, the preliminary 1Q GDP numbers due tomorrow are vital.

Related: Discuss the Euro in the DailyFX Forum, Watch the German GDP 1Q Release Live!

British Pound Volatility Stoked by GDP Estimates, Surge in Factory Activity, New Prime Minister
We finally have some clarity on the political landscape in the United Kingdome. Prime Minister Gordon Brown has stepped down and Conservative Leader David Cameron has taken over the role in a coalition with Liberal Democrat head Nick Clegg. For pound traders, this news bolsters the probability that the government will move budget trimming up on its list of priorities. Furthering this optimism, today’s data would also show industrial production grew at its fastest pace since 2002 and the NIESR GDP estimate came in at 0.5 percent. Yet skepticism remains.

Australian Dollar Loses Ground after Federal Budget Throttles back on the Economic Fuel
Is an effort to cut Australia’s budget deficit a good or bad thing? Considering the leveraged importance afforded to sovereign credit risk, the preemptive step should be seen a sensible step. On the other hand, withdrawing government stimulus means the economy’s impressive pace of growth will likely suffer. Keeping tabs on rate forecasts, the 12-year forecast currently stands at a meager 50bps.

Canadian Dollar Looks to Trade Data to Compliment Bullish Yield Forecast
The Canadian dollar advanced to a near 9-year high against the euro and pushed the USDCAD exchange rate below 1.02 Tuesday as traders appreciated the safe haven and yield potential qualities of the single currency. With no past bailouts under its belt, a stable economy and financial market and yield forecasts running at 170 basis points, the loonie is the best of both worlds. Will trade data further this notion?

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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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