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Dollar Rally Stoked by Renewed European Crisis Concerns, Strong Economic Data

Dollar Rally Stoked by Renewed European Crisis Concerns, Strong Economic Data

2010-05-15 00:47:00
John Kicklighter, Chief Currency Strategist

Dollar Rally Stoked by Renewed European Crisis Concerns, Strong Economic Data
Through the first four days of this week, the capital markets were regrouping from biggest tumble in price and surge in volatility (at least for equities) since 1987. The foothold that market participants had to work with: a 750 billion euro life line from the European Union – one of the largest in financial history. And yet, despite the scale of this safety net, confidence would only manage a slow and choppy rebound that barely compensated for the previous Thursday’s massive losses. The reaction was clearly disproportionate to news. Why the disconnect? Risk appetite had already lost its exuberance and concern that current asset levels are running well beyond fair value was starting to dawn on the crowd. Therefore, the impressive liability that the EU saddled upon themselves that would normally stop fear in its tracks would be absorbed with only moderate impact. All that would be needed to turn hesitation back into pessimism is another round of news that would invite skepticism back into this specific catalyst. That is exactly what the headlines offered Friday morning with news that the French President threatened to withdrawal from the Euro Zone, Moody’s was still on track to downgrade Greece and Portugal maintained the largest exposure to Greek assets as a percentage of overall capital. This was more than enough to cast a shadow over the legitimacy of a bailout (which we will discuss further below) and send the capital markets tumbling. The S&P 500 would drop 1.9 percent on the day, European equities collapsed between 3 and 7 percent, US treasuries climbed and Greek sovereign debt stumbled, most high-yield currencies contracted and the safe haven dollar would rally. For the greenback, the fourth consecutive daily advance would push the trade-weighted index to a new yearly high and draw EURUSD to an 18-month low which is on the precipice of a broaching territory not covered in trekked in four years.

It is difficult to quantify; but it is safe to assume that the dollar’s appreciation was heavily influenced by underlying sentiment. And, going forward, disappointing news for global growth and financial stability will likely remain the primary fuel for the currency’s momentum. Alternatively, supportive events and reports will be suppressed by cynicism (think of it as the inverse set of circumstances of the 2009 market advance in the face of any discouraging data). However, we need to look beyond the gravity of risk appetite; and gauge whether the dollar’s own fundamentals will be able to take over the wheel when the market’s opinions once again shift. Given the tempering of growth trends in the first quarter readings and interest rate expectations, the advantage the currency maintains over its primary counterparts is thin. Nonetheless, the scheduled fodder crossing the wires today would support the notion that the US recovery was stable. As good an assessment of overall growth as can be obtained without actual GDP numbers, the combination of retail sales and consumer confidence figures offered a healthy update for a sector that accounts for more than fourth-fifths of economic activity. The Commerce Department reported a 0.4 percent increase in retail sales that was slightly better than expectations and notably the 12th increase from this series in 13 months (though discretionary sales were weak). The University of Michigan sentiment report would similarly improve to a 73.3 reading to brighten the outlook for future spending. However, it was the one-year inflation outlook (3.1 percent) which was particularly interesting. Interest rate forecasts have dropped off in recent weeks; but this suggests consumers are prepared. If next week’s CPI numbers are high, it may revive the argument for a hike sooner than later.

Related: Discuss the US Dollar in the DailyFX Forum, Dollar Strength Falls to Sovereign Credit Concerns Not Yield Forecasts

Euro Sinks to 19-Month Lows as Reports Show How Fractured EU Leaders are on Rescue
Ever since the European Union announced its 750 billion euro financial rescue package last weekend, there has been a sense of skepticism circulating around the market. For risk appetite, the rebound in positioning has been limited to the retracing the losses suffered on the previous Thursday. Fundamentally, there has been little to truly encourage investor optimism; even less to support confidence in the euro or its assets. Essentially, FX traders were bidding their time until the next clear development would come from the ongoing drama with Greece and the other fiscally instable member economies. Unfortunately, the potential for positive news is severely limited and it was just a matter of time before analysts and/or journalists dug up additional troubles. Unfortunately for the euro, a round of particularly disturbing news would be released all at once on Friday. The most sensational claim was that French President Nicolas Sarkozy threatened to pull his country out of the Euro Zone when Germany seemed unwilling to join the bailout effort. While this may have only been grandstanding, it nonetheless tells us how difficult it is to encourage a joint effort to stabilize the region. If there is this must struggle, what will it be like when they actually have to pony the money up? Other news included a Moody’s assessment that there was a ‘greater than’ 80 percent chance of a Greek downgrade in the near future, it also warned Portuguese banks were the most highly exposed to Greek assets and then there was the rumor that France may be downgraded.

British Pound Has Political Stability but How Will the Deficit/Growth Balance Fare?
The British pound managed an advance against the euro; but it would also set a 12-month low against the benchmark dollar. With the passing of the election uncertainty, the sterling has been released from an anchor on volatility; but not it has been simply set adrift until a fundamental current can once again direct a broader trend. For now investors are left to price in the effect that the planned 6 billion pound deficit cut expected in the next few months will have. It may alleviate sovereign debt risk somewhat; but these adjustments could also slow growth and further defer a return to rate hikes for the BoE. In fact, there is speculation that the central bank will downgrade its growth and inflation forecasts and increase its bond purchase program soon. In the meantime, we will look at the public debt figures that will be released next week.

Australian Dollar Advances against the Current of Risk Aversion thanks to Fundamentals
A market-wide effort was made to lighten the load on risky positions Friday; and yet the high-yield Australian dollar was surprisingly stable through the session. The curbed outlook for interest rates and speculation of a near-term appreciation in the Chinese yuan do undermine the outlook for the Aussie dollar; but with the market looking for stability, the Australian economy and yield offers a unique harbor.

Japanese Yen: Is Japan in Line to Suffer its Own Financial Crisis?
With the European Union already melting down and China considered the next to go with its asset bubble, investors are fully occupied. However, Japan has debt equal to nearly 200 percent of GDP, rampant deflation and an aging population. In time, our attention will shift in this direction.

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

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