What next for the U.S. dollar?
The dominant theme and increasingly apparent over the closure of the Barack Obama victory has been the decline in implied volatility across all asset classes. It seems that investors are increasingly confident that the breakdown in the global financial system can’t get much worse given the measures put into place. The key measure of equity market fear known as the VIX has dropped from 80 to 50, which in turn is inviting investors to reconsider the appeal of investing at home and abroad. In turn, currency market dislocation has subsided and the cost of insuring against volatile exchange rate movements has taken a backseat.
But it’s still too early to tell whether the sky is yet all clear. Financial market dislocation was an extremely strong rationale for pressuring equities lower and qualified both the yen and the dollar as safe havens. But en route, the equity markets have fallen so far that it’s harder for bears to argue with bulls who tout the virtues of extremely appealing price-to-earnings ratio and the fact that a recession is already baked into the cake.
We have to concur that not only was an awful lot of bad news priced in, but also that much of the selling was not aimed at driving the market lower. Forced sellers had to redeem cash to wary investors or to meet margin calls. This is a whole world of difference from buyers being forced to buy in a bull market to maintain the performance of an index. During those frothy times, they are putting cash to work.
The key to watch looking ahead in the currency world will be the unraveling of local domestic economic data. While the dollar rallied sharply last week, the unwinding of risk aversion is not taking a huge toll yet. We noted headlines drawing our attention on Tuesday to its largest fall against the euro since when ever, but we have to point out that as we write, the dollar still trades close to $1.3000. We note also that while the yen has retraced its gains significantly against just about all cross currencies, it’s still bid against the dollar. That should serve as something of a wake up call to those who believe that the saga of 2008 is over.
Open interest on CME euro, pound and yen futures dropped across the board since the middle of last week. It wouldn’t surprise us to learn that some positions were closed on the sharp reversal as dealers implemented stop activity to protect profits on short positions (long in the case of the yen). Elsewhere open interest on Swiss and Australian dollar positions jumped 8%. But with very little supporting evidence from put/call ratios – which in both cases still indicates optimism on each – it’s not possible to say whether dealers are betting on declines or rallies on either unit. The Aussie has rebounded even in the face of an oversized 75 basis point cut from the Reserve Bank of Australia and has rallied from 60 to 70 cents.
The case for a rebound in the Aussie (and the Canadian dollar) is far more compelling than it is for the Swiss. We noted just last week how the Swiss franc’s safe haven appeal has been tarnished and so in the face of less risk aversion, one would expect the Swiss franc to decline rather than rise. But as far as the commodity dollars go, the sudden rejuvenation of commodity prices from soybeans to crude oil, the appeal is quite apparent.
Implied currency volatility took a back seat over the last week with the Aussie and the yen seeing the sharpest declines. Yen volatility came in 11.5% to 26.1% while that on the Aussie fell by close to 15% to stand at almost 36%. The demise in implied currency volatility readings is extremely mechanical and as noted earlier seems to be towing the line from other asset classes where the sky seems less cloudy.
The more clear-cut than anticipated Obama victory does perhaps lend itself to a more likely or even speedier resolution to the economic crisis. However, from our perspective the runaway locomotive has only just been set in motion as it moves over the top of the mountain and as such will inevitably pick up speed over time. The first real test for the dollar, as opposed to Obama, will be Friday’s employment report, which will be depressing reading for the outgoing president rather than the incumbent. It would hardly be a surprise to see analysts jolted once again into the realization that the credit crisis is leaving behind a nasty trailblazer for President Elect Barack Obama to deal with.
As with the stock market, we can’t tell if the capitulation is yet behind us, but we’ll undoubtedly have a test of the October lows. Should that happen, we’ll undoubtedly see a rise in currency pressures play out through rising volatility readings. This time, we’ll be wondering whether those performances will correlate as neatly as they have down with equity price declines or whether the prospect of a deflationary bubble will cause further currency dislocation.
Senior Market Analyst
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