Economic recovery and risk appetite are the two major themes affecting today’s currency markets. After creeping up and almost reaching 90 in March 2009, the U.S. dollar index dropped back down to under 80 at the end of July. How fast the U.S. economy will recover from the economic implosion of 2008 likely will determine how fast the dollar will recover and influence where other currencies go in 2009 and beyond. But analysts say that with recovery comes increased appetite for risk, which could cause investors to move out of the relative safety of U.S. dollars.
“The fundamentals are improving, but positive U.S. fundamentals are bringing risk appetite to the market, which would drive the euro and pound,” says Dan Cook, senior market analyst for IG Markets.
Mark Frey, vice president for forex trading at Custom House, says the market is overwhelmingly focused on the interplay between risk acceptance and risk aversion, with any new rounds of risk aversion benefiting the U.S. dollar as a flight to quality play.
Kathy Lien, director of currency research at GFT, says dollar weakness is the predominant theme in the currency market for the second half of 2009. “The dollar is off so aggressively because risk appetite has improved. Everyone is looking to a potential recovery in the U.S. and all other countries in the fourth quarter into 2010,” she says. Proof of this is the dollar’s inverse relationship with equity markets for most of 2009 (see “Good news bad for dollar”).
Brian Dolan, chief currency strategist for GAIN Capital, says there is tremendous incentive for all G20 economies to limit the extent of dollar weakness and the strength of their own currencies. “The stronger their currencies get, the more delayed recovery is going to be in their own economies. All of the interests line up to put a floor under the dollar.”
Analysts say one reason for the weakness in the dollar is the record budget deficit in the United States. The Congressional Budget Office’s estimated U.S. budget deficit for 2009 is $1.18 trillion. It projects that the deficit will go down in 2010 and beyond (see “Far behind”). Those projections appear rosy to some, and will need to be met to support a dollar recovery.
Andrew Wilkinson, senior analyst at Interactive Brokers, notes that a big deficit could make the cost of borrowing increase, which he says could turn the economy “into the gutter.” “You have to watch what’s going on with the deficit and the currency market and interest rate market’s perception towards the dollar in terms of the deficit,” he adds.
“The deficit concerns undermine the dollar, but those concerns are going to be addressed. As growth begins to recover, the deficit picture will begin to improve, but it’s going to be a long road,” Dolan says.
President Obama’s economic stimulus plans could be a drag on the dollar. “How aggressive [will] the Obama administration be in [tightening] the purse strings? They’ve shown very little restraint at this point, and that’s been accepted by most financial market analysis as the right policy to take. If they keep spending while the economy begins to improve, that could be a dollar negative,” Frey says.
Lien agrees. “The dollar has been weakening because of the stimulus programs and the quantitative easing that the Obama administration has announced. The health care plan is estimated to cost $1 trillion, and in order to pay for that plan the U.S. government will either have to raise taxes, print more money or borrow more. All three of those are going to be dollar negative,” she says.
Traders should pay attention to what central banks are saying about their fiscal policy to predict where currencies are heading next. Most analysts do not expect any of the major economies to raise interest rates until 2010.
Lien expects more consolidation in the next few months. “Volatility picks up in the currency market in August and September, but there’s no major trigger for that volatility because central banks aren’t going to increase interest rates any time soon. Any rate hike from a central bank won’t come until the latter part of 2010. There are no real surprises left out there in the market, and because of that, more consolidation and range-trading is likely,” she says.
Dolan says the countries with commodity currencies, Australia, New Zealand and Canada, are more likely to tighten rates before the United States does. He expects the Eurozone to be on hold for all of 2010, and the UK to begin to increase rates in the first half of 2010. He notes that most of those expectations are already priced into the various interest rate markets.
CHINESE CHECKERS
As the largest foreign holder of U.S. Treasury securities, with an estimated $801.5 billion as of May 2009, China’s influence on the currency market
is huge.
Unless it moves to a significant revaluation of the yuan, Dolan expects China to keep buying U.S. Treasuries. “We have a massive amount of Treasury debt to be issuing and that’s the major negative hanging over the dollar over the next year,” he says.
Wilkinson thinks that China’s buying spree is positive for the dollar. “The Chinese are giving America’s fiscal policy a thumbs-up. If they didn’t agree with what the Americans were doing, they would be foolhardy to continue buying debt at a record pace. They seem to understand the fiscal stance and the prospects for deficits going forward perhaps better than the market does. That would be supportive of the dollar,” he says.
“Currency traders should buy what China’s looking to buy,” Lien says. “The hunt for resources has been their main focus and that’s going to continue, especially in terms of gold. The Bank of Canada is watching commodity prices in China because commodity prices are helping to offset the rise in their currency.” She says that if the dollar continues to weaken, the BRIC nations (Brazil, Russia, India and China) could start diversifying their reserves out of dollars.
Cook agrees. “China, Russia and Brazil are the most vocal about the world moving away from a reserve currency. Despite voicing concerns regarding U.S. policy, China continues to buy massive amounts of U.S. debt so any devaluation of the dollar is going to hurt their overall holdings. They keep buying commodities, which will help the Aussie against the dollar, but it will hold it pretty stable against the euro and the pound,” he says.
Frey says that China has more incentive than anyone to maintain the value of the U.S. dollar. “On a long-term basis, they’re going to be a big player. In the short term, there’s very little they can do. They’re not about to sell U.S. Treasuries.”
CRUDE AWAKENINGS
The correlation between crude and currencies is always strong, particularly with commodity currencies such as the Canadian dollar (see “Loonie for oil”). With the U.S. dollar, there’s typically an inverse correlation — the weaker the dollar, the higher crude goes. Lien notes that the strong correlation between the Canadian dollar and crude is the reason for the fall in the USD/CAD from $1.16 to $1.08 as of the end of July. She expects the USD-CAD to reach $1.10 by October.
“Correlation levels have reached significant highs and at some point there’s going to have to be a little bit of a breakdown. The level of economic activity is going to be subdued enough that commodity prices should not run away on the upside and if they do, we’re looking at the potential of a double-dip recession,” Dolan says.
Wilkinson notes, “There’s confidence displayed through the price of crude oil that the worst is over and we’re not going to roll over in terms of economic activity, so that’s supportive of the commodity currencies.”
Cook does not expect a massive run-up in oil. “Oil is going to go right with the U.S. dollar. I’d look for oil not to get above $75 or below $58. We’ll see a choppy market there and that’s going to translate to a choppy dollar trade, particularly as it relates to the euro and the pound,” he says.
Analysts agree that currency traders should be focused on rates, economic recovery and protecting themselves from risk.
“If we get some surprises and someone’s short the U.S. dollar, they could get hurt. [Traders] should take it day to day; protect profits when they have them, moving stops up to make sure they don’t let it all disappear. The fundamentals right now are mixed and they look to be mixed moving forward the next three months,” Cook says.
Dollar weakness could prevail as risk appetites improve and the dollar is sold off, Dolan says, adding “There are relative growth differentials, and the U.S. is going to do better than the other mature G-7 economies. Europe is going to be the laggard. We’ll put in some dollar lows ahead of September and from there the dollar will start to move a bit higher.”
Frey is not so sure. “As we get into the fall of 2009, it’s not a very pretty outlook for the U.S. dollar in the short-term and we can see some more dollar weakness [through the end of the year],” he says.
A slower recovery for the economy in Europe could mean a slower recovery for the euro. “The dollar is a better place to hold my money than the Eurozone, where it’s going to be the most anemic recovery of all,” Wilkinson says. “The European fundamentals have a tendency to be inherently weak and the ECB (European Central Bank) and the German government’s failure to adopt more stimulus measures is going to leave the Eurozone lagging behind in 2010. [It’s] difficult to be a euro bull.” He expects the dollar to go to $1.30 vs. the euro by year-end.
Dolan’s year-end target for the euro is $1.30-$1.32, and Lien says the Eurodollar could be at $141.50 by October. Cook expects the euro to hit $1.35 by year-end.
Frey looks for a year-end top side of the euro at $1.47. “The downside for the euro has already come to fruition. The ECB in particular was already well behind the curve and we couldn’t get all of the Western European heads all in the same mindset for what we needed to do from a stimulus standpoint,” he says.
As for the pound, Dolan says that the UK’s economy will recover faster than the Eurozone. “The major drags on the pound are the quantitative easing, and they’ll finish that up in August and announce they’re not going to do any more, and that will be sterling supportive. In line with the overall dollar view, we look for the pound to top out below $1.70 before September and move back to $1.55 to $1.58 by the end of the year,” he says.
Wilkinson, however, does not believe the British recovery is on track. “You’re not going to have a big rally in housing or commercial real estate in any of these economies. There’s going to be slower growth. The pound will go to $1.55 by year-end,” he says.
Lien says the pound could go to $1.66 by October. Cook says that by year-end, “If [the pound] breaks to the upside, $1.72 is very realistic; if it breaks to the downside, $1.55.” Frey expects some retracement in the pound in the short-term, finishing the year around $1.62.
Risk aversion also is connected to the yen. Frey offers a year-end prediction of 98 for the yen, while Wilkinson expects the dollar to buy 100 yen before year-end.
“The budding recovery is not bad enough to force the yen to 90 against the dollar. The dollar is more likely to appreciate against the yen as risk aversion gradually dissipates,” Wilkinson says.
Dolan says the dollar-yen is going to be higher in the fourth quarter on better growth prospects, improving risk appetites and higher rates in the U.S. that will drive treasury yields higher and dollar-yen higher with it. He expects it to be $1.02-$1.05 by the end of the year.
Risk and recovery are the recurring themes for the dollar and the currency market at large.
“The fundamentals for the dollar all come down to the recovery trade, when economic growth is going to resume. By the fourth quarter, we’ll have some more concrete data in hand that is going to suggest that there’s a return to growth,” Dolan says.
Cook says the fundamentals for the dollar are mixed. “Risk is hard to determine right now, which is why we see back and forth movement [in currencies]. There’s still a lot of weight on all economies and until that’s cleared up, it’s going to be a cage match between the dollar, pound and euro,” he says.
And although the dollar has been reacting negatively to positive economic news because of its status as a reserve currency, long-term, its strength depends on a U.S. economic recovery.
