Shock and Awe the dollar is higher

QE2 will be launched and exit strategies can now gather dust. Bernanke’s highly anticipated speech last Friday was not as dovish as the market expected. The Fed is still weighing their policy options, while admitting more policy action is needed. The large scale asset purchasing that the market has been betting on is still unresolved. We can expect changes to the FOMC statement to show that the policy makers plan to maintain low interest rates longer than the market expects. Fundamentally, there was not enough clarity for the longer end yield curve traders, the no ‘shock and awe’ has left the market dismantling a portion of their short dollar trades.

The US$ is stronger in the O/N trading session. Currently it is higher against 15 of the 16 most actively traded currencies in another ‘volatile’ trading range.

Forex heatmap

Forgetting Bernanke for a minute and if focusing on Friday’s data, it beat most of markets expectations. There are more signs that the US economy is doing better heading into the final quarter. Retail sales rose for a third consecutive month in Sept., up +0.6%. Capital market’s was expecting a rise of only +0.4%. It’s worth noting that the increase followed a revised climb for the previous month to +0.7% (the biggest increase in sales in over five months). Bernanke focused heavily on the inflation woes in his Friday’s speech. Sept.’s CPI rose +0.1%, while the core (ex-food and energy) remained unchanged. On a year-over-year basis, consumer prices are up +1.1% while the core is +0.8% higher. Bernanke summed up the situation nicely in his speech before the released data when he stated ‘in the light of the recent decline in inflation, the degree of slack in the economy, the relative stability of inflation expectations, it is reasonable to forecast the underlying inflation will be less than the Fed’s goal for some time’. The proof is in the pudding.

The USD$ is higher against the EUR -0.81%, GBP -0.80%, CHF -0.53% and lower against JPY +0.26%. The commodity currencies are weaker this morning, CAD -1.13% and AUD -0.75%. Dollar profit taking is the order of the day since Friday. It has managed to pressurize the loonie, aided by weaker commodity and equity prices. Even with the Canadian trade deficit narrowing to -$1.34b in Aug., from a revised -$2.55b in July last week, the loonie only spent a brief period above parity vs. the dollar as we wait for the BOC decision tomorrow. The market expects the currency to consolidate around these levels until after Governor Carney’s decision becomes public. The currency briefly found favor last week on the back of the MAS actions of widening their trading band, effectively tightening monetary policy. Big picture, because of the softer Canadian data this quarter and because of the strong economic ties with the US there is already much QE priced into the market. Investors and speculators alike are all partaking in the lemming one-directional short-dollar trade. On this basis we may have already seen CAD’s short term highs. Year-to-date, the CAD has appreciated +4.1% vs. its largest trading partner south of the border. Traders and investors have mostly trimmed their hike bets and will try to stay close to home.

The AUD won the battle of reaching parity, albeit briefly, and aggressively fell from its twenty-seven year high on speculation that the Fed would add less monetary stimulus than expected, damping demand for higher-yielding growth assets. Analysts note that going into next months Fed meeting’s that the ‘risks are skewed towards further disappointment’ which has the market aggressively pricing out some of the QE2 premium. Earlier last week, a rebound in Australian consumer confidence (+3.3% vs. -5%) and an unexpected increase in Japanese machinery orders (+10.1% vs. -3.7%) boosted optimism in the region’s economy. A stronger employment report down-under this month also supported the currency to print new highs vs. the greenback. Australia’s employers added +49.5k workers and the unemployment rate held at +5.1% in Sept. Month-to-date, the AUD has climbed +7.1% vs. the buck as data fueled bets that the RBA will raise interest rates before the year ends. Futures traders now see a 42% chance that the RBA will increase its target rate next month, down from 66% last week. Investors are better buyers on deeper pullbacks as the interest rate differential continues to be of appeal for alternative investments (0.9868).

Crude is lower in the O/N session ($80.74 -51c). Oil fell to its lowest level in two-weeks in the overnight session as the dollar strengthened, curbing the appeal of commodities as an alternative investment. Analysts note, that the dollar’s value is taking out any type of fundamental trading at the moment. The commodity temporarily climbed on the back of growing speculation that the Fed will give the US economy a boost, by default pushing commodity prices higher. Since the release of the FOMC minutes showing policy makers are prepared to buy more government debt, debase their currency, crude had climbed +1.2%. Now that the dollar has done an about turn, commodity prices have come under renewed pressure. Last week’s inventory report revealed a small drawdown on stocks. Crude inventories fell by -416k barrels to +360.5m, compared with the estimated increase of +1.2m barrels. Crude analysts note ‘this is currently a shoulder season for product demand ahead of the winter heating season’. Technically, we should expect inventories to gravitate towards their highs. Not to be left in the cold, gas inventories fell -1.8m barrels to +218.2m, just above the weekly estimate of a -1.4m drawdown. Distillate stocks (heating oil and diesel), fell by -255k barrels to +172.21m. Finally, the refining capacity fell by -1.2% to 81.9%. It seems that the drop in refinery runs has probably caused the drop in fuel supplies. The market remains wary that the underlying fundamentals have not changed despite prices remaining rangebound.

Gold, for a second consecutive day, has pared some of its record gains as the rise in the dollar has curbed the demand for commodities as alternative investment. For most of last week, investors traded with a distrust of currencies and gold seemed to be the only solution as investors used it as a proxy for a ‘third reservable currency’. With market confidence wavering in currency prices, and with cheap money, has been making commodities attractive on any deeper pull backs. Any time that governments are in the business of printing money then the commodity is bound to do well. To date, gold has outperformed global equities and treasuries (+23.8%), prompting record investment in gold-backed exchange-traded products. The debasing issues of the dollar, coupled with the sustainable growth issues of the US economy has investors generally seeking protection in an asset with a ‘store of value’. With the Fed on the verge of implementing further QE programs ‘tend to be supportive of asset prices and is fueling concerns about the potential longer-term inflationary affect of such measures’. The opportunity costs of holding gold are low due to low interest rates ($1,359 -$12.70c).

The Nikkei closed at 9,498 down -2. The DAX index in Europe was at 6,486 down -6; the FTSE (UK) currently is 5,688 -15. The early call for the open of key US indices is lower. The US 10-year backed up 5bp on Friday (2.53%) and is little changed in the O/N session. Long-end prices tumbled last week, pushing yields to their biggest weekly increase in over a year, on speculation that Fed’s efforts to spur the economy will reignite inflation. The market had expected to see some Japanese interest in the long bond auction, mostly on the back of a rally in the JPY would attract demand, however, this did not happen, further pressurizing the curve. The Fed has admitted to future QE2, but they will continue with caution. Until the amount is know, most likely at its next meeting, the market has product to distribute.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.

Dean Popplewell

Dean Popplewell

Vice-President of Market Analysis at MarketPulse
Dean Popplewell has nearly two decades of experience trading currencies and fixed income instruments. He has a deep understanding of market fundamentals and the impact of global events on capital markets. He is respected among professional traders for his skilled analysis and career history as global head of trading for firms such as Scotia Capital and BMO Nesbitt Burns. Since joining OANDA in 2006, Dean has played an instrumental role in driving awareness of the forex market as an emerging asset class for retail investors, as well as providing expert counsel to a number of internal teams on how to best serve clients and industry stakeholders.
Dean Popplewell