Weak Dollar Illusory as Correlated Trade Shows Gains (Update2)

Feb. 8 (Bloomberg) -- For all the concern over the $1.6
trillion U.S. budget deficit and record debt load, the dollar is
as valuable now as 35 years ago.

Measured against a basket of currencies from the Group of
10 nations proportioned by how they trade against each other,
the greenback is up about 3 percent since 1975, according to
Bloomberg Correlation-Weighted Currency Indexes. That was four
years after the Bretton Woods agreement, set up in 1944 to link
currencies to the price of gold, collapsed. The U.K. pound has
dropped 34 percent and the Canadian dollar has fallen 6 percent.
The U.S. dollar gained 6 percent since November after
losing 12 percent in the first 11 months of 2009 as measured by
the Bloomberg index.

Barclays Capital and Morgan Stanley say the
U.S. will grow faster than the rest of the developed world this
year and 2011. At the same time, Europe faces worsening finances
in Greece, Spain and Portugal, Japan’s economy is struggling and
concerns about valuations in emerging markets are increasing.
“To quote Mark Twain, the reports of the dollar’s demise
have been greatly exaggerated,” said Win Thin, a senior
currency strategist in New York at Brown Brothers Harriman &
Co., which manages about $40 billion in assets.


Rising Demand
Nowhere is that more evident than in the market for U.S.
Treasuries. The amount of America’s government debt held by
investors outside the U.S. rose 17 percent to $3.6 trillion in
2009 through November, according to the Treasury Department.
Purchases may continue to rise as investors seek refuge
from growing sovereign credit risk in the euro area. The dollar
“will benefit from relative liquidity of the U.S. Treasury
markets,” Barclays Capital currency strategists led by David
Woo in London said in a Feb. 5 report.
Barclays Capital economists said in a report the same day
that U.S. gross domestic product may grow 3.6 percent this year,
versus 2.5 percent for the developed world, and 3.1 percent in
2011, compared with 2.6 percent elsewhere. Japan’s GDP may
expand 1.9 percent this year, and the euro zone 1.3 percent,
they said.

A day earlier, strategists at New York-based Morgan Stanley
boosted their dollar forecast, saying it will strengthen to
$1.24 per euro by year-end from its previous estimate of $1.32.
It traded at $1.3676 as of 6:46 a.m. in New York today. The firm
sees the U.S. currency gaining to 109 yen from 89.42 today, and
rallying to $1.49 to the pound from $1.5578


Reserve Currency
Investors and traders predicted last year the dollar would
lose its position as the world’s reserve currency, which means
it’s the first place central banks look to park their cash.
“With all the concerns about the problems with the U.S.
financial system last year, the banking sector in the euro zone
looked a bit more stable,” said Robert Sinche, chief strategist
at Lily Pond Capital Management LLC in New York. “That created
a sense of the euro as an alternative to the dollar.”
Central banks that disclose breakdowns of their reserves
bought a record $60 billion worth of euros in 2009’s second
quarter, more than half of their new cash in the period, based
on International Monetary Fund data adjusted for exchange-rate
changes using methodology developed by Barclays Capital.

They then reversed course, putting 15 percent of new
reserves, or $17.8 billion, into euros in the third quarter, the
smallest share of any period in which their reserves grew since
early 2008. Central banks put 45 percent, or $52 billion, into
dollars, up from 36 percent.


Rally by Default
Rather than a referendum on the U.S., the dollar may be
rallying by default. Nouriel Roubini, the New York University
professor who predicted the credit crisis, said on Feb. 4 that
the greenback may weaken for the next three years.
Moody’s Investors Service said last week the U.S.
government’s Aaa bond rating will come under pressure unless
additional measures are taken to reduce budget deficits
projected for the next decade. The ratio of government debt to
GDP and revenue increased “sharply” during the seizure in
credit markets and recession, Moody’s said.
“If the current upward trend in government debt were to
continue and become irreversible, the rating could come under
downward pressure,” said analysts led by Steven Hess, a senior
credit officer at Moody’s in New York.

The Obama administration’s plan to offset spending by more
than $1.2 trillion over 10 years showed larger deficits and
higher debt levels than in the original budget, Moody’s said.
The ratio of debt to GDP in the U.S. will continue to expand,
reaching 76.5 percent in 2019 compared with an earlier forecast
of 70.1 percent, Moody’s said.
Treasury Secretary Timothy F. Geithner said in an ABC News
interview broadcast yesterday the U.S. isn’t in danger of losing
its Aaa rating.

“Absolutely not,” Geithner said, when asked whether a
downgrade is a concern. “That will never happen to this
country.”


‘A Better Bet’
The U.S. Office of Management & Budget said America’s
budget deficit will fall each year through 2014, to $706 billion
from $1.56 trillion in 2010, as borrowing needs drop to $814
billion from $1.75 trillion.

“Under stress, people trust the U.S. to do the right
thing,” said Sebastien Galy, a currency strategist at BNP
Paribas SA in New York. “The U.S. is a better bet.”
A global reserve currency must provide investors with the
ability to invest, which requires liquid markets, and few
capital controls, according to investors. China’s yuan can’t
replace the dollar because it isn’t fully convertible and
doesn’t float freely. The euro region and the markets for
commodity currencies, such as the Australian, New Zealand and
Canadian dollar, don’t have enough trading to absorb the amount
of cash the reserve banks hold.


‘No Alternative’
“There is no alternative to the dollar, so it’s status as
a reserve currency can’t be under threat,” said Adam Boyton, a
senior foreign-exchange strategist at Deutsche Bank AG in New
York.

The dollar’s preeminence will remain intact, as it
continues to be the most widely used currency in business and
finance worldwide, the Federal Reserve Bank of New York said in
a report released Jan. 5. Some $580 billion in banknotes, or 65
percent of all bills in circulation, were held outside the U.S.
as of March 2009, according to Fed data.
The greenback has an 86 percent share of the foreign-
exchange market, more than twice the euro’s 37 percent. Its
share of the international debt market is 39 percent.
“The international role of the dollar remains substantial
a decade after the introduction of the euro, and despite changes
in the value of the dollar and the financial turmoil that began
in 2007,” Linda Goldberg, a vice president at the New York Fed,
wrote in the report.


Relative Deficits
While the Congressional Budget Office expects America’s
debt to reach 65 percent of GDP in 2010, that would still be
below the 77 percent of GDP the European Commission expects for
Germany, the U.K.’s 80 percent and Japan’s 180 percent.

“I would want to stay away from the euro, the euro zone
and some of the emerging European currencies,” Michael Gomez,
the co-head of emerging markets at Pacific Investment Management
Co., said on Feb. 4 at a conference in Moscow. The Newport
Beach, California-based firm manages the world’s biggest bond
fund.

At their meeting this weekend in Iqaluit, Canada, Group of
Seven finance ministers pledged to press ahead with economic
stimulus measures. Canadian Finance Minister Jim Flaherty told
reporters that “we need to continue to deliver the stimulus to
which we are mutually committed and begin looking at exit
strategies to move to a more sustainable fiscal track.”


Yen Gains
Rather than using a weighted average of exchange rates
based on trade data, which is reported on lag and subject to
revision, the Bloomberg Correlation-Weighted Currency Indexes
calculate weights based on variances in exchange rates.
The indexes have a start date of Jan. 2, 1975, and a base
value of 100. The index for the dollar was little changed at
102.69 today and the yen index was at 395.70. The Swiss franc
index was at 271.20 and the euro index was at 107.60, from
271.23 and 107.58 on Feb. 5 respectively. The index for the euro
replicates the German deutsche mark before 1999, when Europe’s
common currency started trading.

The New Zealand dollar index fell 0.2 percent to 50.14
today, the Swedish krona index climbed 0.1 percent to 52.89 and
the Australia dollar index dropped 0.2 percent to 64.07.
Though the dollar is the world’s reserve currency, it
doesn’t affect the movement of foreign-exchange rates as much as
the euro, the indexes show. Since the euro’s creation, its
correlation to other G-10 currencies has steadily risen,
overtaking the dollar in 2004 and all others by December 2008.

Via: Daily Forex

US Dollar Extends its Run but How Long will Risk Aversion Hold?

Fundamental Outlook for US Dollar: Bullish

- Risk appetite takes the lead on the US dollar’s rally
- Non-farm payrolls has a limited impact on volatility, but the fundamentals are still weak
- Will the dollar’s drive straight through next week or are there correction in store?


Considering the extraordinary rally the dollar was able to muster
this past week, and the momentum it has added to the currency’s
impressive bull trend; it may seem inappropriate to start speculating
on when this drive will stall. However, it is vital to always have a
view on the life span of a trend. Otherwise, how would we know when to
take profit or otherwise stick it out for the full breadth of a
developing move?

The primary fundamental drive behind the dollar’s current run is a deep source of momentum. The reversal of risk flows in the financial markets can last for some time and entail substantial
shifts in underlying capital. Throughout 2009, investors were looking
to reinvest their speculative capital that had been idled by the worst
financial crisis in memory. From cash and other ‘risk-free’ assets,
investors were looking to first put their money back to work and second
to avoid excessively risky markets. This meant a large influx of
capital into specific markets. Naturally, a bottleneck of liquidity
would form; and asset prices would rise dramatically in response. And,
though values were undoubtedly depressed when the market’s first
reversed higher in the beginning of the year, they were equally
overinflated by the end of the year. What we are experiencing now is a
move to find an equilibrium that is supported by the potential for
growth and expectations for returns. This brings us to the critical
question: how much excessive premium is there left to work down?

It is a complicated task to determine when the markets are fundamentally
overbought or oversold – especially in the time frame of just the
forthcoming week. There has been a move to deflate risk in the capital
markets for approximately three weeks now; and the progress that some
benchmarks (like the Dow) have made is very modest compared to the
initial buildup. For this reason alone, it is reasonable to assume that
a natural retracement can develop for a considerable time. However, for
the dollar, the currency has already retraced more than 50 percent of
its losses against the euro since its early-December reversal. As long
as the risk aversion trend maintains its momentum, the greenback will
benefit; but the amplitude of the currency’s move can diminish. A
market flow reason for this is that the market may be comfortable in
reinvesting in safe havens other than the US dollar and Treasuries.
Another factor in this move is that carry positions that were funded
using the US dollar (which has the lowest three-month Libor rates among
its major peers) are being unwound and capital is being repatriated to
the US. In near-term, the bearing on sentiment will depend on the
catalysts available and the ease in developing trends. The focus will
remain on big-ticket concerns like sovereign debt risk, efforts to curb
speculation and the focus on potential points of systemic risk. And,
with a relatively light scheduled docket, there may be little standing
of the way of such trends.

The dollar’s broader trend will be defined by the general quality and
direction of risk appetite; but in the end, this will be developed
through the unpredictable nature of group fear and greed rather than
any definable economic indicators. Among the few definable drivers that
can have a meaningful effect on the sense of risk appetite for the
global markets are the first readings of 4Q GDP numbers for the
European region and Fed testimony on systemic risks. Other scheduled
indicators like the advanced retail sales report, University of
Michigan consumer confidence survey and trade balance will likely play
a reduced role with short-term volatility.
- JK

Fundamental Forecast for Euro: Bearish

- Euro hits five-month low on S&P 500 tumbles
- Fear of Greek debt crisis spreads to Spain and Portugal, sends Euro lower
- Forex futures and options forecast for Euro shows many fear further losses


The Euro finished the week substantially lower against the safe
haven US Dollar on sharp declines in the US S&P 500 and broad
deterioration in financial market risk appetite. The ongoing budget
deficit crisis in Euro Zone member Greece grew beyond its borders,
causing a substantial widening in sovereign bond yield spreads for
countries such as Portugal and Spain. Arguably the worst crisis to
threaten the stability of the European Monetary Union to date, market
reactions only exacerbated losses and the Euro was especially weak
against the resurgent US Dollar.


Short-term forecasts subsequently depend on the trajectory of financial market risk
sentiment, how it relates to European asset classes and the continued
viability of the EMU. Though the 16-member Euro zone is no stranger to
turmoil, sustained budget crises threaten to shake the foundations of
the union and present real danger to the euro. Markets are subsequently
likely to ignore anything but the biggest surprises in upcoming
economic event risk and instead pay very close attention to ongoing
activity in sovereign deficit troubles. The key question rolling
forward is whether or not Greece can contain its growing budget deficit
and whether any problems in one country can cause contagion across the
broader Euro Zone. Similar budget issues in Portugal and Spain have
come to the spotlight despite their comparatively manageable fiscal
shortfalls and underline risks that fiscal troubles may spread to other
EMU members.

Greece is in special danger not only due to the sheer size of the
fiscal deficit as a percentage of GDP, but any political efforts to
institute cuts in spending and rein in the deficit have been met with
fierce popular opposition. The political deadlock is especially
troubling given that the Greek government will need significant funding
in the months ahead as the deficit grows and interest rate payments
skyrocket. If markets are unwilling to purchase Greek debt, then it
seems likely that the strongest EMU countries may need to bail-out the
debt-ridden country. Hawkish rhetoric from European officials suggests
that few can stomach any such action, and it will be critical to see
any and all developments in what remains a volatile situation across
the common currency zone.

Fundamental data in the week ahead will likely take a backseat to
broader financial market activity, but it may be important to watch any
surprises in upcoming Q4, 2009 Gross Domestic Product reports from
individual countries and the broader Euro zone economy. Consensus
forecasts call for the second consecutive quarter of Euro zone economic
growth at a 0.3 percent QoQ change. Any especially sizeable surprises
could have pronounced effects on domestic financial markets and—by
extension—on the highly risks-sensitive Euro currency. Long-term
correlations between the Euro/US Dollar exchange rate and the US
S&P 500 remain near record-highs and emphasize the pair’s
sensitivity to risk appetite. Suffice it to say, any strongly negative
GDP data releases or continued EMU deficit struggles could have
similarly dire effects on the Euro.
– DR

Via Calyon A.K.A. CIB

http://forum.thelordoftrading.com/the-research-crypt-f8/ca-cib-the-day-ahead-re-branding-and-re-invention-t525.htm#1229

Japanese Yen to Decline if Risk Recovery Lifts Carry Trades

Fundamental Forecast for Japanese Yen: Neutral

- US Dollar Selling Intensifies Against Japanese Yen
- Speculative Sentiment Points to Continued Yen Gains
- Yen Futures Positioning Reverses From Bearish Extreme


The Japanese Yen may temporarily decline after five consecutive weeks
of gains as an upward correction in risky assets boosts carry trades at
the expense of the stand-by funding currency.

The MSCI World Stock Index, a gauge tracking global equities’ performance,
has capped a fourth consecutive week of losses – the first such losing
streak since July 2009. While this would suggest that risk aversion is
still in play, a sudden reversal on US exchanges late into Friday’s
session suggests an upward correction may be ahead. Indeed, the last
two hours of trading saw the S&P 500 recovery from a 1.8% selloff
and narrowly finish the day in positive territory.

Rumors that the European Union will announce a bail-out of
debt-stricken Greece and Spain this weekend was cited as the reason for
the sudden about-face in US trading. This seems plausible: from its
inception, the European Union was always an arrangement of geopolitical
expediency rather than sound economics. In fact, a plethora of
economists have produced evidence over the years to show that even the
original six western European nations that formed the common market did
not have economies that were convergent enough to be unified into a
single unit, which surely means the much shakier southern European ones
were not even close.

This means that, tough talk about fiscal discipline notwithstanding,
the European Union does not see it as politically acceptable to allow an economic failure that would
compromise the structural integrity of the regional bloc. On balance,
this means a bail-out is probable at some point. The short-term
implications of such a rescue would likely give a short boost to
investor confidence, allowing for an upward correction in risky assets.


Carry trades - a good bit of which are funded with capital borrowed
cheaply in Yen - followed the spectrum of risky assets lower over
recent weeks. Indeed, a Deutsche Bank index tracking G10 FX carry trade
returns has had a near-term correlation reading of well over 0.90 with
the MSCI World Stock Index. As traders moved capital out of carry
trades along with bets on other risky assets, they bought back Yen to
repay the borrowed capital used to establish the positions, sending the
Japanese unit broadly higher. This dynamic may be thrown into reverse
if risk appetite is to correct higher on an EU bailout, sending the Yen
lower in the near-term.
Read

The British Pound retraced the overnight advance and slipped back
below the 1.5700 level as the Bank of England lowered its outlook for
growth and inflation, and the exchange rate may maintain the downward
trending channel from the November high (1.6879) as the central bank
expects price growth to fall back below the 2% target.


Talking Points
• Japanese Yen: Slightly Higher Against Higher-Yielding Counterparts
• Pound: BoE Holds Dovish Outlook, Maintains Option for Further Easing
• Euro: Germany Considers Bailout Options for Greece
• US Dollar: Trade Balance on Tap

British Pound Tumbles Lower on BoE Comments, Euro Maintains Channel Formation

The British Pound retraced the overnight advance and slipped back below
the 1.5700 level as the Bank of England lowered its outlook for growth
and inflation, and the exchange rate may maintain the downward trending
channel from the November high (1.6879) as the central bank expects
price growth to fall back below the 2% target. The BoE said the
recovery was “somewhat weaker” than previous expects and sees the
ongoing slack in the private sector to weigh on price pressures over
the medium-term, and forecasts GDP to expand approximately 3.2% in the
second-quarter of 2011 as the expansion in monetary and fiscal policy
continues to feed through the real economy.

At the same time, the central bank expects to see a moderate recovery
this year and saw the downside risks for growth and inflation
diminishing, but anticipates inflation to undershoot the target as
price growth is likely to average 1.2% over the next two-years. The BoE
sees the CPI topping out around 3.3% in the first-quarter, which will
certainly lead Governor Mervyn King to write a letter to Chancellor of
the Exchequer Alistair Darling, and reiterated that it is “far too soon
to conclude” its asset purchase program. In addition, Governor King
expects the U.K. to maintain its AAA credit rating and said that the
BoE is prepared to shift gears as the central bank aims to balance the
risks for growth and inflation. Meanwhile, the economic docket
reinforced an improved outlook for the region as industrial outputs
increased 0.5% in December to top forecasts for a 0.2% rise, while
manufacturing advanced 0.9% during the same period after rising a
revised 0.2% in the previous month.

The Euro weakened against the greenback and slipped to a low of 1.3733
during the overnight trade, and we may see the exchange rate maintain
the downward trending channel from the January high (1.4581) as the
U.S. dollar loses its appeal as a funding currency. Nevertheless, an
unnamed official told reporters leaders of the European Union will
discuss a possible bailout for Greece tomorrow as the group looks to
conclude its summit, while Germany Finance Minister Wolfgang Schaeuble
told policy makers that the country may go beyond loan guarantees in
order to support the euro-region as a whole. At the same time, European
Central Bank board member Yves Mersch held a dovish outlook for
inflation and said that the deterioration in the labor market continues
to weigh on price growth, but said that the central bank should be
mindful and “not underestimate the risks of prolonged excess liquidity”
as the economy recovers from the worst recession since the post-war
period.

U.S. dollar price action was mixed overnight, with the USD/JPY pulling
back from the high (90.02) to remain relatively flat on the day, and
the greenback certainly appears to be losing its appeal as a funding
currency as market participants speculate the Federal Reserve to
normalize policy this year. Nevertheless, the budget deficit for the
world’s largest economy is expected to narrow in December, with the
balance forecasted to increase to -$35.8B from -36.4B in the previous
month, and the data is likely to encourage an improved outlook for
future growth as the nation emerges from the recession. Meanwhile, Fed
Chairman Ben Bernanke and Treasury Secretary Timothy Geithner were
scheduled to testify in front of the House Financial Services Committee
later today, but the hearing has been postponed due to the heavy
snowfall in the North Eastern states.

The yen has seen its support wane as the prospect of a
bailout for Greece has calmed fears. The EUR/JPY has started to
consolidate following a test of trendline support. Scalpers may want
to steer clear of dollar crosses today as markets decipher Fed Chairman
Ben Bernanke’s outline for pulling stimulus. Additionally, failure by
European officials to produce a solution for Greece’s debt troubles
could spark another bout of risk aversion and yen strength.


The 61.8% Fibo extension of the 112.22-139.29 advance lies just
below and could limit downside risks. The pair broke below the level on
Greece induced panic which discounts the significance of the move,
maintaining the level’s credibility. Rising trendline support on a
short-term basis is also converging which could fortify the level.
Therefore, with yen strength favored at this time the brief bout of
consolidation makes the pair an ideal scalping target.



Quantitative Metrics

A wide Bollinger band width of 1287 pips for the EUR/JPY is a product
of the current bearish trend and a red flag for scalpers. Adding to the
concerns over the pair as a target is the ascending ATR at 185 pips
which is the second highest of the most traded pairs. An elevated one
week implied volatility reading of 15.11 is a sign that volatility will
return and limit’s the pair’s time frame for generating profits.

Despite the rally in the U.S. dollar, the Japanese Yen has certainly
benefitted from the rise in risk aversion and is the best performing
currency amongst the major currencies on Wednesday, while the New
Zealand dollar pared the previous day’s advance after failing to cross
back above the 10-Day SMA at 0.6977.



Despite the rally in the U.S. dollar, the Japanese Yen has certainly
benefitted from the rise in risk aversion and is the best performing
currency amongst the major currencies on Wednesday. The USD/JPY pared
the overnight decline and is 20pips higher on the day after moving 77%
of its daily ATR, and we may see the exchange rate cross back above the
10-Day SMA at 89.93 going into the Asian trade as the greenback
continues to rally across the board. However, the lack of momentum to
cross back above the 100-Day SMA at 90.12, with the 30-minute RSI
approaching overbought territory, we may see price action hold between
89.50-70 as the 120 and 240 SMA continue to converge.







The New Zealand dollar pared the previous day’s advance after
failing to cross back above the 10-Day SMA at 0.6977, and the
high-yielding currency may continue to maintain the downward trending
channel from the January high (0.7444) as investors scale back their
appetite for risk. The NZD/USD remains nearly 60pips lower on the day
after moving 67% of its average true range, and we may see the pair
continue to retrace the sharp advance from Tuesday as the greenback
appears to be losing its popularity as a funding currency. Prepared
statements from Fed Chairman Bernanke release earlier today showed that
the central bank is certainly aiming to normalize policy this year, and
seems as though raising the discount rate will be its first step as the
world’s largest economy emerges from the recession. As a result,
interest rate expectations are likely to drive price action going
forward, and economic developments could play a bigger role in driving
price action for the major currencies. Nevertheless, as the economic
docket is expected to reinforce an improved outlook for the New Zealand
economy, a rise in retail sales paired with an increase in home sales
could push the exchange rate higher as the RBNZ Governor Alan Bollard
looks to tighten policy towards the middle of the year.

Via DailyFX:

US Dollar Outlook Depends on Federal Reserve – What Can We Expect?

Fundamental Outlook for US Dollar: Bullish

- US Dollar gives up ground as Euro Zone plans Greece bailout, markets rally
- Disappointingly vague plan nonetheless sparks S&P pullback, Greenback rally
- US Dollar risks pullback in the context of a broader reversal on futures positioning

The US Dollar finished the week almost exactly where it began,
confounding traders with volatile short-term moves yet remaining nearly
unchanged. Similarly choppy price action in the S&P 500 underlined
financial markets’ indecision and gave few clues on future short-term
direction. It seems that financial markets have reached somewhat of an
impasse. On the one hand, months and months of stock market advances
leave more medium-term momentum to the topside. On the other, the
S&P 500 and other major indices remain in a clear bear market and
risk further losses following a fairly long period of appreciation.
Determining which scenario is most likely is critical to establishing a
clear trading bias for the US Dollar. As one of the lowest-yielding
major world currencies, the Greenback often falls victim to speculative
selling as traders buy higher-yielding currencies. Yet strong bouts of
financial market risk aversion most often force substantive US Dollar
rallies, and it remains critical to watch risk trends through
short-term trading.

Options markets short-term volatility expectations on the US Dollar have pulled
back in recent trade, but speculators should watch for any surprises in
US economic event risk through the days ahead. Top events will start
with Wednesday’s Minutes from the most recent Federal Open Market
Committee rate decision to be followed by the following days’ Producer
and Consumer Price Index reports. All three events threaten to force
substantive shifts in market interest rate expectations and, by
extension, the US Dollar.

FX traders will watch whether the FOMC gives further hints on when it
may begin raising interest rates in 2010, while any especially large
surprises in PPI and CPI could likewise offer clues on the trajectory
of central bank rates. Fed Chairman Ben Bernanke recently outlined the
steps the central bank could take to begin withdrawing massive monetary
policy stimulus in an address to the US legislature. How soon those
plans can be put into action wholly depends on the pace of economic
recovery and trends in national prices. Recent disappointments in US
Nonfarm Payrolls data would imply that the FOMC is in no hurry to
tighten monetary conditions. Yet it serves to note that Kansas City Fed
President Thomas Hoenig dissented in a 9-1 vote to keep the Fed Funds
rate near zero for “an extended period”. Whether or not his relatively
hawkish bias will gain broader traction is an important topic and it
will be important to monitor the statements from the FOMC minutes.

If the Fed shows any willingness to tighten rates through the coming
months or we see any substantive surprises in PPI and CPI data, the
fragile US S&P 500 could break considerably lower and send the US
dollar higher. Overnight Index Swaps show zero percent probability that
the Fed will raise interest rates through the coming months. Stock
markets rarely respond positively to higher borrowing costs, and any
signs that rate hikes could come sooner could easily crimp risk
sentiment. Given clear indecision across financial markets,
clarification could spark the trends that most traders crave.

Euro Weighed by Growth, Interest Rate and Financial Stability Doubts

Fundamental Forecast for Euro: Bearish

- The EU agrees fundamentally agrees to a bailout for Greece but leaves the details for a later date
- Just as financial stability concerns subside, weak 4Q GDP readings add another burden to the euro
- Is EURUSD’s steady, descending trend channel promising new lows or ripe for a reversal?


Just six months ago, the euro was prized for its growth outlook,
interest rate forecasts and its status as the primary alternative to
the US dollar (a currency that has fallen from grace since the
financial crisis). Today, we have a very different picture of the same
currency: there is little sign of a rate hike from the ECB on the
horizon; Growth is very uneven across the Euro Zone’s various member
economies; and the very stability of the European Monetary Union has
been thrown into doubt. This is perhaps the most dramatic shift of any
of the major currencies; and yet this dire fundamental backdrop is not
fully appreciated. In the week ahead, the market will keep its focus on
the Greece to see whether EU officials can rescue an economy that is
quickly fading without evoking severe side effects along the way.

Thereare a few approaches the European Union can take to defuse perhaps the
greatest threat to its stability in its relatively short history.
However, there is no scenario that does not come with a significant
potential for failure. The first option (and the most ideal for policy
makers) is to maintain a verbal assurance to Greece’s stability and
depend upon market sentiment to improve on its own. Realistically, the
global economy and financial markets are heading toward recovery; and
while the country may not reach its aggressive deficit cutting goals,
the progress would be tangible and officials would allow for more time.
The trouble with this picture is that risk aversion runs deeper than
the health of this single economy or region; and a short-fall will
simply concentrate fear around the euro. The more likely outcome is
that a single economy or the group could extend a lending facility that
will ensure against default and buy the economy time. Here, there is a
‘moral hazard’ issue. Other member economies will see that they will be
bailed out should they breech the EU’s guidelines. And, there are more
than a few members that could use aid right now and will almost
certainly need it should conditions continue to deteriorate.

The more complicated and ominous scenario would be for Greece or
another member to eventually secede from the Union. This is a more
unlikely scenario; but there are those that believe that this is
ultimately inevitable. The Economic and Monetary Union is little more
than 10 years old and already major problems have developed. Sharing
monetary and fiscal guidelines among many different economies will
naturally develop leaders and laggards. Greece, Portugal, Spain and
others are in their current state partially due to inappropriately low
interest rates through the years preceding the economic crash. Now they
are suffering due to 3 percent limits on debt to GDP ratios. It may
take a while for such a dramatic change to come to the EMU; but will
almost certainly happen eventually.

Regardless of the path officials choose to take with Greece and the
fragility of their Union; there is ultimately little they can do to
guarantee stability. The only definitive stabilizer would be a general
improvement in risk appetite – an unlikely outcome give the abundance
of fundamental cracks in the system and excess premium built into the
capital markets. If the long-term continuity of the euro is cast in
doubt, the currency could suffer a terminal loss of confidence. But,
this would be a development that would take time. In the meantime, we
will simply match the details of the Greek bailout plan with background
risk appetite. And, for short-term volatility, we can look to the
number of notable economic indicators that are scheduled for release.
The top market movers are the ZEW survey figures and the PMI activity
numbers

Japanese Yen: What Happens when the Carry Tides Change?

Fundamental Forecast for Japanese Yen: Bearish

- Yen follows risk appetite trends that follow the progress on a possible Greek bailout
- USDJPY maintains the general bias but lacks the momentum and volatility of other yen crosses


There is a critical difference between a currency that is driven by
its funding status in the carry trade and one that is treated as a safe
haven. On the surface, the two may seem the same since they have
recently produced the same end result. A clear example can be drawn
from the Japanese yen and the US dollar; both of which have established
considerable bull trends over this past month thanks to a strong pace
behind the recent wave of risk aversion that has washed over the
markets. However, it is critical to discern the differences between
these two roles; because the yen’s continued strength is fully
dependent on one and threatened by the other.

Currently, when there is a strong move towards risk appetite or risk aversion; the
cumulative effect on a funding currency and safe haven currency are the
same. Yet, should sentiment begin to flag and stabilize or background
fundamentals begin to shift, the differences between the two will start
to show through. For the Japanese yen, it is safe to label the currency
a primary source of financing for the carry trade. Over the past 15
years, the benchmark yield that has backed the unit has remained near
zero. Naturally, as global yields rise and risk appetite starts gains
momentum, investors will look to take loans or build leverage in yen
and invest elsewhere for a higher rate of return. Throughout the past
year, worldwide interest rates may not have climbed; but speculative
appetite has recovered and encouraged a dramatic build up in carry
outlays. Currently, investors are realizing that growth and expected
returns are developing at a protracted pace; and many have found
themselves stretched in terms of risk. And, considering the sheer
influx of speculative fund over the past year; there is plenty of room
for the yen to continue to appreciate should market participants
continue to unwind their risky positions.

Where will the winds of risk aversion originate? The interesting thing
about a bear market is that any substantial crack can turn into a
canyon. Over the next week, the most threatening dynamic to general
market stability is the European Union’s bailout plan for Greece. The
group has already generally committed to offering aid; but they have
yet to decide exactly what the rescue will entail. Policy makers would
prefer to restore confidence in the country’s own efforts to cut its
deficit and generally recover. However, concern over the broader
stability of the Euro Zone will likely render that option unviable.
Therefore, policy makers will need to develop a plan that is definable,
quantifiable and does not invite moral hazard. This will be a difficult
benchmark to meet. Furthermore, should an answer be made for Greece;
there are any number of potential backups for feeding fear (Portugal,
Spain, China, US and the list goes on).

There is plenty excess premium and a glut of fundamental problems
behind the market to keep the risk aversion current strong. However, at
some point, the carry interest that has been built up through the
Japanese yen will meet a point of equilibrium (a level where the rate
of return on a spread trade is stable enough that the additional risk
is compensated for). When that level is hit, the yen’s advances will
stall. Yet, at the same time, the US dollar could continue to gain.
The reason for the different paths is the latter’s appeal as a safe
haven. While both currencies have pent up short interest from the 2009
build up; the yen doesn’t quite fit the bill. Fundamentally, Japan is
facing an uneven economic recovery, deflation and long-term financial
troubles. It is for this reason, that 12-18 months out, it is not
difficult to imagine Japanese rates still holding at zero. A long-term
carry candidate will respond less to short-term risk aversion as
investors see the potential. For this reason, we will have to watch the
4Q GDP figures due at the beginning of the week. While they may not
offer much initial volatility given the market conditions when they are
released; the implications for interest rate forecasts can generate a
meaningful shift up or down the risk curve.

Fears rise for dollar carry trade future

By Peter Garnham
Published: February 23 2010 19:14 | Last updated: February 23 2010 19:14

AT Thee World Economic Forum in Davos last
month, Zhu Min, deputy governor of the People’s Bank of China, spoke
openly about his biggest fear for global financial markets in 2010.
“To me, the big risk this year is the dollar carry trade,” he
said “It is a massive issue. Estimates are that the dollar carry trade
is $1,500bn – which is much bigger than Japan’s carry trade was.”His
fear was that the carry trade might start to unwind, pushing the dollar
higher and derailing the rally in asset markets that has accompanied
the global economy’s emergence from the financial crisis.

It is a sentiment shared by other investors, particularly now that the dollar
is strengthening after a prolonged period of weakness last year. Just
as the Japanese yen jumped higher following the collapse of Lehman
Brothers in 2008, so the dollar could appreciate sharply in the next
few months, and assets such as commodities, equities and other higher
yielding currencies sell off. The dollar became the funding
currency of choice as global asset markets recovered from their
post-crisis lows from March last year. This was because ultra-low
interest rates in the US encouraged carry trade investors to sell the
dollar to finance the purchase of riskier, higher-yielding assets. The
result was that between March 1 and the start of December, the dollar
fell more than 17 per cent on a trade-weighted basis.

But now as the dollar recovers, there are increasing fears that the carry trade will unwind.
Since December, the US currency has risen more than 8 per cent
on a trade-weighted basis, last week touching an eight-month high
But predicting the end of the dollar as the world’s funding currency of choice may be premature, analysts say.
The first part of the dollar’s recovery seemed to be related to year-end
position adjustment. Then forces emerged at the start of the year that
have extended the dollar’s gains. First, China responded to an
explosion of new bank loans in early January by allowing bill rates to
rise and twice raising bank reserve requirements. This sparked a wave
of profit-taking on commodities and emerging market equities, which in
turn required investors to buy back the financing currency, the dollar.

Second, Greece’s fiscal problems exploded and exposed a fissure
in the foundation of European Monetary Union, causing some to question
the very existence of the euro. This has weighed on the single currency
and helped spur the dollar higher. Now, a surprise move by the
Federal Reserve last week to raise its discount rate, the emergency
rate at which it lends to banks, has raised fears that US interest
rates might rise quicker than expected. In truth, measuring the
carry trade is an inexact science. Even China’s concerns over the size
of the dollar carry trade, and hence its fears over a sharp
appreciation in the dollar, have to be seen in the context of its own
currency policy. Under pressure from its trading partners to de-peg its
currency from the dollar and let the renminbi appreciate, China’s
warning about an unwinding of the carry trade may not be surprising.

Tim Lee at pi Economics, who estimated the yen carry trade rose as large as
$1,000bn between 2004 and 2007, says he finds it hard to get anywhere
near China’s estimate for the dollar carry trade of $1,500bn, saying
that it stood between $500bn and $750bn at the end of the fourth
quarter.Marc Chandler at Brown Brothers Harriman says estimates of the dollar carry
trade need to be taken with a large pinch of salt.He says there are signs that some
investors may be unwinding positions. First, positioning figures from the Chicago Mercantile Exchange,
often used as a proxy for hedge fund activity, have shown speculators have reduced
their bets against the dollar to go long on the currency and now have
record short positions in the euro. Second, emerging market
equity funds have seen their first outflow for three months as fears
over monetary policy tightening in China, Brazil and India have
increased.

However, Mr Chandler says the longer-term market
appears not to have unwound their carry trade positions significantly,
with the dollar’s recent rally more probably attributed to events
outside the US. “While speculators in the futures market are
short euro at record levels and have trimmed short US dollar positions,
we suspect that the medium and longer terms investors are slower to
reverse structural positions,” he says. “The dollar’s recent strength appears to be
more a function of bad news overseas than good news in the US.”Indeed,
analysts say there is little evidence outside the short-term
speculative data that investors have built significant long positions
in the dollar. Furthermore, they say the dollar is unlikely to
lose its status as a funding currency, despite the Federal Reserve’s
decision to raise the discount rate.

The Fed has been at pains to point out that the move does not herald the start of a series of
increases in US interest rates, which, according to the central bank
are likely to be kept “exceptionally low for an extended period”.John
Normand at JPMorgan says concerns about sovereign risk issues in Europe
and the surprise actions of other central banks have boosted the dollar
over the past six weeks.The Reserve Bank of Australia failed to
raise interest rates this month while the Bank of England announ­ced
its willingness to extend quantitative easing. “These policy
shifts have contributed to dollar strength,” he says. “But it would be
a mistake to extrapolate a view that the US will lead a global
tightening cycle which will transform the dollar from a funding to an
investment currency, and therefore deliver a year-long dollar rally.”

Precious metal and U.S. dollar start to trade in tandem, but for how long?

Gold's been quite the rebel lately -- and investors are giving it much more than a passing glance.The precious metal recently broke from its usual inverse relationship with the U.S. dollar to move more in sync with the climb in the greenback, showing off its prowess as a resilient world favorite."Gold moving up with the dollar is a sign of tremendous strength in gold," said Sam Kirtley, chief executive officer of SK Options Trading.Gold futures prices are up nearly 5% from this month's low of $1,050 an ounce in New York. The U.S. dollar index, which measures the U.S. unit against a trade-weighted basket of six major currencies, has also climbed, gaining more than 2% from its low in February."Both gold and the dollar have been trending upward since early this month," said Brien Lundin, editor of Gold Newsletter. "If gold and the dollar can decouple, [that would] hold important implications for the metal going forward."And those implications are likely to be good for gold. A decoupling in the relationship would mean that "investors are not only buying gold as a U.S. dollar hedge but as a safe-haven asset too, and buying for this reason is so heavy it is outweighing the
selling from U.S. dollar strength," said Kirtley.

But the direction of the precious metal and dollar are destined to diverge again -- and when they do, gold may or may not come out a winner.The global markets are currently focusing on Europe's troubles, feeding a rally in the dollar, yet gold is still trading at around $1,100, said Kirtley. "So if gold can make gains, or even just tread water whilst the U.S. dollar rallies, it will soar if the greenback was to begin to drop."On the other hand, "even though gold prices have been moving up with gold over the last month, if the U.S. dollar continues rallying, this will eventually flow through to have a negative impact on gold," he said. "In that case, "the biggest possible risk for gold at present is a strong, sustained rally in the U.S. dollar."Eyes on the MetalFor now, however, the gold market's apparently changing relationship with the dollar deserves a closer look because it can offer hints for gold's next direction.After all, "we are so used to looking at gold rising when the dollar falls that the concept of gold rising when the dollar rises seems to break the rules," Julian Phillips and Peter
Spina, editors at GoldForecaster.com, said in a weekly newsletter sent Tuesday.

In most eyes, it has.Most daily commentaries blame the inverse relationship between the gold and the dollar as the
main reason for gold's moves, said Phillips and Spina. And that "normal linkage" has been decoupled because of "worries over fiat currencies," leading traders to establish gold positions as protection against an unraveling of fiat currencies, said Charles Nedoss, a metals analyst at Olympus Futures. "This can be referred to as the 'fear trade'."What's happening now is truly putting gold's durability on display."Gold's ability to rise in most major currencies is suggesting people are choosing it as an alternative to paper currencies," said Peter Grandich, a metals writer at Agoracom.com. And people are choosing the
precious metal "because of the huge amount of debt the western world has piled up and the belief the only way out from under it is to reflate."Consider, as well, that around the world, central banks have recently become net buyers of gold. That's likely just the "first inning" of these purchases, said Patrick Kerr, a managing director at Amerifutures Commodities & Options.

The central banks can buy gold now at these price levels or they can do it "later at higher prices, perhaps much higher prices," he said. The "smart" countries looking to buy gold are taking immediate action since "each day that goes by without as much gold as they can get reduces their national wealth as the fiat currencies are devalued."There are "definitely changes brewing worldwide" and "gold is in transition right now," said Kerr."In a world where governments are openly devaluing their fiat currencies in an attempt to ease increasing stimulus debts and increase exports, central banks are figuring out the best way to preserve their wealth: the U.S. dollar and gold. Look for them to trade up together," he said. However, gold may have an advantage.Gijsbert Groenewegen, a managing partner at Silver Arrow Capital Management, points out that the dollar, which he said is likely to go higher purely for technical reasons covering the carry trade, "will not transform from a funding currency to an investment currency."Carry trades involve borrowing funds in lower-yielding currencies, such as the dollar, and investing them in assets denominated in higher-yielding
currencies.

Carry trades are less attractive to investors as their appetite for risk wanes, and they liquidate their positions to avoid losses.When investors unwinding those dollar-carry trades and are left holding the greenback, they will question why they're holding the currency when the U.S. economy is "in shambles," he said. "At that stage, investors will massively buy gold and silver."Currency FixFor now, investors are still interested in the dollar."Capital is fleeing from troubled currencies," said Phillips and Spina. "They turn to the dollar because it is the world's prime currency and one, at the moment, less in danger because of this role."However, the fundamentals for the greenback are pointing to "trouble," Phillips and Spina warned. "When the crises really hit the dollar, all currencies ... of the monetary system [except China's yuan] will become volatile," he said.As shown by the weakness in the euro, there are "structural dangers facing the paper currency system itself," they said. "The attempt by the eurozone to integrate so many of these politically, economically, culturally separate sovereign states was bound to suffer structural damage when a rough storm hit.

"Now that the structural problems of the eurozone are exposed, "it is clear that both [the euro and dollar] face problems that should cause the gold price to rise," Phillips said in emailed comments.Given that, "it is now in most nations' national interests to hold the gold they have in the face of the worst storm the currency system will ever see," Phillips and Spina said. "As a matter of prudence, gold is being acquired quietly, but in volume."Warning SignsStill, some may even argue that the dollar and gold haven't really decoupled at all."I don't think gold is moving up with the dollar, though there are individual days when this does occur," said Mark Leibovit, chief market strategist for VRTrader.com.

Right now, he thinks gold is following a "cyclical pattern for weakness into possibly mid-March." Afterwards, he expects prices to stage a strong rally that may take gold to new highs this summer.Ned Schmidt, editor of the Value View Gold Report, wasn't quite so optimistic. "In a world where U.S. dollars are becoming relatively rare, little reason exists for the value of the dollar to fall against other currencies," he said, emphasizing that he doesn't see any decoupling between the dollar and gold."No inflation in the U.S. and lack of money supply growth means no inflation will arise," so the dollar will not crash and gold "will have one more rally before hitting lows in the coming summer," he said.Then again, it may be a good idea for investors to buy, if gold hits those lows between now and summer."Lack of money supply growth in the U.S. will force the Federal Reserve to take action by fall," Schmidt said. "That will send gold to new highs."