Dollar Takes its Guidance from the Euro Rather than Risk as Correlations Flex
Posted by aangsunu on 16 July 2010
source : dailyfx
Three months ago, the fundamental structure of the markets was relatively easy to interpret. A rise in risk appetite would lead to an obvious and prompt advance for equities, commodities and high-yield currencies. Should sentiment deteriorate, these same securities would retreat and safe havens like the US dollar and Treasuries would in turn climb. Today, it seems that the underlying concept remains; but there are more and more instances were a currency or asset class deviates from its predefined position. This is to be expected though as the economic, financial and yield potential for countries develop at different rates and as speculative interests themselves waver. Today’s we were met with both a corrective move in risk trends and a remarkable divergence from the US dollar. Looking for an accurate gauge of investor optimism, we can still find a reasonable reading from equities. Through the Asian and European sessions (and through much of the active US trading day), selling pressures were consistent. This negative view was facilitated in part by the disappointing US sales data and the downgrade in the FOMC’s growth projections yesterday; but the real catalyst for the move was the release of China’s second quarter GDP report along with a range of important monthly data. The growth report was top event risk for the entire day; and the outcome was discouraging. The 10.3 percent rate of annual expansion may seem a strong reading given the US is running a 2.7 percent clip; but it is important to compare apples to apples. Through the first quarter, the world’s third largest economy was running at an 11.9 percent rate; and the consensus forecast by economists was for a 10.5 percent reading. Not only did this round of data disappoint; but this particular economy is considered the symbolic leader of the global recovery, it reflects a clear reaction to the withdrawal of stimulus (an effort being made worldwide), and it further sets a bearish precedence when the G7 nation’s release their own growth readings (the UK is scheduled to report on the 23rd and the US on the 30th).
With the reversal in risk appetite (leading to the first decline in seven days for many benchmark US and European equity indexes), we would naturally expect the US dollar to recovery lost ground as it climbed back into its role as a safe haven. Instead, the single currency would put in for an aggressive drop through Thursday’s session that would seem to reflect a positive correlation to risk trends. Instead, the sharpest decline in two weeks on a trade-weighted basis was partly encouraged by the recent deterioration to the dollar’s own fundamental backdrop (the growth outlook has cooled and interest rate expectations have fully receded). More influential though was the positive influence of the euro. In its role as a safe haven currency, the greenback based the majority of its progress on the euro’s weakness – a relationship that is made clear with the EURUSD’s steady six-month decline from the beginning of December. This makes sense given the liquidity of the exchange rate and the sheer size of the two economies as alternatives to one another. And, after such a consistent and aggressive decline, the euro has significant room to further retrace. This natural buoyancy met a catalyst in the news that the Spanish government’s debt auction met more than two-and-a-half times what was offered despite signs that the banking system has grown increasingly dependent on ECB loans and in the face of downgrade speculation. Putting this into context, we have seen a number of successful debt sales amid downgrades and deterioration in finances. Nonetheless, this crisis seems to be put on hold. When it comes back to life, or China takes its place, the greenback will step back in.
In the meantime, we turn to the US economic docket for guidance on short-term volatility. Today’s data held relatively little sway. Far more interesting tomorrow, the June CPI data will fill in dour rate speculation and the U of M survey will give a very early projections of future growth.