Forex: Dollar Posts Uneven Gains as Equities Collapse

Talking Points:

• Dollar Posts Uneven Gains as Equities Collapse
• Yen Crosses Suffer Universal Decline, Risk Aversion is Spreading
• Australian Dollar Surges after RBA Holds Rates Steady

Dollar Posts Uneven Gains as Equities Collapse

Equities, high yield bonds and FX-based carry trade all collapsed to open the week. The market’s foundation for risk appetite is crumbling; and yet, the dollar’s performance Monday was decidedly uneven. The Dow Jones FXCM Dollar Index (ticker = USDollar) was virtually unchanged through the day. On an individual basis, the greenback seemed to be at a standstill, with the more active British pound and Japanese yen strong arming the biggest moves on the majors’ behalf. This disconnect is remarkable considering the S&P 500 posted its biggest single-day drop in over six months (2.3 percent) and the VIX Volatility Index closed at a 13-month high. All things considered, these benchmarks of investor sentiment are flashing disturbing warning signs to the markets, and yet the dollar is not capitalizing on its safe haven status.

Looking for the fundamental disconnect, the USDollar’s medium-term correlation to the S&P 500 (as a measure of risk trend sensitivity) has notably diminished, but it is still positive at 0.19 – unbecoming of a safe haven currency. As for the currency market’s volatility index (FX VIX), the relationship to the dollar is just as tepid at 0.08. The dollar is slow to pick the safe haven mantle back up in part due to the focus on the Fed’s significant monetary policy change from boundless stimulus to a tangible Taper and given the frequent starts and stops of unfulfilled sentiment shifts. We have seen many sharp corrections in the past that turned out to be the terminus of short-lived corrections in a very persistent bull trend. When skepticism over risk trends is dropped, appetite for liquidity will send capital more forcefully into the dollar’s embrace.

As for scheduled event risk, the ISM’s January manufacturing activity report released this past session touted more than its fair share of influence over capital markets. The 51.3 survey reading was notably above the growth-contraction line (50.0), but it was also the biggest miss relative to expectations for the data series. Meanwhile, the employment component dropped and the new orders measure posted the largest drop in over three decades. This data weighs both risk trends and the dollar as it can undermine investor appetite while simultaneously putting the Fed’s Taper commitment in jeopardy. Ahead, we have Fed officials speaking; but it will likely be risk trends that dominate.

Yen Crosses Suffer Universal Decline, Risk Aversion is Spreading

There is a difference between the concept of a safe haven and that of a funding currency. During periods of instability in the global financial markets, the need for stability and value retention trumps all other concerns – especially finding a competitive yield. That asset or currency that draws capital during that period is a safe haven. Japan, as the third largest economy with the third most frequently used currency fits the traditional ‘safe haven’ bill, but its present fundamental appeal is far more immediate and volatile. Before we reach an extreme of all consuming demand for liquidity in the risk appetite scale, there is a need to first unwind risky exposure. As it happens, the yen crosses are traditional carry trade pairs that appreciated between 30 and 45 percent during their BoJ QE build up peak, and that was done on the back of historically low yields. The recent bouts of selling pressure for the yen crosses is what we would expect to see if sentiment trends were rolling over. And, Monday’s drop – ranging between 0.4 percent for CHFJPY and 1.9 percent for GBPJPY – is convincing of momentum.

Australian Dollar Surges after RBA Holds Rates Steady

The Reserve Bank of Australia (RBA) announced Tuesday morning that they were holding the benchmark lending rate unchanged at 2.50 percent and no hikes were on the immediate horizon. Yet, this outcome was less dovish than what traders had come to expect from the central bank – leading the Aussie dollar to a sharp rally that seems to defy the seeming neutrality of the outcome. The AUD rallied between 0.9 and 1.6 percent against its counterparts through the early hours of the new trading day. Of particular interest from the event, there was a notable softening of rhetoric towards the possibility of future rate cuts as well as the regular suggestions that the currency was overbought.

British Pound Collapses after Modest Manufacturing Activity Miss

Similar to the dollar’s reaction to its own data, the British pound suffered a tangible bearish shock after the release of the UK manufacturing activity report for January. Yet, where the US data offered record-breaking disappointments, the UK version was a modest 0.6 point miss (56.7). The difference is that the dollar holds a safe haven status while the pound is trying to sustain near-term BoE rate hike hopes.

Euro: Is the Troika Making a Third Greek Rescue Package?

The euro was just as mixed on the open of the week as the dollar was. From economic event risk, the update of January factory activity numbers doesn’t carry the growth speculation influence that the advanced / first measures do. Meanwhile, the news headlines are offering new concerns. While liquidity pressures in EONIA rates are easing, there are unconfirmed reports of Troika officials discussing a third Greece rescue package.

New Zealand Dollar Shows Greater Sensitivity to Negative Data, Jobs Figures Ahead

After the RBNZ’s last monetary policy meeting, the market moved to fully price in a 25 bp rate hike from the central bank at its next meeting. Were this a development for any of the other major central banks, it would be cause for rally. Yet, the market has long priced in a hawkish bias and eventual hikes for New Zealand. Expectations have outpaced action, and now the market is sensitivity to anything that undermines it.

Emerging Markets Topple to Lowest Level in 7 Months

The emerging markets tumbled through Monday. While the official Argentine Peso rate was steady versus the dollar, other currency’s in this grouping (South Korean Won, Chilean Peso, Brazilian Real, South African Rand, etc) plunged. With risk trends growing broader and more intense, this most sensitive selection of global investments will not escape the pain. The MSCI EM ETF is now at a 7-month low.

Gold Rally Does Little to Progress Bullish Drive Despite Risk, Carry Slump

Risk aversion is starting to grow infectious. Emerging markets are still experiencing capital flight. And, now even the US dollar is facing pressure over its favorable Taper pace. These seem like ideal circumstances for gold to revive its safe haven status as well as its alternative-store-of-wealth role. And yet, the metal was only able to manage a modest 1.1 percent rally that moves us little closer to $1,300.

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--- Written by: John Kicklighter, Chief Strategist for DailyFX.com

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