Tuesday, July 15, 2008

07/15/2008 08:43 AM

Can Bernanke Talk up the Dollar?

Retail sales increased by a weaker than expected 0.1% in June, after a downward revision in the May figure to 0.8% from 1.0%. Sales ex autos rose 0.8% ex autos versus an expected 1.0% increase following downward revisions. The wearing out effect of the stimulus checks is emerging a faster than expected as the slump wasn’t only limited to autos.

Fed Empire State rose to -4.92 in July from -8.68 June, with an improvement in the new orders index (8.27 from -5.48) but deterioration in the employment index (-6.32 from 1.16). The Prices paid index surged to fresh record highs at 77.89, while the 6-month outlook index plummeted to 15.55, its lowest level since Sept. 2001.

PPI rose 1.8% versus expectations of 1.3%, core PPI rose 0.2% versus 0.3%.

Is the Dollar Too Big to Fail?

A new wave of selling sends the dollar to fresh all time lows against the euro at $1.6038, 3-month lows vs. the British pound at $2.0146, and 4 week lows against the yen and the Canadian dollar at 104.88 and 0.9945. Gold surges to 4-month highs at $983.40 per ounce, while oil nears a new high at $146 per barrel. The principal culprit is markets’ increasing realization of the policy dilemma dogging U.S. policy makers. Talking up the dollar by the Fed and Treasury failed to work as market players were too aware of the policy contrasts between the U.S. and the rest of the world. As the long as the Fed is unable to follow up words with actions with a rate hike, any managing of inflation expectations by means of tough inflation talk is futile, especially when the European Central Bank and Bank of England are facing record inflation levels.

In a year characterized by rescues of ailing mortgage lenders, investment banks, Government Sponsored Enterprises and even the U.S. consumer and home owners, the question becomes: will the U.S. dollar be next? The importance lies in stabilizing the U.S. dollar for the aim of capping energy prices and relieving the supply shocks emerging from excessive strengthening in non-USD currencies. But the deteriorating market and economic conditions in the U.S. continue to be the chief causes of the broad decline in the U.S. currency. As long as these continue, the dollar will deteriorate regardless of any jawboning by policy makers, which would be perceived as bluffing rather than communicating real policy intentions.

Fed’s Inflation Focus has Backfired

Recall that when the global market turmoil began a year ago, broad dollar selling was not the only dynamic in the market. The unwinding of yen and Swiss franc carry trades had shifted speculative capital from high to lower yielding currencies, prompting a strengthening in the US currency against the Aussie, Kiwi, loonie and other higher yielding currencies. This year however, the bulk of bad economic and market has been concentrated in U.S. firms (Fedex losses) investment banks (Lehman), quasi government institutions (Fannie and Freddie), rising unemployment rate and falling housing and manufacturing. Besides shaking confidence in U.S. markets, these dynamics have reduced financial market liquidity to the extent of rendering any expectations of higher US interest rates an impossible, if not a dangerous step. And even if the Fed was only jawboning bond yields and the US currency so as to quell inflationary expectations, the approach has backfired severely at a time when eroding liquidity and economic activity.

This explains our long held forecasts for at least one more interest rate cut before year-end. The majority of market forecasters had bought into the Fed funds futures pricing of as much as 60% chance of a Q3 rate hike. But things are now changing. While we expect two 25-bp rate cuts in the fed funds before year-end, there is an increasing possibility of an inter-meeting 50-bp rate cut in the discount rate.

At 10 am Fed Chairman Bernanke to give semi annual monetary policy testimony to Congress. Bernanke will be pressured to come up with dollar-supporting remarks given the June 3rd speech where took the unusual step from a Fed official to aggressively talk up the currency. But priorities are increasingly seen elsewhere as market and economic confidence that even a bail out for Fannie and Freddie is unlikely to stabilize the weakening macroeconomic fabric and reduced liquidity in the interbank market. Talking tough on inflation will be largely negative for US stocks, while any steps to shore up the economy via signaling rate cuts should boost stocks, bonds and even boost the dollar against the yen.

Euro Surges to $1.6037 Despite Slumping Confidence

The focus on the dollar’s woes is highlighted by the markets’ shrugging of marked deterioration in the Eurozone and UK. Germany’s ZEW investor sentiment hit a record low in July as the economic expectations fell to - 63.9 from - 52.4 points, well below the consensus estimate -57.0. The ZEW current conditions index plunged to 17.0 from 37.6, against forecasts of 32.8. The euro’s retreat in early June has made further gains beyond $1.60 viable from a technical perspective. But from a fundamental angle, we remain unconvinced that the euro will knife through as high as $1.62. The gains are more likely to be gradual and slow as Eurozone fundamentals remain overshadowed by negative US conditions. Interim pullbacks are a pre-condition for the upward move. Resistance stands at 1.6070, with support climbing to as high as 1.5970 and 1.5930.

USDJPY Eyes 103.80

Reflecting sharp reduction in risk appetite and escalating dollar woes, USDJPY drops 1.5 yen to 104.60. We mentioned yesterday about the ominous prospects of a failed positive reaction in US stocks to the Fannie and Freddie rescue. With US stocks continuing to decline and the VIX extending its surge towards 29, traders see little choice other than buying JPY versus USD. Our month target stands at 102.50, which we reaffirm. The next main objective stands at 104.35 followed by the 100 day MA of 104. Any recoveries are limited to 105.30 and 105.70.

Sterling Hits Breaks $2.0 as UK Inflation Hits 3.8%

Soaring UK inflation extended GBP advances beyond the weak USD story as June CPI jumped 3.8% y/y from 3.3%, exceeding expectations of a 3.6% rise. The figure is the highest since the series began, but core inflation was only at 1.6% as the main culprit continued to be food and non-alcoholic beverages. A 0.4% decline in June retail sales underlined the duality between weak stalling economic growth surging inflation but traders were fixated on the USD side of the story. But its worth mentioning that GBP is at its session lows against AUD, NZD, JPY and CAD.

GBPUSD knived through the 200-day MA today for the first time since March 18, suggesting the current rally may hold. But we remain unconvinced. Aside from the possibility of any interventionist steps from G8 policymakers, the increased risk of a UK recession makes further GBP buying unsustainable. The key resistance stands at $2.0170, followed by 2.0220. Support surges to 2.0050 and 2.0010.

Analyst Bio

Ashraf Laidi, Chief FX Analyst at CMC Markets, oversees the analysis and forecasting functions of key currency pairs as well as decisions and trends of the major global central banks. Mr. Laidi is also responsible for education and informing clients on the essential dynamics underpinning FX markets.

Prior to joining CMC, Mr. Laidi has worked for such varied organizations as the United Nations, the World Bank, and Reuters. Mr. Laidi regularly provides expert opinion to various electronic, print and the broadcast media outlets.

Mr. Laidi has appeared regularly on CNBC-TV, Bloomberg TV, the BBC and PBS’ Nightly Business Report. His insights also appear in the Financial Times, The Wall Street Journal, Barron’s, The New York Times, CBS Marketwatch, TheStreet.com, Futures Magazine and a host of other international publications.