Dollar Closing In on 5% Targets, Where are the Value Points?

The type of moves that we have seen in the currency market during the Asian and European trading sessions are typically what we see in a quarter or a half year. USD/JPY has fallen 5 percent, AUD/USD is down more than 8.5 percent while the NZD/USD is down 7 percent. The sell-off in the Japanese Yen crosses are even more severe with AUD/JPY down 13.5 percent and NZD/JPY down 12 percent. Here is a list of the biggest movers as of 9am ET:

Yesterday, I warned against a premature top in the EUR/USD!

Although it may be very tempting to say that the dollar has hit a top, especially against the Euro, in order for this EUR/USD rally to be real and for investors to be convinced to stop selling higher yielding currencies, we need to see stabilization in the financial markets and a return of confidence.

The mentality in the currency and stock markets is sell now, ask questions later. The low yielding US dollar and Japanese Yen continue to be the biggest beneficiaries of risk aversion. The only thing that investors want right now are safe haven plays. The dollar’s strength will force emerging market countries to rush to prevent a flight of capital out of their currencies – more rate hikes could be likely. With deleveraging being the theme of the day, when confidence is lost, it will be difficult to recover.

Where are the Value Points for the Currency Market?

In the Wed edition of my Daily GFT Report and on CNBC and Bloomberg I talked about how the dollar could rise another 5%. At that time, the EUR/USD was trading at 1.2829 and the GBP/USD at 1.6236. The GBP/USD has already hit my 5 percent target and at one point this morning even became undervalued on a purchasing parity basis. Although the UK GDP report confirms that the country is headed for a recession and validates the weakness, I believe that we have seen a near term low in the currency pair.

The EUR/USD on the other hand has only dropped 2.5 percent. The EUR/USD does not become a value play until 1.15-1.20. As for USD/JPY, it has also reached my target of 95. Although I won’t be a buyer at these levels, I won’t be a seller either. There are no rewards for heros in this type of market.

Will the BoJ Intervene?

If you are wondering about Bank of Japan intervention, don’t expect it to happen. As an export dependent nation, a strong currency is not in Japan’s best interest. However unlike in the past where the BoJ has intervened when USD/JPY fell below 105 and 100, we may not see any action by the Japanese government this time around. Since the problems are inherent in the US and the Eurozone, intervening at this time may be counterproductive for the Japanese. The Japanese government needs to stand aside and allow the US and Eurozone governments to take their measures to spur growth and not strengthen the dollar for their own short term relief.

If intervention was on the table, the Japanese PM would not make the following comment this morning:


Risk of Limit Down Day in US Stocks

With S&P futures already trading at limit down this morning, there is a decent chance that circuit breakers may be hit in the first hour of trading. The moves in the Dow Jones Industrial Average these days is strikingly similar to the move in 1906 and 1907 (Here is a chart from Barclays). In the last phase of the sell off between Q2 of 1907 and Q4 of 1908, the Dow dropped 37% before it bottomed out. From the August 11500 levels in the Dow, a 37% move would take the index down to a new 6 year low of 7245.

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Barclays Capital

Barclays Capital

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Finally Stabilization for the Financial Markets?

In the face of today’s 200 point positive and negative swings in the Dow, it could be argued that the US dollar has been relatively stable if you only look at the daily change of the 3 major currency pairs. The EUR/USD rallied 100 pips, the GBP/USD was unchanged while USD/JPY fell 75 pips. This compares to multi hundred pip moves for all 3 currency pairs on Wednesday.

Even the largest market movers had a far milder move today than yesterday. On a percentage basis, the largest market mover was AUD/JPY which dropped 1.09% while it was CAD/JPY yesterday which dropped five times that amount. These moves however masks the volatility that we are still seeing on an intraday basis; the EUR/USD hit a new 20 month low while the GBP/USD fell to a fresh 5 year low.

Although it may be very tempting to say that the dollar has hit a top, especially against the Euro, in order for this EUR/USD rally to be real and for investors to be convinced to stop selling higher yielding currencies, we need to see stabilization in the financial markets and a return of confidence.

Keep an Eye on Job Losses

Even though the non-farm payrolls report is not due for another 2 weeks, all signs point to serious job losses and for that reason we are still concerned about the outlook for the US economy and by extension we are also wary of today’s rally in US equities. According to the Financial Times, more than 78,000 people could be laid off from Wall Street. For the world outside of finance, massive job cuts have also been announced by companies like Yahoo, Merck and General Motors. Although we will not get to the double digit unemployment rates that we saw during the Great depression, we do expect the current unemployment rate to climb to a new 5 year high. Since consumer spending is the backbone of the US economy, a weak labor market will depress spending, which should in turn lead to softer growth. Therefore even though buyers have returned to the equity markets, there will be plenty of reasons for them to bail once again.

Emerging Markets to Welcome any Dollar Correction
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Lehman CDS Auction Prevents Euro and Pound from Rallying

With the lack of any major US economic data on the calendar this week, the big event risk for the stock market and the US dollar is the Lehman Brothers’ Credit Default Swap settlement on October 21. The fear that European banks may be forced to pay out on the default protection has prevented the Euro and British pound from rallying despite the recovery in US stocks. The estimated payout on the CDS could be as high as $365 billion, more than half of the US government’s $700B bailout plan. The settlement should be most if not all in US dollars, which is why there has been a strong demand for dollars against the next 2 most actively traded currencies. If the CDS settlement triggers no bankruptcies, then the stability that we are beginning to see in the financial markets may last.

The sheer relief that there has been no negative news this weekend has helped the stock market and high yielding currencies recover. The liquidity that central banks have pumped into the financial markets are also finally having an effect on the credit markets. As indicated by the table below, everything from 3 month LIBOR spreads to the TED spread and currency volatilities have fallen since Friday and most of these indexes are down sharply from last Monday. This shift indicates that banks and other counterparties are becoming less risk averse and more willing to lend to each other which is helping equities and carry trades rally.

bernanke Is $700B Not Enough?
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Weak Consumer Spending = Negative GDP

Retail sales dropped by the most since August 2005 as consumers cut spending on cars, furniture, electronics, clothing and sporting goods. Americans are even eating out less and only spending on the necessities – health care and gas.

With fears of a deep recession that may feel like the depression driving the dollar and equities lower, the latest consumer spending report suggests that GDP growth in the third quarter may be negative. Retail sales dropped every single month in the third quarter and since consumer spending is such a big component of GDP, we may finally see those recessionary growth numbers. Core producer prices increased but headline prices declined. Headline numbers have become just as important as the core numbers, which means that the data today gives the Federal Reserve an excuse to continue cutting interest rates.

Interest rates at 1 percent before the end of the year is a very real possibility. Given the way the futures markets are trading, there is a decent chance that we will see the Dow test 9000 today. This will weigh on USD/JPY and other carry trades. Over the past few weeks, the equity market has been sell-off positive for the dollar but negative for the Japanese Yen.

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Is Earnings Season Bringing Back Recession Fears?

The feel good factor in the markets was relatively short-lived with the 400 point rally in the Dow this morning turning into a more than 76 point decline by the end of the US trading session. The US dollar weakened against every major currency but the reversal in the Dow has caused the greenback to recover some of those losses. Given that the Dow saw its largest point gain ever on Monday, a correction would be natural. However, in this fickle and unsteady market environment where investors are not sure how hard they should be pushing the buy button, aXny significant correction will leave investors extremely insecure about being long stocks.

The currencies that will be impacted the most are the US dollar and the Japanese Yen because continued weakness in equities has been helping the dollar but hurting the Yen.

What to Expect for Third Quarter Earnings?

With the third quarter earnings season in full swing, the latest correction in the stock market is partially attributed to the fears of a recession. Former US Fed Chairman Paul Volcker said on Tuesday that there is a risk of a considerable recession in the US and Europe. We find the debate of a recession quite interesting because talking about whether a recession is here or not is just a matter of semantics. Everyone from individuals to corporations large and small is already acting like a recession is here. In fact, not many people would argue that the US economy is in the worst shape since the Great Depression. Over the past 50 years, there have been 6 times that the US economy has fallen into a recession and to be compared to the Depression at a time when we have yet to see two consecutive months of negative GDP growth indicates the potential of addition weakness for the US economy. So far, third quarter earnings have been soft, forcing many companies like Pepsi to cut jobs. In the second quarter, many multinational US corporations benefitted from positive currency translations. The dollar’s weakness boosted their overseas earnings helping to contribute to the company’s profitability in the second quarter. However the 15 percent rally in the US dollar over the past 3 months will erase any positive currency contributions, increasing the chances of earnings reports missing expectations. This is part of the reason why rating downgrades by Standard and Poors has hit a 6 year high. Taking a step back, it would be surprising if the credit crisis and the meltdown in stocks did not lead to a major slowdown in the global economy. With retirement accounts falling as much as 40 percent in value over the past month, individual and corporations will become increasingly frugal especially going into this holiday shopping season which could lead to more troubling times for the US economy. Recessions fears are real and will remain for some time.

Details on the US’ Recapitalization Plan
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