Dollar will Stabilize when Yields Stop Falling

Saying the U.S. dollar is falling out of bed would almost be an understatement given the recent price action in the greenback. Over the past three months, the dollar lost more than 10 percent of its value against the euro, Swiss Franc and Australian dollar. Since July, every one of the G10 currencies outperformed the debilitated buck and the latest dollar dump has even driven some currencies to significant highs. The greenback is the one currency that no one wants to own right now but the currencies that are in greatest demand are the Japanese Yen, Swiss Franc, and Australian dollar. The reason why investors are buying the Swissie and Aussie in size is because of their stable economies, healthy economic outlook and correlation with gold prices. The Yen on the other hand is being bought not because their economy is performing better than the U.S., but because investors are seeking safety in low yielding currencies that are not the dollar, the Chinese are buying Japanese bonds, exporters are hedging and carry trades are continuing to unwind their long dollar, short yen positions.

Today’s sell-off in the dollar today pushed the euro above 1.40, the Yen to a fresh 15 year high against the greenback, the Swissie and Aussie to a record high. Although the weakness of the dollar can be attributed to concerns about the U.S. labor market, the primary reason why the dollar came under assault is because U.S. yields continue to fall. Of course these factors are related since weaker economic data raises the chance of the Fed following through with additional asset purchases which are bearish for yields, but what is important is that bond traders have been particularly in tune with the market’s sentiment. Two year Treasury yields fell to a fresh record low of 0.359 percent while ten year yields dropped to the lowest level since January 2009. The dollar will continue to fall as long as U.S. yields continue to decline. If there is any hope for a rebound in the greenback, we would need to see U.S. yields stabilize first. The following chart shows the strong relationship between USD/JPY and U.S. yields. Since the beginning of the year, the correlation between these instruments on a week to week basis has been approximately 90 percent!

Dollar Tanks as Jobless Claims Signal 75bp Rate Cut from Fed

The US dollar is tanking as jobless claims rise by the largest amount since November 1982, 26 years ago. As I have suspected, it is the 1980s all over again.

This confirms that the 533k drop in non-farm payrolls last month will not be the bottom in the labor market. When claims first hit 573k in January of 1982, non-farm payrolls dropped by -327k. It rebounded significantly the next month (-6k), but that was only precursor to another 10 consecutive months of job losses with non-farm payrolls revisiting the -300k levels in July (NFP in July 1982 was -343k). These jobless claims numbers reflect the massive layoffs that we have heard in the past weeks from companies like AT&T, Viacom and Sony. Continuing claims hit 4.429 million, the highest since 1982.

The widening of the trade deficit leads us to believe that GDP will take a big dive in the fourth quarter. The Treasury market is already pricing in the possibility of deflation and depression with yields in zero to negative territory for the first time since the Great Depression and incoming data supports that thesis.

The weekly jobless claims number will add pressure on the Federal Reserve to cut interest rates by 75bp next Tuesday. Fed Fund futures are already pricing in a 100 percent chance of a 75bp rate cut from the Federal Reserve next week. This would take US rates to 0.25%, making the US dollar the lowest yielding currency in the developed world.

If the Fed takes interest rates to zero, we could see USD/JPY fall to 13 years lows and the Euro to return to 1.35.

Even though volatility in the currency market has compressed since October and November, the Federal Reserve’s next interest rate decision is a major event risk because interest rates will be taken to historically low levels. Not only are the Fed expected to take interest rates to the lowest level this generation has ever seen but they have to figure out how to effectively signal their intentions of taking US interest rates to zero without completely spooking the markets. This will be a difficult balance to walk and one that could easily lead to an expansion in volatility in the currency market.
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Dow 10k Could Mean USD/JPY at 100

On Friday, the Dow hitting 10,000 still seemed to be a remote possibility, but today, that is starting to become a reality. We have warned on near daily basis about the danger of carry trades. Although the EUR/USD’s reaction to the systemic risk in the financial markets was not as clear, there was a clearly negative implication for USD/JPY. Not only did we talk about the 70 percent correlation between the S&P 500 and USD/JPY, but there is also a similarly tight correlation between USD/JPY and the VIX index, which measures the volatility of the stock market. This means that the weakness in stocks and the rise in volatility drove USD/JPY below 105. To put today’s move into perspective, the drop in US stocks today was the most since the September 11 attacks in 2001. Unless stability returns to the financial markets, all of the Japanese Yen crosses including USD/JPY will continue to suffer.


Since the beginning of the year, we have lost 3 of the largest investment banks on Wall Street and such unprecedented developments have called for unprecedented actions by US government and Wall Street officials. Since the announcement of Lehman Brothers filing for bankruptcy and Bank of America taking over Merrill Lynch, AIG has been given special permission by US authorities to tap into $20bln of its own capital to prevent a liquidity crisis and credit downgrades. The Federal Reserve is also holding a special meeting to discuss possible remedies to AIG’s problems. The ECB and the Bank of England have pumped more liquidity into the financial system while the Federal Reserve made an unusual intervention to drive Fed funds lower.


Why Did Fed Funds Soar to 6 Percent when Futures are Pricing in a Rate Cut?

Fed fund futures are pricing in an 80 percent chance of a 25bp rate cut tomorrow by the Federal Reserve. This is a big change from last week, when the only thing that the market was thinking about was a rate hike. However despite this sharp shift in expectations, Fed funds surged to a high of 6 percent, 400bp above the Fed’s target rate of 2 percent intraday. This jump in the overnight lending rate between banks indicates that no one wants to take on risk. Trust is a commodity these days as the move in Fed fund futures suggests that no one knows if their counterparty will be here to survive another day. Fund funds gave back all of its gains by the end of the US trading session, but that does not mean that risk appetite has returned – quite the contrary. AIG is in big trouble, Washington Mutual is still on our watch list with their bonds now cut to junk status by Moody’s and the worries now turn to Goldman Sachs and Morgan Stanley who will be releasing earnings this week. Large write downs could drive a nail in the coffin for the US stock market and USD/JPY. Of all the pairs in the currency major, USD/JPY and other carry trades will be hit the worst. Over the past 3 years, there has been a 68 percent correlation between the VIX and USD/JPY, so higher volatility means trouble for the currency pair. Although consolidation in the banking sector was something many people expected, no one thought that the consolidation would occur because of Chapter 11 filings.

Will a Fed Rate Cut be Enough to Shore Up Confidence and Trigger a Reversal in the US Dollar?
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In the Financial Papers: Today’s Top Forex News 07.22.08

kathysmallHere is the “In the Financial Papers Radio Broadcast” (Length: 6:22 minutes). The player should load automatically. Please let me know if you like it. Contact Kathy

Read my Daily report on

In the Financial Papers:


Podcast Covers:
Paulson and Plosser Comments
Fed Appears to Focus on Inflaiton Ahead of Growth
Measures to Avoid the Worst Recession in 30 Years
United Airlines Planned to Cut 7000 Jobs as Fuel Costs Surge, 6000k jobs cuts at Wachovia
Weak Earnings from American Express and Wachovia
Oil Prices: Have they Peaked?
Russians are Coming, Wallets in Hand

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Will the US Dollar Continue to Fall?

Pandemonium has hit the financial markets. The dollar is trading below parity against the Swiss Franc, it has fallen to a new record low against the Euro and to a new 1995 low against the Japanese Yen.

Will the Dollar Continue to Fall?

Yes. The futures curve is currently pricing in a 90 percent chance of a 100bp rate cut and a 6 percent chance of a 10 percent rate cut. By the end of June expect rates to come down to 1.5 percent. This is the minimum that the Federal Reserve must do to stabilize the financial markets.

If they want to put an end to the pain however, they will need to be more creative. The discount rate cut on Sunday is not enough. What is 25bp really going to do for the markets? Banks are in seizure mode and are focused on nothing but minimizing counterpary risk. LIBOR rates are skyrocketing and everyone is holding their breath, waiting for the next shoe to drop. For this reason, the dollar and carry trades will continue to weaken.

Will there be Intervention?

Not anytime soon. The Japanese have expressed concerns about disorderly movements, but since their last intervention in 2004, their top priority has been to convince China to revalue their currency. I doubt that they will be willing to risk the past 4 year’s efforts 3 weeks before the finance minister’s meeting in Washington DC and 4 months before the G7 meeting that they will be hosting.

As for the ECB, they are worried about sharp and excessive moves, but they have their eyes peeled on 1.60. As long as we hold below that price level, I don’t expect any verbal intervention because in 2004, the EUR/USD rallied 13 percent in 2 months before the ECB called the move brutal. If we count 1.59 as the high today, the EUR/USD has only appreciated 10 percent over the last 2 months. The ECB’s top priority is inflation. The strong Euro is cushioning the pain on high commodity prices.

Don’t expect the Fed to come out and buy dollars either. They need a weak currency to draw in foreign investors that may be looking for value and to boost exports.

However this is not to say that there couldn’t be a coordinated liquidity injection or a similar move reflecting solidarity amongst global central bankers.

What about Carry Trades?

With high volatility in the stock market, and 300 point swings in currencies, don’t expect a recovery in carry trades either. If anything, expect further weakness in USD/JPY to drag the other yen crosses lower. The demise of Bear Stearns has made everyone gun shy. I am sure that risk managers across Wall Street banks are on red alert, forcing their traders to minimize risk.

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