IB FX View

Bernanke throws dollar a lifeline

Friday October 9, 2009

After reaching a 14-month low point against its major trading partners, the dollar was in recovery mode on Friday morning as the dollar index rebounded following comments from the Fed chairman that interest rates would ultimately have to rise. In a week when the focus shifted to monetary tightening, those nations where monetary policy seems stranded on an island of weak growth and abundant capacity have seen currencies suffer. Mr. Bernanke's comments offered the dollar the promise of a safe passage back to civilization and as he did inadvertently diverted the spotlight to the stranded British economy where the pound suddenly slipped once again.

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U.S. monetary policy will be addressed when the economy improves. That was the message Mr. Bernanke conveyed just as London's Financial Times showcases the issue of a sliding dollar in its headline, Asia tries to slow decline of dollar.

The rise in Australian interest rates earlier in the week, the first move of any G20 nation, left the dollar frozen in the headlamps this week as investors realized that the rationale for moving up short rates in the U.S. simply isn't there. As Mr. Bernanke pointed out the low rate of inflation and the abundance of spare capacity in the U.S. economy will allow for an extended period of low rates. Add in the fact that the New York Times weighed in earlier with an unsourced comment from sources on Capitol Hill raising stringent opposition to the removal of fiscal and monetary stimulus and the boost to the dollar might provide nothing but a temporary reprieve.

However, the dollar has indeed rallied to $1.4750 to the euro and ¥89.44 to the yen for the strongest advance for the greenback in two weeks. We can't simply ignore his comments because the market impact has also been felt elsewhere.

The 10-year treasury note future has fallen about 20/32 today raising the yield to 3.32% from 3.20% earlier this week. The spread between the two-year and 10-year yields has widened notably by seven pips to 233 basis points. Short-dated Eurodollar futures have also reacted negatively and at the December 2010 contract have shed one-eighth of a percentage point to predict a fed funds rate of 1.75% within 14 months. The one-year calendar spread reflecting the gradient of the curve between the end of this year and next shot up from 1.19 basis points yesterday to 1.35 points today.

This seismic shift in expectations is for real and one that is helping the bid to the dollar today as real money moves from a focus of Fed inaction to one of possible action. We recall that just two weeks ago Fed governor Kevin Warsh noted that any rate hikes might have to be more significant than in the past, which may possibly argue for a steeper yield curve.

The British pound felt the full backlash of the dollar's gain and slipped to as low as $1.5020 Friday morning. Earlier producer prices data, which precedes the key consumer price data by a week, showed a larger than anticipated rise in prices at the factory gate. The 0.5% increase was bigger than the 0.1% forecast. Some are sensing that the recent relapse for the economy dogged by a weak financial sector is the more significant current emphasis for the Bank of England where management of inflation is fast becoming its secondary role. The pound also slipped against the euro, which today buys 92.66 pence.

The Canadian dollar proved why its defined as a commodity dollar today after an employment report, which predicted job gains of 5,000 turned into an employment bonanza of 30,600 jobs bringing the rate of unemployment back to 8.4%. The Canadian dollar surged to 95.66 U.S. cents. The U.S. trade deficit also steadied as the cheaper dollar in August created a surge to a 2009 year-to-date record for the value of exports. This again proves the strength of the Canadian economy as it sucks in cheaper American goods.

The dollar's rally against the Japanese yen came against the backdrop of a weaker machinery tools report from Tokyo. Data for September was due to show a 2.1% increase in tool orders but provided a 0.5% result. This perhaps suggests a lengthening recovery time for the domestic economy, which probably undermines arguments for a stronger yen predicated on domestic expansion.

Andrew Wilkinson