Last week as we wrapped up our analysis for the year, we noted that with the euro buying $1.40 at the time, its reversal from $1.4719 signaled a drop to $1.35 for the first week of January. The ensuing slide to as low as $1.3317 ushered in by a New Year dollar buying frenzy proved the point that the fat lady hasn't yet inhaled. Once again there has been a minor revision of the thought process surrounding prospects of the dollar, but suffice it to say that while the healing process has begun, the patient might display further signs of illness first. The dollar rose against the yen, the euro and the Swiss franc to begin the year while longer term currency option plays indicate less bearish prospects for the euro than just a week ago.
One might have argued that the arrival of a stimulus package here in the United States would be dollar negative. After all, that same sentiment initially weighed on the dollar when the FOMC finally arrived at zero percent for the fed funds rate. And with bounding fiscal laxity setting the tone, one might assume that with the medication firmly in place investors can rest assured that the economic future of America and therefore the global economy is on the mend. That would presumably leave investors punishing the explosive debt issuance through a negative outlook on the dollar.
We have made the point before that this is an entirely wrong approach. Currency trading has a strong underlying current of the here and now. Sentiment changes on a dime and it's very difficult to marry a medium to long term picture to intraday gyrations. Standing on the sidelines and commenting on what we observe certainly has its merits.
When soon-to-be President Obama commented on the approximately $750 billion stimulus package, we found his accompanying comments salient when he told reporters that the situation was worsening and that a serious response was required. Many investors misplace price discovery with economic misfortune. In other words they believe that the low point of the equity markets in late November probably marked the low-point of the recession. As we have warned before, this isn't like any other recession before. The low point so far for stocks may indeed be tested before the end of the first quarter, driven by weakness in sales and employment. Try finding anyone who will tell you today that unemployment will be lower by the middle of 2009 than it is today this week we are likely to see a 7%-plus handle in Friday's employment report for the final month of 2008.
So with worse to come, we still would argue that not only have other economies got worse to come too but that the dollar's role as a safe haven or as a preferred liquidity tool will remain a feature throughout the first half of 2009. That very likely means a fresh low for the euro under $1.2317.
There was also a sharp reversal of the thought process in what the ECB might do. For those of you with short memories, we'd remind you that now marks the sixth month anniversary of when the ECB last raised interest rates. Talk about not having a grip on reality, but we'd point to this as a serious blunder that will likely lengthen the European recession.
This week, the announcement of weaker than expected consumer price inflation has allegedly given the ECB a green light to relax its benchmark repo rate next week. That has caused investors to ditch euros in favor of the strengthening dollar. The additional rumor that the European fiscal policy-makers are secretly discussing a tall-order tax plan ought to be worrisome to euro bulls. They always felt that the yield differential that the euro commanded would remain intact since the ECB always felt that there was some kind of trade off between fiscal and monetary policy tools. If both tools were ever needed, it is now.
America is showing that and slowly other nations are adopting that thought process. This philosophy will hinder the argument going forward that the dollar will be undermined by a deteriorating budget balance. At a time when public money is fast replacing private money across global economies ask yourself who won't have a serious fiscal problem. America's might be the largest, but it won't be isolated.
Over the duration of the week put open interest on the yen declined across the PHLX World Currency Options series. Investors bailed out of profitable bearish positions as the Japanese currency fell to its weakest in a month against the dollar. What's happening here is that government and central bank response around the world has made investors less pessimistic that equity markets will reach new lows. The intraday gyrations have indeed stopped for now at least and that's detracting from implied options volatility levels. Some investors have even ventured back into Australian and Canadian dollar plays as they ease their way back into markets.
The Russian standoff with Ukraine, which has shut off gas pipelines to the rest of Europe accompanied by ongoing Middle East tensions, has created a positive yet unwelcome rebound in energy prices. Investors need to be careful not to mistake this rise with a sustainable bull market for commodity prices predicated on rising demand.
When the President-elect speaks and sends a chilling message, it's worth listening despite the fact that he is still a couple of weeks shy of inauguration. When he finally gets to the White House, much might not have improved for the economy. That tells us that a stronger dollar rather than a weaker one will likely greet him on Pennsylvania Avenue.