US Dollar: A Puppet of the Stock Market?

The rollercoaster ride in the stock market also hit the currency market today. At one point, the rally in the US dollar evaporated as the stock market collapsed on fears that the financial sector could be in for more trouble. After having been up more than 100 points at the beginning of the US trading session, the Dow Jones Industrial Average choked back all of those gains to end the day down 56 points. This was not before falling more than 160 points, then reversing back to flat and then dropping once again. The meltdown in stocks was triggered by Lehman Brother’s warning that Fannie Mae and Freddie Mac could be forced to raise as much as $75 billion in capital to offset write downs and meet new accounting rules. Fresh trouble in the financial sector is the type of uncertainty that the market cannot handle right now. The new earnings season is about to begin and Fannie and Freddie’s problems resurrect concerns about the resiliency of US companies in the face of soaring prices and falling demand. The US dollar has merely been a puppet of the stock market today as liquidation out of US stocks lead to liquidation out of the US dollar. Normally, hawkish comments like those from San Francisco Fed President Yellen would help the dollar, but today, traders were more worried about the problems in the financial sector and how Yellen’s comments suggest that there will be no relief from the Federal Reserve. Pending home sales, wholesale inventories and consumer credit are due for release tomorrow. These are Tier 2 economic data which means that they will not be particularly market moving. We still believe that the US dollar has bottomed and as such, we look for more gains against the Japanese Yen and Euro. The US economic calendar is very light, but the disappointments in German industrial production could lead to even more disappointments for other Eurozone reports this week, which would weigh on the EUR/USD.

Euro Fundamentals Turning Sour

Last Thursday, ECB President Trichet shocked the currency markets by saying that he has no bias about future monetary policy, sending the Euro plunging against the US dollar. The Euro came under further selling pressure after the German industrial production dropped 2.4 percent in the month of May, which compares to the market’s call for a 0.3 percent rise. The drop comes in sharp contrast with the rebound in the manufacturing PMI report and suggests that the trade numbers on Wednesday could be weak. Cracks in the Eurozone economy are beginning to show and these problems could be exactly what prevented Trichet from being more hawkish. Either way, the ECB is done for now which should limit any gains in the Euro. We still believe that no bias equals no action in the EUR/USD so expect the 1.53 to 1.59 trading range to remain intact for the rest of the summer. Meanwhile the unemployment rate in Switzerland continues to drop. The jobless rate hit 2.3 percent last month, the lowest level in 6 years. This has helped the Swiss Franc hold near its 17 year highs against the Japanese Yen.

British Pound: UK Economy Could Fall into a Recession

The UK economy is worsening which is having a big impact on the British pound. Last week economic data indicated that the service, manufacturing and construction sector all contracted in the same month. The last time this happened was 7 years ago and at that time, GDP growth slowed to 0.1 percent, the weakest level since the second quarter of 1992. This morning, UK industrial production fell 0.8 percent, 8 times more than the market’s forecast. The entire UK economy is slowing and the country is now at risk of falling into a recession. This has become such a serious problem that there is even speculation the Bank of England could cut interest rates on Thursday. Given current inflationary conditions, we do not think that this is possible, but we do believe that the British pound will continue to trend lower ahead of the meeting. GDP growth should continue to deteriorate in the coming quarters, making the Bank of England’s job even more difficult. The report on house prices that is due for release tomorrow and that should also be pound bearish.

Canadian Dollar Gains Strength, Australian and New Zealand Dollars Retrace

Oil prices have retraced today, but that has not prevented the Canadian dollar from strengthening against the greenback. This is partially due to the fact that business confidence improved modestly in the second quarter. Up until now, the Canadian dollar has had a hard time rallying because of fears that the slowdown in the US economy would spillover to the Canadian economy. However the summer Business Outlook Survey from the Bank of Canada indicates that this concern is not shared by Canadian businesses which coincide with Friday’s sharp rise in the IVEY PMI number. Building permits were also better than expected, reflecting continued strength in the Canadian housing market. Good news also came out of Australia with construction sector PMI improving, but that has failed to prevent the Australian or New Zealand dollars from being hit by US dollar strength.

More Trouble Ahead for the Japanese Economy?

The rollercoaster ride in the Dow has triggered significant volatility in the Japanese Yen crosses. With the exception of NZD/JPY and AUD/JPY, all of the other carry trades have recuperated their intraday losses to end the higher. Japan’s economy is crumbling under the weight on higher oil prices because they import nearly all of their oil needs. According to BoJ Governor Shirakawa, the surge in commodity prices could lead to lower profit and weaker growth and because of that they will remain on hold for the foreseeable future.

Kathy Lien is the Chief Currency Strategist at FXCM.