US Dollar Plunges as Return to Risky Assets Drains Demand For Safe Havens

An improvement in investor sentiment proved to be to the detriment of the US dollar, which slumped more than 1 percent against the euro and British pound, over 2 percent versus the Canadian dollar, and a whopping 8.33 percent against the Australian dollar. We’ve seen that during the past few weeks, demand for the greenback has picked up significantly as a safe-haven asset, but now that we’ve seen a turnaround in risk aversion, the US dollar is selling off quite a bit along with the other major safe haven: gold.

Last Friday I mentioned that the pressure was really on for the Group of Seven (G7) or European Union (EU) to come out with a statement strong enough to help stabilize the markets. The G7’s statement on Friday failed to do the trick, but the EU’s statement on Sunday – which was a bit more specific on policy actions – appeared to do the trick (see the Euro, British pound section below for more). Indeed, the credit and stock markets started to show signs of recovery, as indicated by the sharpest rise in the DJIA since 1933 and broad declines in overnight Libor rates. This trend is likely to continue in coming days, barring the release of negative financial news, as there is no key data scheduled for release out of the US on Tuesday.

Euro, British Rebound as EU Summit Focuses On Debt Guarantees, UK Buys Majority Stakes in RBS, HBOS

The euro and British pound rebounded when trading resumed on Sunday, as the European Central Bank, Bank of England and Swiss National Bank said they were ready to inject as much as needed into the markets for US dollar funding in a coordinated effort with the Federal Reserve. Furthermore, the EU’s summit in Paris concluded with a statement signaling the implementation of other measures meant to stabilize the markets, including arrangements where individual governments would guarantee some types of new medium term debt (up to 5 years) issued by banks. The statement also brought up the issue of recapitalization, an idea that is now starting to gain traction European countries like Spain, Italy, Germany and France now that it has been implemented in the UK. In fact, the British government announced that they would buy majority stakes in Royal Bank of Scotland Group (RBS) and HBOS. The news also triggered massive gains for foreign stock markets, as Germany’s DAX Index jumped 11 percent, the sharpest gain since the index was created in 1988, while the FTSE 100 gained 8.3 percent as all but six stocks rose.

Looking ahead, trading of the euro and British pound will continue to depend greatly upon risk sentiment in the markets, with risk aversion working out of favor for the currencies since the US dollar has recently generated demand as a “safe-haven” instrument. On Tuesday, the euro faces event risk from a scheduled speech by ECB President Trichet, who will give the keynote address at a meeting of The Economic Club of New York. Meanwhile, the British pound could see volatility on the release of UK CPI, as annual inflation growth is anticipated to accelerate to a rate of 5.0 percent. The BOE has said in the past that they expect CPI to breach the 5.0 percent level in coming months, but these expectations did not stop them from cutting rates on October 8 by 50bps to 4.50 percent in a coordinated effort with the Fed and ECB, among other central banks. Indeed, the credit crisis and the sharp economic slowdown in the UK have taken the spotlight from inflation fears, but if UK CPI proves to be even stronger than forecasts, the British pound could rise. On the other hand, a weaker-than-expected result could spark GBP/USD selling. Overall, my bias for the euro and British pound this week remains cautiously bullish, as we’re likely to see retracements throughout the financial markets of the sharp moves experienced over the past two weeks.

Japanese Yen Hit Hard as Volatility Cools

A decline in volatility led the Japanese yen fell versus the majors on Monday, dropping more than 1 percent versus the greenback and Swissie and plunging over 3 percent against the British pound and Canadian dollar. The biggest losses were against the high-yielders though, as the currency lost 10 percent against the Australian dollar and 5.38 percent against the New Zealand dollar. Indeed, demand for carry trades rose as the CBOE’s VIX Index dropped from Friday’s record high. Furthermore, looking at the solid inverse correlation between the Japanese yen and US stock markets, it isn’t entirely surprising to see such declines given the global rallies in equities. In the near-term, the Japanese yen could continue to slip as traders become a bit more risk seeking. In the long-term though, my bias is bullish on the low-yielder, as significant perils loom for the financial markets given persistently tight credit conditions.

Terri Belkas is a Currency Strategist at FXCM.