US Dollar Suffers a Sharp Reversal Despite Positive Confidence Report

Up until the open of the US session, it seemed as if the dollar was going to find significant reprieve to last week’s selling. However, when US-based liquidity filled out, the steady appreciation behind the world’s most liquid currency was quickly reversed in a matter of hours. If that wasn’t a clear enough sign that underlying risk trends are still holding their sway over investors’ appetites, the same bias was reflected in the broad pull back in the Japanese yen and the aggressive, 2.6 percent from the S&P 500 Index.

And, though the initial drive against the dollar may have grown out of the market’s efforts to diversify and re-invest into higher yielding assets; there is growing evidence that speculation and sentiment are perhaps playing a larger role in extending the currency’s losses. In turn, we have to determine whether this is grounds for a fundamentally based reversal in the greenbacks favor. One of the most palpable reports of sentiment for dollar interest (and it is accessible to those outside of Forex to boot) are the levels measured through the CFTC’s Commitment of Traders (COT) data. Released each Tuesday, this morning’s report indicated net short interest in the US dollar was at its most extreme since last July – around the same time that EURUSD failed a second time to surmount 1.60 and subsequently fell over 3,600 pips in the following three months. Does this mean that there is an imminent reversal or that the world’s most liquid currency pair will mark an equivalent decline as the one between July and October? In a one word answer: no. Sentiment is prone to extremes; and these acute shifts from equilibrium can last a long time. However, fundamentals may inadvertently be building a case in the dollar’s favor.

It is hard to remember a time when the US dollar was not highly correlated to risk trends; but that was the case just six to eight months ago. The currency’s rivalry with the Japanese yen as a top safe haven was born out panic and the need for liquidity that developed during the worst of the financial crisis in September and October of last year. It is only natural that the greenback should lose some of the premium that was built up during this period; but as long as speculation’s sway over the broader markets moderates, so too will its influence on the dollar. Looking beyond to objective fundamentals, it is looking more and more like the US economy is pulling out of its decline as fast as its strongest economic competitors. This is not to mean that readings for economic activity are positive; but rather, they are closer to signaling growth than the Euro Zone and UK figures for example. For traditional event risk this morning, the most market-moving piece of event risk was the Conference Board’s consumer confidence survey. The May reading did improve for the third consecutive month as expected; but the pickup was far more aggressive than the consensus was calling for. At 54.9 (anything above 50.0 signals net optimism) the gauge was at its highest level since September and logged its largest jump in six years. A breakdown of this report shows that this largely the reflection of expectations (which surged 21.3 points to 72.3), while the ‘Present Situation’ measure printed a tepid 28.9. This reflects a lot of optimism in the government’s ability to carry the economy back into to positive growth, which many feel is ill-advised; but confidence does have a direct correlation to spending nonetheless. In other news both the Richmond and Dallas regional manufacturing activity indexes printed better than expected results for May; while the lagging S&P Case-Shiller home housing index reported a deteriorating pace. We will see whether tomorrows existing home sales data and the quarterly House Price Purchase Index from the Federal Housing Finance Agency reports the same.

A Heavy Round of Data Doesn’t Support a Tempered Pace of Recession for the Euro

While the dollar was no doubt the most active currency for the day, the euro would be the most fundamentally interesting. A mixture of leading and lagging indicators added to the fundamental argument as to whether the ECB should extend its rate cut region and expand its dalliance into quantitative easing or not. Carry the most weight – but ultimately lacking the volatility punch that a first round reading would have garnered – was the final measurements of 1Q German GDP. A superficial look at the headline numbers would have garnered little of additional value beyond confirmation that the economy shrank 3.8 percent in the first three months of the year – the steepest decline since these records began nearly 40 years ago. However, there was real surprise in the fact that capital investment plunged 7.9 percent (much more than the 4.5 percent expected) and exports dropped 9.7 percent (though that was lighter than the consensus projection). It is details like these that will push back the viable recovery time for the economy and thereby tax the central bank’s efforts to taking a more neutral pace with monetary policy.

The other indicators for the day were more timely, but less market-moving. The German GfK Consumer Confidence reading for June held at 2.5 for the second month. From the breakdown, the economic outlook edged closer to a positive reading, while income expectations offset the gain. For the Euro Zone the volatile current account balance for March was still firmly planted in deficit, but moderately better than the previous month. On the other hand, the industrial new orders contracted for an eighth consecutive month. Looking ahead to tomorrow, the discussion on interest rates may intensify thanks to the release of the preliminary German CPI figures for May. However, there is no hard release time given.

Is the Yen Truly a Safe Haven And New Zealand Dollar a Source for Yield?

Risk appetite has been the primary fundamental driver for the markets since April; and though volatility has backed off over the past week, it remains so today. However, the generally accepted risk-philic and risk-free currencies that the market has grown so used to over the past six to twelve months are not guaranteed. When sentiment is at an extreme, the panicked or greedy flock to the same currency; but when conditions settle, the fundamental are read for what they are. Looking at the disputed top and bottom of the risk spectrum; we have seen the support for the Japanese yen and New Zealand dollar in their respective roles shift. Japan recently reported its worst recession on record - even if the Bank of Japan and Cabinet office lifted their outlook for the ‘tempo’ of deterioration for the first time since 2006. How safe can an economy that has struggled for more than a decade with inflation, capital investment and growth really be? On the other side, will economic instability and a tumbling yield undermine the kiwi’s appeal as a high return currency? The government is expected to report its annual budget soon and the economy is considered at risk of another credit rating downgrade.

Terri Belkas is a Currency Strategist at FXCM.