IB FX View

Dollar bears mull the prospect of higher U.S. rates

Monday June 8, 2009

Our opening gambit following Friday’s payroll shocker noted the sudden reversal in fortunes of the dollar at that time. Follow through dollar selling rapidly abated and dealers looked the other way. As the weekend beckoned, more investors came down on the side of the dollar as the next likely big mover. Having reached $1.4267 in the aftermath of Friday’s reported loss of 345,000 jobs in May, the euro has weakened dramatically to as low as $1.3805 in Monday’s trade.


Click on link for updated table throughout the day at http://www.interactivebrokers.com/en/general/education/FX-View.php?ib_entity=llc

Powering the dollar higher today is a combination of elements, the largest of which is the notion that yields are about to change dramatically in favor of the dollar. Expectations that the Fed will banish its near-zero interest rate policy before thanksgiving have risen to 50%. Just one week ago those chances were just one-in-four.

Another downgrade for Ireland’s sovereign credit rating, its second in 2009, also opened up yet another gaping wound for the euro currency. Standard and Poor’s cited the negative outlook on account of the utter weight the government has put itself under in order to support the financial sector.

In Britain, while Prime Minister Gordon Brown did indeed survive the weekend, it was an uncomfortable ride. During the 2004 European Parliamentary elections his Labor Party, at the time under Tony Blair’s leadership, won 22% of the vote. Sunday’s poll revealed a sharp drop to 15.3% of the vote. For the first time in 91 years, since the end of the First World War, the Conservative Party won the Welsh vote, a traditional safe haven of the working man’s vote. This single statistic paints the picture of a rudderless government waiting for collapse.

The pound continues to lose friends while this collapse plays out. Meanwhile, former Bank of England policy maker, David Blanchflower predicted in an interview that the bank is likely to seek to expand its approved 150 billion corporate and government bond buying program in order to further expand its support for the economy. As a new factor into the frame for sterling, this potential for further quantitative easing is letting gthe pound down somewhat on Monday. How much of this is simply the fact that the dollar is in favor today is hard to tell. The pound is down to $1.5923 this morning but is pushing back to 87 pence against the euro.

Interest rate futures got hit hard and on heavy volume at the CME on Friday after the employment report. Yields rose by around 35 basis points and more across the curve with policy sensitive short dated notes getting hit the worst. The key for dollar trading here is that all of a sudden yields are back in favor of the dollar. While most investors have bent over backwards to find green economic recovery shoots, the dollar yield curve has crept higher. When you compare the ECB’s official 1% stance to the Fed’s 0.25% short rate, one can see the advantage of holding euros day to day. However, when you move further to the key 10-year area the picture is not only different but has changed dramatically of late.

During the last year, the spread between equivalent German and U.S. 10-year yields has favored the Europeans by an average 34 basis points. A week ago that spread had dissipated. Today in light of the rosier jobs outlook in the U.S., the U.S. holds the advantage with the spread out to 15 basis points. Now, there’s no competition here. In fact, we’re pretty sure that most central banks will speak up about this recent back up in yields in efforts to talk them down. Simply put, successful U.S. policy is currently backfiring in that suddenly the cost of borrowing has increased dramatically to corporates and homebuyers.

When investors mull the reason why American yields are rising at a faster pace than European ones, they can quickly refer to quantitative easing as the key reason why confidence might be returning. The question going forward now is whether the U.S. can pull Europe from its mire given the simple fact that politicians across that continent are dead set against quantitative policies. The perception of relative improvement for America leaving the Euozone to recover on its own could be enough to send the euro all the way back to, well, a lot lower than today’s $1.3850.

Andrew Wilkinson

Senior Market Analyst ibanalyst@interactivebrokers.com

Note: The material presented in this commentary is provided for informational purposes only and is based upon information that is considered to be reliable. However, neither Interactive Brokers LLC nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. Neither IB nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities or other financial instruments mentioned in this material are not suitable for all investors. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue. The information contained herein does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation to you of any particular securities, financial instruments or strategies. Before investing, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.