Dollar Catches Flight-to-Quality Flows on European Downgrades for Biggest Gain in 5 Weeks

•    Euro Seems to Still Not Appreciate the Gravity of a Rating Cut to Greece and Portugal
•    British Pound Weakens as Data Deteriorates and Polls Imply Hung Parliament
•    Australian Dollar’s Interest Rate Outlook Fully Dependent on Consumer Inflation
•    Japanese Yen Rallies as Risk Aversion Tide Rises, but Will it Last?

Dollar Catches Flight-to-Quality Flows on European Downgrades for Biggest Gain in 5 Weeks
The risk tolerance of investors around the globe was put to the test Tuesday with the unexpected news that Standard & Poor’s was downgrading the sovereign credit rating of both Greece and Portugal. The first concern with this event was how prolific its implications would prove. The next question was what securities were at risk and which would prove to be the best mooring to whether the potential storm. For the dollar’s place in this debacle, the severity of the global shock this event threatened was the most important factor. Assessing the situation from a global perspective, lowering Greece’s credit rating to ‘junk’ status further put the nation out of reach of reasonable assistance from the European Union and IMF. The dimmer the outlook for this particular economy, the closer they will come to default. There is considerable exposure to this particular nation’s assets in portfolios across the world; and such an event could lead to significant loss. Alone, the news about this single economy would be very concerning; but taken along with the announcement that another EU member was receiving a two-level downgrade at the same time, the danger is far more pervasive. Now the issue looks more like a structural problem for the Union that threatens to evolve into a crisis for the global economy. Under these conditions where safety is at a premium and risk must be unwound, the dollar once again shines as a safe haven. While there is an argument to be made about gold’s unique isolation from sovereign debt risk; it is the dollar that exemplifies the liquidity and relative heft of the world’s largest economy.

Given the dollar’s fundamental position, its marked appreciation through the day should come as little surprise. In fact, a consistent rally through the end of the US session would lead the dollar index to its biggest single daily advance since March 24th. Looking to its performance against different groups of currencies, we can assess both the individual currency’s strength in this fundamental swell and asses where the stress cracks are in the market itself. Advances against the euro to fresh 12 month highs are obvious given the origination of the problems; but the GBPUSD decline (though sharp) falls within broader congestion. The real activity comes through those pairs that have a greater sensitivity to risk appetite. The Canadian and New Zealand dollar-based majors suffered greater dollar gains than EURUSD. Another distinct sign of a sharp change in sentiment can be read in USDJPY’s tumble through the session. When fear spikes, the first concern is reducing risk exposure. The second is seeking speculative shelter. These often go hand in hand; but they are can have very different effects between the Japanese and US currencies. More carry interest is founded on the yen; so a sudden shift in sentiment and the beginning of a larger shift in risk will begin in its crosses. However, for safety, the greenback is far more attractive for its economy, financial position and even its potential return.

Not to become completely distracted by the highly fluid changes in underlying sentiment, the dollar was also establishing its own medium and long-term health through fundamental data today. While the positive turn in the S&P/Case Shiller’s annual home price index was notable; the 19-month high in consumer confidence would speak to a stronger source of domestic growth. Looking ahead to tomorrow’s docket, the most pressing event risk for the day is the Federal Open Market Committee’s rate decision. No change in the benchmark is expected; but market participants have become highly sensitive to even minor changes in rhetoric that can be used in speculating their time table.

Related: Discuss the US Dollar in the DailyFX Forum, US Dollar’s Advance Threatened by Greek Bailout Relief

Euro Seems to Still Not Appreciate the Gravity of a Rating Cut to Greece and Portugal
The next step in a burgeoning financial crisis has been taken. With Greece still waiting on Germany and the other European Union members to agree on specific loan conditions to release the 45 billion euros that the region pledged along with the IMF, the nation has found itself in an even deeper hole with the Standard & Poor’s rating agency lowering its sovereign rating to junk status (BBB+). It would have been difficult enough for Greece to have balanced an inevitable economic recession along with its austerity cuts; but accomplishing this at financing costs that junk bonds command is highly improbable. What’s worse, this rapid implosion is starting to pull other EU members down as well. Portugal’s own rating was cut two levels from A+ to A- suggesting this country’s own troubles cannot simply be glossed over with the help of a robust market. Popular opinion amongst the citizens in both countries is further an issue. A pool from Greek Public Opinion reports that 60.9 percent of Greeks oppose a bailout from the EU and IMF. In Portugal, strikes are gaining pace against planned austerity cuts. Ireland and Spain have also come under scrutiny given credit default swap premiums. With each week, this looks less like a Greek problem and more like a euro problem.

British Pound Weakens as Data Deteriorates and Polls Imply Hung Parliament
Every piece of pound-centric event risk that crosses the wires is filtered through the uncertainty that surrounds next week’s general election. A popular opinion poll cast by ComRes Ltd yesterday has shown support for Conservatives at 32 percent, Liberal Democrats at 31 percent and Labour at 28 percent. If this is how things settle, it would mark the first time in over three decades that Parliament hasn’t seen a majority. While this may be good for debate, it impedes pushing through necessary legislation to fix the economy and/or budget deficit. With that in mind, the weak BBA mortgage reading and the unchanged reading from the CBI retail activity make the next administrations job that much tougher.

Australian Dollar’s Interest Rate Outlook Fully Dependent on Consumer Inflation
Not long ago, Reserve Bank of Australian governor Glenn Stevens commented that the nation’s overnight lending rate was “pretty close” to normal. This average level that he referred to doesn’t seem a firm number; but the comment was nonetheless a sign that further rate hikes would come at a slower pace. Does that mean a pass at the May meeting? He also suggested that depends on the 1Q CPI numbers.

Japanese Yen Rallies as Risk Aversion Tide Rises, but Will it Last?
The Japanese yen is an immediate benefactor of a risk aversion move. This is not due to any explicit appeal to hold the currency through financial stress. Rather, this link is made due to the fact that the currency has been used so heavily to build up carry positions. However, when the carry unwind starts to give way to demand for true security, the yen’s appeal will start to fade.

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