IB FX View

It won’t happen overnight

Friday May 22, 2009

A good foreign exchange dealer, so they tell me, is one who’d not hesitate to sell his mother. In a world where rumors lead to selling and facts lead to buying there is a strong relationship between success and following one’s instinct. The dollar is once again in the trash can today getting buried deeper by the minute under a mountain of order tickets reading ‘sell on stop.’ As we noted here yesterday, the deterioration in the fiscal health of western governments on account of propping up the global economy should indeed be rewarded by lower marks all round from the ratings agencies. Today PIMCO’s Bill Gross stated that same obvious fact that, sure, the AAA-crown worn since 1917 by the U.S. government will ultimately slip. The prospect that it won’t happen overnight was lost on the forex market who mercilessly beat up the dollar.

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So why is the test-case British pound advancing today? While the euro surpassed $1.40 earlier the pound has been busy making a beeline for $1.60. And the yen too has surged to below 94.00 this morning prompting one official to note that the government is not seeking to intervene in the currency markets just now since the problem seems to be dollar weakness rather then yen strength. Independent yen strength on the other hand would give greater cause to act and would give a greater chance of success. Right now a fight on behalf of the dollar would be as much fun as swimming up the Niagara Falls.

The potential loss of its credit rating has prompted treasury secretary, Timothy Geithner to admit that the U.S. fiscal position is not a pretty sight. With debt as a percentage of GDP expected to reach 12.9% by the end of next year, Mr. Geithner did the commendable thing and said that the government needs to apply a policy stance and take appropriate measures that would lower the deficit to around 3% of GDP in the medium term. That would be around the same level that the Europeans have targeted over the past decade.

The problem has become one of too much debt. S&P assigned a one-in-three chance that the U.K. might lose its AAA status on account of a rising debt burden that will see outstanding government debt equal to gross domestic product. The same fact is hurtling its way towards the U.S. and there seems little that will stop it including repayment of TARP by the bigger banks.

For the dollar, things have taken a dramatic turn for the worse. It used to be that conventional theory stated that the benefits of taking the lead in global recovery, regardless of the taxpayer cost, meant that the U.S. would lead the globe from its torpor and the dollar would benefit from that increased health not to mention the boost from the prospect of rising interest rates fostered by a return to economic growth.

Today that philosophy has been turned on its head to the point that the ECB officials might even join in the American Memorial Day celebrations on Monday and raise a large tankard of beer as they slap their lederhosen, congratulating one another over being right not to ease monetary policy through the quantitative path.

The question going forward is not whether the U.S. was right to print money to save the system. Rather it will be whether or not the economy will revive in the event of a run on the dollar, which will invariably stick in the Fed’s throat as it tries to issue debt on behalf of the treasury to plug the deficit. While observers might be right that the U.S. might never default on its debt it might end up paying a high price for doing so, literally.

Overnight the Bank of Japan had a rethink in its latest assessment of the economy. It probably helped the yen, but that factor is possibly lost in broad dollar weakness. The BoJ used the fact that the economy shrank at a 15.2% pace in the first quarter coupled with a recent leveling off in production and export declines to conclude that the skies were clearing. The BoJ also widened the variety of acceptable collateral that it will accept from lenders. It will now take on board European government debt as collateral in exchange for term-funds to lenders to ensure that the financial markets continue to thaw.

The weakness of the dollar is lighting a fire under commodity currencies. The rise in the euro to $1.40 is priming dealers to prepare for the Aussie to ramp up to 80 U.S. cents as a result. Currently the unit stands at 78.38 and is up another penny today. The Canadian dollar is also on an absolute tear and is heading for 90 U.S. cents. One U.S. dollar today buys C$1.1200 and marks a 6 penny decline since Monday. That’s a huge swing in sentiment as gold and crude oil rise.

Andrew Wilkinson

Senior Market Analyst ibanalyst@interactivebrokers.com

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