IB FX View

Risk aversion theory boosts yen and dollar

Wednesday October 28, 2009

Ongoing concerns over a budding recovery have pushed to one side the appetite for high yield and serve to punctuate a slide in the dollar. Investors watching recent increases in various measures of volatility and bond yields accelerated by a shifting emphasis to central banks’ exit strategies have heightened the expectation that an imminent market correction is well overdue. The rally in the euro nevertheless still looks as though it has life left in it as the single European currency treads water at $1.4790.


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Investors have increasingly grown concerned by a self-fulfilling rally in stock indices as risk appetite has been largely driven by relief that recovery seems to be taking root. A falling dollar was merely a symptom of this rise in activity, domestic and abroad, to the point that there was no good news for the dollar. Arguably signs of an economic failure are the only positives for the dollar.

As the dollar sank, commodity prices were driven ever-higher. The dichotomy here is that this inverse relationship holds regardless of recovery. Technically, dollar weakness on sliding growth could conceivably drive commodity prices higher simply on the basis of their status as alternative assets.

In turn stock markets have read rising commodity demand or prices as evidence of recovery. Because this recovery marks the start of the cycle, it does hold the prospect of being extremely powerful. But in turn many investors declare this rally to be an imposter, overstating the likely slower average pace of growth over time, which is indeed plausible.

Having pumped the equity markets higher and marched the dollar down a dirt-track of despair, investors have been swift to react to this week’s decline in U.S. consumer confidence and a drop in mortgage applications to a two-month low. The accusation is that doom-and-gloom is just around the corner and that equity appreciation can’t sustain itself under such circumstances.

Yet in their haste such investors stand accused of over-thinking the plausibility of an exit strategy in the event of renewed economic weakness. Such an example of this was presented overnight when the Australian consumer price index returned its lowest quarterly reading in a decade. Third quarter CPI was a meager 1.3% and compares to that of the second quarter of 1.5%. Investors were swift to do two things. The local dollar was heavily sold and interest rate expectations were pared sharply.

The Aussie dollar has declined to 90.41 U.S. cents and is down a whole cent and a half in New York. For all of its stern rhetoric of late, let’s not forget that the RBA still needs reason to lift rates in this deflationary environment even when growth appears locally robust courtesy of activity in Australia’s largest export partner, China.

The Canadian dollar also fell sharply and is currently quoted at 93.15 U.S. cents from Tuesday’s closing price of 93.86. Today falling prices for crude oil and a friendlier environment for the U.S. dollar, which is cotton-draped in global stock market losses today, have taken their toll on the loonie.

The Japanese yen continues to rise and is fast-approaching ¥91 per dollar and has continued its safe haven role by rising to ¥134.65 per euro. The yen strengthened especially against those currencies typically favored as carry-trade candidates owing to their higher benchmark yields. In turn, this is helping to lift the dollar higher by its bootstraps as risk aversion gains traction.

While we understand the argument that the stock markets may well have priced in too much too soon, the present correction currently looks no worse than precisely that – just another correction. Today’s durable goods orders for September continue to show that the economy continues to push forward and that recovery is indeed on track. The dollar’s demise is likely to resume with the onset of a fresh calendar month next week.


Andrew Wilkinson                                                                    

Senior Market Analyst                                                               ibanalyst@interactivebrokers.com       


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