FURTHER BAD NEWS TO PUSH BUCK LOWER
JANE FOLEY
RESEARCH DIRECTOR, FOREX.COM
AYEAR after the fall of Lehman Brothers, the established rhetoric in the markets is that the shocks that unbalanced the finance system and the global economy have still not dispersed. However, the markets are saying otherwise.
Shorting the US dollar has become de rigueur. The euro, Australian and New Zealand dollars have all hit 12-month highs against the US dollar this month. Coincident with the weaker dollar, the FTSE 100 index is also back at its best levels for a year.
The implication is that asset markets are vulnerable to a correction, but last Friday morning’s pullback failed to gather steam. There is plenty of talk in the markets that the autumn may bring a moderate correction in risky assets and this view was captured last week in the surprise fall in Germany’s ZEW survey, which reflects the views of the investment community. However, last week’s better-than-expected US retail sales and production data fed the perception that the global economy continues to mend and supported the move into risk.
The decision to sell the dollar in order to finance positions in higher yielding “risky” currencies is, of course, dependent on the relative position of US rates. Last week’s cautious economic outlook from Federal Reserve Chairman Bernanke did nothing to alter the view that US rates will remain low for some time. Speculation is beginning to emerge that the Fed may be forced into hastening its exit policies, but this talk is difficult to swallow, given the very low levels of inflation and the high and still rising levels of joblessness.
The US consumer price index was down 1.5 per cent year-on-year in August, with the core index stable at a moderate 1.4 per cent year-on-year. In the near term, the upcoming FOMC meeting will be closely watched for any clues as to the timing of a policy change.
Into the New Year the prospects for the dollar may improve on the back of the US interest rate outlook, which will likely find support from projections that the US economic recovery will be faster than that of the rest of the G3.
A survey by financial information provider Bloomberg points to US growth of 2.4 per cent in 2010. Eurozone growth, by contrast, is projected to be just 0.9 per cent. In tune with this outlook, the survey suggests that ECB rates will be raised by a total of 25 basis points during the course of next year while the Fed will hike rates by a far greater 100 basis points. Any rise in Bank of Japan rates next year is likely to be very muted. Once the Fed starts to hike rates (possibly not until the middle of next year), expectations that the pace of the move may be relatively aggressive suggests that the dollar’s new role as a funding currency may not be sustained for more than a few more months.
Support for the dollar in the form of interest rates differentials may be in the pipeline, but a more immediate flurry of dollar buying would emerge if there was a general correction away from risky assets. The global economy is still sufficiently weak to imply a high risk of more negative news over the months ahead. Despite the healing process which has been underway this year, the banking sector remains a likely contender for more nasty news.
The FTSE global banks index has rallied almost 170 per cent since its lows this year. However, the continued vulnerability of parts of the sector was highlighted on Friday by reports that the Lloyds Banking Group had failed to raise enough capital to meet the FSA’s strict requirement. As a consequence, Lloyds has reportedly been forced to abandon its plans to withdraw from the government’s toxic debt insurance scheme.
Earlier last week Moody’s warned that UK banks could register further losses of £130bn over the next few years and losses of £250bn if the UK’s economic performance proved to be weaker than expected. Expectations of slow economic growth are seen by Moody’s to be the primary cause of higher loan arrears and bad debts, though government support should limit the scope for downgrades.
These issues are not just confined to the UK. A sustained period of slow growth will increase the incidence of bad news from US and European banks also and potentially from other sectors of the economy too.
While the improvement in the global economy over the past months will limit the extent of any correction in the risk trade over the coming months, bad news would still inevitably push investors back into safe haven assets. This suggests a stalling in the upswing in equity indices and that it may be premature to expect the euro-dollar pair to sail past the 1.500 level any time soon.
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