Dollar Enjoys Its Biggest Rally in Five Weeks, What Lies Ahead?

When we have the S&P 500 puts in for its largest decline this year and the dollar subsequently wins its biggest daily rally since January 5th, we have to consider something bigger is afoot. A seismic shift in risk appetite trends is the greenback’s best catalyst for a meaningful rally, and there is plenty of thematic event risk that we can point out to suggest that just such a move is upon us. However, ‘news’ has betrayed us too many times recently. We have to monitor momentum, the level of correlation and the premium on risk protection (the VIX volatility index produced its biggest daily jump in three months Friday) all in concert next week. Confirmation is important when it comes to a true trend change.

Euro’s Indifference to Financial and Economic Problems Coming to an End

Over the past months we have seen what the true definition of bear trend and bull trend is through the performance of the euro. When a market responds to positive developments but minimizes the influence of the disappointing, we have a bull trend on our hands. Alternatively, when a positive view simply can’t gain traction while each disappointing report is met by greater selling pressure, the bears are in control. At this point, the euro has grown so oversaturated by ‘news’ that both sides are skeptical. That is especially true as we continue to carry forward the unpredictable Greek issue forward. Once again, we have series of critical votes that need to go through: Parliament must agree to further austerity measures (supposedly over the weekend), the private investor bond swap must go through and the EU must accept all the proposals to approve the second bailout package. And, this time, we are coming to critical deadlines and facing every-more dramatic ultimatums. Through it, perhaps the market will remember, this does not solve all the regions issues. Another important line to follow: 4Q GDP releases.

Australian Dollar Sensitive to Risk Threatens Critical Volatility Next Week

Through the final trading day of this past week, the Aussie dollar was the worst performing of the most liquid currencies. That’s only fitting, considering the high-yielder was one of the strongest performers (second only to the New Zealand currency) over the previous two weeks when optimism was on the rise. The two things that we need to establish for the Aussie dollar over the coming week is which direction underlying risk trends take and whether the RBA’s hold this past week has permanently altered the unit’s rate bearing. There is plenty of evidence to suggest a larger correction can develop, but history tells us that optimism amid stimulus can be resilient. As for the currency’s yield bearing, the 12-month rate forecast jumped from nearly 100 bps of cuts to 63 bps, but swaps tell us there is still a 66 percent chance of a cut next month.

British Pound Has its Risk Bearings as Well as Meaningful Event Risk

In the yield spectrum, the sterling ranks near the bottom of return, but it is also a fundamentally-sensitive currency. The connections the UK holds to the troubled Euro Zone via trade lines, European Union ties and financial market integration means the pound is at constant risk of catching the same cold that the euro itself is suffering – especially true given Prime Minister Cameron’s vow to stay the austerity course. Hence, should the Greek situation deteriorate in the upcoming week; the sterling will trace the euro lower against most pairs (though risk aversion could balance the performance against high yield currencies). Aside from the whiles of risk and reward, pound traders should keep an eye on the docket. The CPI and jobless claims data is good for short-term volatility, but the BoE minutes will give us a lasting view of policy.

Japanese Yen Facing Another Painful Swell if Sentiment Collapses

Japanese Finance Minister Azumi tried his best to extend the yen’s tumble this past week. Daily speeches regurgitated the same threat to take ‘decisive’, ‘bold’, ‘firm’ or ‘extraordinary’ action in the foreign exchange market should the yen be driven by ‘speculators’ to excess volatility or heights. Adding a little more bite to his bark, the policymaker further said that the decision of further manipulation from the Ministry of Finance (as opposed to the BoJ) rested with him. A situation where the mood of a single person can decide such a meaningful market dynamic adds a level of caution to those looking to bid the yen. However, the influence this may have had was undermined when Azumi stated in Parliament that he started the October intervention at 75.63 and stopped after USDJPY reached 78.20. While the level didn’t necessarily trigger the effort, FX traders may nevertheless use it as a target. Moving forward, the market may put the pressure on and drive the benchmark pair back towards lows should risk aversion light a bid under the yen. Unique solutions like Noda’s fund for foreign purchases may need to be fast tracked.

Swiss Franc Playing More the Role of Euro-Counterpart, Less Safe Haven

Over the past weeks, a steady bearing on growth-sensitive capital markets has offered an even keel for the balance of risk appetite. However, the critical absence of momentum (our technical gauge for conviction) has rendered the Swiss franc a questionable funding currency in the carry trade. Looking at the correlation between the S&P 500 (our benchmark for risk trends) and the various franc-based crosses, we have noted a substantial deviation in performance. Pairs like AUD/CHF, NZD/CHF and CAD/CHF have diverged from the equity index (whereas AUD/USD, NZD/USD and USD/CAD are all running exceptional relationships). We see the issue more clearly when we set the franc against the dollar and yen. The correlations for CHF/JPY and USD/CHF are incredible matches for EUR/JPY and USD/EUR (inverted). A constant threat of intervention, a diminished export market and the spread of the Euro Zone is melding the franc to the euro. We will really test this link if risk trends grow heavy.