All the World’s a Stage

Wednesday December 24, 2008

The greenback made a sharp reversal last Thursday as currency investors heeded the type of message that we attempted to convey here in this very commentary. The euro rallied to $1.4750 before appetite dried up before it abruptly gave up practically 10 whole cents. Heading into thin-holiday trading the euro is back at $1.4000 exactly. Implied currency volatility drew in over the course of the week, which was largely a reflection of the contraction of assumed volatility in equities. Narrower daily trading ranges on the S&P 500 index have prompted investors to mark down their expectations of violent swings in the future, which has sent the VIX down from a peak of 80 to around half that today.

In options trading we continued to see a swell of put action on the euro where investors are trading into the March puts at the 1.19, 1.20 and 1.21 strikes using the PHLX World Currency Options contracts. This build clearly defines to us that the smart money is banking on a resumption of dollar strength into 2009.

The sea-change occurred last week when the Fed ran out of room in terms of being able to offer lower rates. In moving to a target range of zero to 0.25% on the fed funds rate, it has gone as far as it can and is now in the business of leaning on bond and note yields through open market purchases. At that point investors swiftly concluded that the focus was no longer on policy approach, rather it was on the ugly twin deficits, for which America deserves punishment through a weakening of the dollar. That mentality rammed headlong into the surge barrier very quickly as investors continue to recognize that the dulcet tones of the fat lady have not yet been heard.

With the four-week average jobless claim value in the States running at its highest since 1982 we are blissfully aware that current monetary policy action is not yet working. Sure it takes time, yet the fiscal response is not yet written. Let’s just say that the theater has been booked for the 2009 season but so far the stage is not set.

Investors also have to weigh up the risks associated with continually buying Japanese yen following comments from government that intervention is a real threat should it decide to play kick ball with the market. This alone was enough to stem the advance of the yen versus the dollar and the euro has also stopped its losing streak against the euro. The most interesting battle to watch to commence 2009 will be when and if tumbling equity markets create a sufficient jump in the yen’s value through risk aversion to spur the BOJ into yen sales.

The commodity dollars too are trying to get the wind at their backs, currently using each positive equity market development as an excuse to improve against the dollar. However, they are increasingly hindered by weaker Asian bourses on top of being undeniably crippled by the ongoing slump in commodity prices. With many annual raw material prices fixes to be negotiated by April, the Australian and New Zealand dollars face a tough start to the year.

While the euro has been the recent currency of choice, spanking the pound to within an ace of parity against the British pound this week, investors are overlooking the fate of any “high-yielding” currency, which are undoubtedly heading to zero as soon as central bankers can muster bold enough moves to get there. Granted, they have already taken such steps, but there is surely more to run. This won’t be about getting the right monetary and fiscal mix, rather it will be an onslaught from both angles that shifts the globe from its torpor.

As we head to the closure of trading for 2008 it could be argued that we are at a crucial point of either dollar reversal or continuation. Indeed that is what created the recent violent dollar swing. For now we don’t see many signs of improvements around the globe that would force us to state that the dollar’s fortunes should reverse. We are heading to the point where the stage is set for 2009, which could be off to a very messy start