The dollar staged a recovery this morning on bad European data and after Fitch issued a downgrade and negative outlook for several types of Russian sovereign debt, following a warning earlier in January. This reversed the better tone toward risk as shown by a rise in U.S. stocks yesterday that was a dollar-negative as safe-haven impulses receded.
The euro fell over 185 points overnight after the dollar hit its worst level Tuesday afternoon at 1.3058, flirting with a resistance line around 1.3100. Overnight, the euro tested the US high and made a slightly higher high at 1.3071 but then demand collapsed. But as Asia was closing down and Europe came in, the euro hit the skids and fell to a low of 1.2816 by 07:45 EST.
Causes include the Fitch Russian downgrade, a big drop in European retail sales, the pending UK and ECB policy meetings on Thursday and the rise in the yen across the board. One story circulating London was that the dollar was the victim of an unfounded rumor that the Chinese “will begin to shy away from the dollar,” but the sentiment vanished under the weight of hard economic data from Europe and the UK.
More influential was the euro/yen taking a nosedive from 117.02 last night to 114.22, and this has spilled over to the euro/dollar.
Meanwhile, sterling was hanging to gains at 1.4450 in the face of widespread expectations of a 50 basis point rate cut by the BoE tomorrow. Sterling’s buoyancy is hard to understand, but the theory is that aggressive Central Bank policy is being rewarded (see the aussie).
The NIESR (the most respected British forecaster) said the UK economy will shrink by 2.7% this year and stage only a "feeble" recovery in 2010. It said the government's current economic projections--for a recession that is over by the Q3 of this year and followed by a strong recovery--are over-optimistic.
A big factor for the stock market on Tuesday, along with a concurrent fall in risk aversion which hurts the dollar, was the news late yesterday that one of the stimulus plan proposals (from the Republicans in the Senate) is a corporate tax cut from a 35% rate to 25% for one year.
Another addition to the stimulus plan, this time from the Democrats, would be a reprise of the 2005 repatriation tax break whereby multinational companies could bring cash home from foreign subs at a lower tax rate—5% instead of 35%. The 2004 “Homeland Investment Act” induced repatriation of $255 billion in 2005, which supported the dollar at the time. We suspect that this time around, similar legislation would be taken as a positive in the equity markets and therefore weaken the dollar against the higher-yielders and strengthen it against the yen.