Dollar rally continues as investors flee to safe havens

Tom Tong28/May/2012Currency Updates

Gloom deepened in most financial markets last week. Commodities, currencies and credit indices fell sharply, and the main beneficiaries were again the dollar and non-peripheral Government bonds. Interestingly, non-European equities bucked the trend, stabilizing in a week where nearly every other risk asset sold off. More negative news from the Eurozone and China contrasted with moderately optimistic reports out of the United States. Some safe havens continued to benefit from investors pessimism, as the US dollar rose nearly 1%, as German yields dropped to yet another all-time low (two-year bonds were auctioned off at essentially zero interest rate last week). Dismal economic, political and financial news in the Eurozone drove the Euro to two-year lows, as European authorities once again delayed critical decisions until a summit to be held in late June.

The common currency has now reached our target for the first quarter, down to 1.25 dollars. It was only a few weeks ago that this forecast was lower than that of just about all market strategists and commentators. We will be releasing updated currency forecasts this week.


Very busy week in the UK. Inflation numbers, GDP revisions and the MPC minutes all came out last week, and all of them supported our view that the Bank of England will be considerably more dovish than the consensus expects. GDP growth for the first quarter was revised down by 0.4% annualized, to -1.2%. April inflation surprised to the downside. The headline YoY figured dropped sharply from 3.5% to 3.0%. Finally, the MPC minutes showed that, in spite of the 8-1 vote, “several members” had been on the fence as to the May decision not to extend QE. We think that the consistently negative macroeconomic surprises published since the meeting, together with the deteriorating crisis in the Eurozone, will push the committee towards an increase in the gilt purchase target as early as June meeting; for now, ours remains very much a minority view, as most commentators expect no such decision until later in the summer at the earliest. Sterling continued behaving in the manner we have been predicting, as a low-beta version of the Euro. It rose by about 0.8% against the common currency while dropping by almost the exact same amount against the greenback.


The string of disastrous macroeconomic and policy news out of the eurozone continued unabated throughout last week. The PMI business sentiment indicators surprised sharply to the downside, down to 45.9 in May and firmly in contractionary territory for the eurozone as a whole. The pain is now clearly spreading from the periphery into the core; Germany’s manufacturing PMI dropped to 44.6, which bodes ill for the German export machine. Commentators are coming around to our view that the eurozone is firmly in a recession that will be neither shallow nor short. It is increasingly clear that the main hope for the common currency is now a policy response that swings away unambiguously from the disastrous austerity policies implemented so far, and there is very little to indicate that such a change is in the offing. The informal summit last week delayed any decisions to the European Council to be held in June 28-29. Given the increasingly precarious state of Spanish banks, where Bankia shocked markets announcing that it will need an additional 19 billion euros of state aid to avoid insolvency (about 2% of Spanish GDP), as well as the upcoming June elections in Greece, this lackadaisical approach to the crisis on the part of European authorities is breathtakingly irresponsible, and will lead us to revise our medium term forecasts for the common currency even lower this week. We cannot avoid the immodesty of pointing out that, once again, our quarterly target for the common currency has proven to be right on the money.


There were mixed news out of the US last week. On the one hand, a spate of better than expected reports on the housing sector confirmed our view that housing is providing some support to the US recovery, as it rebounds from its 2011 bottom. Stocks of unsold housing are back to pre crisis levels, and prices appear to be finally bottoming out. Rising rents around the country also seem to be consistent with a moderate housing shortage, as the excesses of the real estate bubble have now been more than fully corrected. News out of manufacturing were less positive. The durable goods report for April was sharply lower than expected, although it was contradicted to some extent by the industrial production report for the same month. These were all April data, however. It will be critical to see what effect the worsening Euro crisis will have on business confidence, and for that we await the May data, led by the employment report next week. For now, we maintain our cautiously optimistic outlook on the US economy and the dollar.


Written by Tom Tong

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