The USD is in a win-win situation at present. Good economic data in the US helps to advance expectations of US monetary tightening, lending the USD support, regardless of the positive impact on risk appetite. Similarly, bad economic news is also supporting the USD as it leads to higher risk aversion. Either way the USD has surged over the past few weeks, appreciating by close to 5% since its low on 25 November.
There was a similar but directionally opposite move in the USD last year taking place from almost the same time. The USD index hit a high around 21 November 2008 but fell by over 10% in just less than a month. If the same pattern is repeated this year the USD index has much further to strengthen although it is worth noting that the drop in the USD last year reversed practically to this day a year ago, with the USD subsequently rising by close to 13% in the next few months.
Given that the move at the end of last year may not be the best comparison given the distortions due to the crisis and massive repatriation to the US in Q1 2009 it’s worth looking at what happened in 2006 and 2007 for a better comparison. From the beginning of December 2006 to 11 January 2007 the USD strengthened by 3.5% but then dropped by around 4.5% within the next 3 months. Similarly, the USD strengthened by close to 4% from the end of November 2007 to 20 December 2007. However, the USD dropped by over 8% in the three months after. So what I am saying is that it is way too early to suggest that the USD rebound will be sustained over coming months and judging by past evidence all its doing is proving better levels to sell for a subsequent decline over Q1 2010.
Is the USD really in a win-win situation? Well, the more plausible explanation is perhaps a bit more simplistic. It’s year end and the market is squaring up, with FX moves being exaggerated by thinning liquidity. There is some support to this theory from the CFTC Commitment of Traders IMM data which revealed a sharp reduction in net aggregate USD short positions in the latest week, with a further sharp reduction in net short positions expected in next week’s release.
Whilst it is too early to buck the trend yet, going into early next I look for a reversal of the recent appreciation in the USD against the background of improving risk appetite and US interest rates that are unlikely to go for a long while yet.