US dollar under pressure

May 15, 2009 — Mitul Kotecha

The US dollar has come under major pressure, with the US dollar index (a composite of the dollar against various currencies) falling to 4-month lows.   The weakness of the US dollar has been broad based and even the Japanese yen which normally weakens as risk appetite improves, has strengthened against the USD.  The euro has also taken advantage of dollar weakness despite ongoing concerns about the European economy. The main source of pressure on the dollar is the improvement in market appetite for risk.  

As I noted in a previous post, “What drives currencies?” risk appetite has been one of the biggest drivers of currencies in the past year.   This has pushed other drivers such as interest rate differentials into the background.   In the post I also stated that we would all have to watch equity markets to determine where currencies will move, with stronger equities implying a weaker dollar.

The dollar looks particularly sickly at present and it is difficult to go against the trend.  It will need a major reversal in equity markets or risk appetite to see a renewed strengthening in the dollar.   Although I still think it will require some positive news as opposed to less negative news to keep the momentum in equity markets going (see previous post) the prospects for a stronger dollar remain limited.   

Over the coming months the dollar is set to weaken further and those currencies that have suffered most at the hands of a strong dollar will benefit the most as risk appetite improves.  It is no coincidence that the UK pound has strengthened sharply over recent days, and this is likely to continue given its past undervaluation.  Other currencies which were badly beaten such as the Australian dollar and Canadian dollar will also continue to make up ground, helped too by a rebound in commodity prices.   

Aside from improving risk appetite the dollar may also come under growing pressure from the Fed’s quantitative easing policy, especially if inflation expectations in the US rise relative to other countries as a consequence of this policy.  It will be crucial that the Fed removes QE in a timely manner and many dollar investors will be watching the Fed’s exit strategy closely.  

Although the US trade deficit is showing improvement another concern for dollar investors is the burgeoning fiscal deficit.   The US administration revised up its estimate for the FY 2009 deficit to $1.84 trillion or about 12.9% of GDP, highlighting the dramatic deterioration in the US fiscal position.  Concerns about this were highlighted in an FT article warning about the risk to US credit ratings.

The deterioration in dollar sentiment has also been reflected in speculative market positioning, which has seen speculative appetite for the dollar drop to its lowest level in several months. The bottom line is that any recovery in the dollar over the coming weeks is likely to be limited offering investors to take fresh short positions as investors continue to move away from holding the dollar.

Posted in central banks, Commodities, Currencies, Economics, equity markets, Europe, Financial crisis, US, US administration. Tags: , , , , , , , , , , , , , , , , . 6 Comments »

How compelling are equity valuations?

May 12, 2009 — Mitul Kotecha

Relief over the results of the US bank stress tests, better than expected US jobs data, generally less negative economic data in general, as well as better than expected Q1 earnings provided markets with plenty of fuel over recent days and weeks. This has helped to spur an improvement in risk appetite and a resultant strengthening in equity markets. Meanwhile, government bonds have sold off, commodity prices have risen and the USD has weakened.

At the time of writing the S&P 500 has recouped all its losses for the year, having climbed around 34% from its low on 9th March. To many this has sent a bullish signal about the path of the economy ahead given the historical lag of around 5 to 6-months between equity gains and economic recovery but to others include myself this is sending a false signal. Even if the economy stabilizes any recovery is likely to be slow.

As stocks have risen, cautiousness about the current rally has intensified, with many now calling for equities to correct lower. This could partly reflect sour grapes from those investors who have missed the move in equities (I like to think that I am not in this camp even if I did miss the move) but there is also an element of truth in terms of equity market valuations, which have risen sharply over recent weeks. Although arguing whether stocks are cheap or expensive depends on what measures are used there is even some caution coming from equity bulls.

Bloomberg estimates one measure of equity valuation, the Price / Earnings ratio of the S&P 500 at 14.78, which is still below the estimated P/E ratio of 15.96 but much higher than the P/E ratio of around 10 at the beginning of March. Other estimates also suggest that the current P/E ratio on the S&P 500 is approaching a long run average, which suggests that further upside for equities may be more difficult in the weeks ahead.

What now? So far markets have reacted to the fact that economic conditions are the past the worst and the reaction has reflected less negative economic data releases, with many data releases coming in ahead of expectations. Going forward, it will require actual positive news as opposed to less negative news to keep the momentum going. If positive news is lacking the improvement in risk appetite and equity market rally will falter, especially as valuations are arguably far less compelling now.

I would be interested in your view about whether you think the rally will continue. Please tick the the relevant circle in poll on the sidebar to give your view and also view what others are thinking.

Posted in bank rescue, Bond markets, Commodities, Currencies, Economics, equity markets, Financial crisis, US, US administration. Tags: , , , , , , , , , , , , . 5 Comments »

Fed throwing everything but the kitchen sink at the crisis

March 20, 2009 — Mitul Kotecha

The aftermath of the Fed’s surprise decision to buy US Treasuries was dramatic across markets, with Treasury yields dropping, equities rallying and the dollar sliding. The Fed has now moved from what was initially credit easing to full blown quantitative easing. Effectively the Fed is throwing everything but the kitchen sink at the problem and is arguably the most aggressive central bank at present.

What are the implications:

1) Equities like the news and it helped extend a rally that had been in effect for a couple of weeks. But the momentum is likely to run out quickly as the bad news starts to filter back into the market once again.

2) Commodity prices rallied, especially gold. Why? Inflation concerns intensified following the Fed move due to the risk that the Fed will not be able to end it’s programme of “printing money” quickly once the economy starts to turn around. Commodities are set to rally further.

3) The dollar dropped like a stone, and although it is difficult to see it regaining much ground in the wake of a central bank that flushing the market with dollars, its falls looks overdone. For now, the dollar looks like it has entered new weaker currencies and may even benefit if the market appetite for risk declines again.

4) Other central banks in particular the European central bank will be under huge pressure to follow the Fed. The Bank of England, Bank of Japan and Swiss National Bank have already moved but not as aggressively as the Fed. So far the ECB has been reluctant to act and technical issues mean that it can’t act in the same way as the Fed. Nonetheless, the rise in the euro means that something may need to be done and quickly.

5) The move by the Fed shows that policy makers are doing all they can to turn things around, but this is merely a reflection of the severity of the crisis. Economic recovery is still some months away

Posted in Bond markets, central banks, Commodities, Currencies, Economics, equity markets. Tags: , , . Leave a Comment »
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