Forex: Dollar – Where Is the Redemption Rally with the S&P 500 Slump?

Talking Points:

Dollar: Where Is the Redemption Rally with the S&P 500 Slump?
Euro Finds Little More than Stability with IMF Growth Upgrade
Japanese Yen Weigh their Risk Link Through Carry as Equities Dive

Dollar: Where Is the Redemption Rally with the S&P 500 Slump?
Is this the risk aversion move dollar traders have been waiting for? The S&P 500 suffered a 1.2 percent tumble Tuesday – the biggest in drop in six weeks and a clear break of 2013’s robust support. Furthermore, the VIX Volatility Index (considered a ‘fear’ gauge) climbed above 20 percent for only the second time this year. While the benchmark US equity index is a particularly effective measure of speculative appetite as the tradition portfolio’s ‘risk ‘ asset and its further backstop in stimulus support, it does not alone establish the investment habits of the entire market. And, given the headwinds to the greenback in its local debt ceiling risk; the dollar needs the kind of risk aversion that leverages liquidity.

To override the innate trouble of foreign capital turning away from a US fiscal crisis, the dollar needs to see global financial conditions freeze up and thereby leverage fear while also limiting viable alternatives for liquidity. While the S&P 500 and Dow Jones Industrial Average’s trendline breaks are notable first steps, we have not seen the panic and market-wide deleveraging that are the dollar’s true strengths. We see that clearly enough in the Dow Jones FXCM Dollar Index’s (ticker = USDollar) hold to an ever-tightening trading range – less than 40 points. Perhaps a better illustration of the fundamentals behind this lack of contagion in fear though is the level of the FX Volatility Index. Where the equities version has soared to stones-throw of the 2013 high, the currency measure of fear is at a five month low and continues to drop from its June high. If the dollar is to rally – not simply jump higher – sentiment needs to devolve to more dire and desperate levels.

As we keep a close eye on the intensity of investor sentiment, the ingredients for the changing tides must be monitored. Day 8 of the US government shutdown passed with both the White House and House of Representatives digging in on their budget standoff. To that effect, the market is starting to take the risk of at least some short-term US funding issues seriously (any delay in payment is a technical default). Credit default swaps have swelled to levels last seen in August 2011 when a Washington standoff led the United States to a downgrade of its AAA credit rating by Standard & Poor’s. Another sign of trouble, yields on one-month Treasuries have soared to their highest level since 2008 – leading to an inverted yield curve short of the two-year mark. Meanwhile, giving capital market bulls some hope, it was rumored that Fed Vice Chairman Janet Yellen would receive President Obama’s official nomination to replace Ben Bernanke tomorrow. She has been the frontrunner for some time, and the Fed’s Taper timetable is already delayed. It’s hard to imagine Yellen will seriously expand the dovish pace.

Euro Finds Little More than Stability with IMF Growth Upgrade
The IMF released its updated growth forecasts for the global economy, and the general tone was somber. One significant exception amongst the major regions though was the Eurozone. Despite fears of global fiscal imbalance and blurred monetary policy commitment, Euro-area received a growth upgrade from June for 0.4 percent contraction this year and 1.0 percent growth in 2014 (compared to -0.6 and +0.9 percent). This cautious optimism was accompanied by warnings that the ECB may need to step up with more easing – bearish for the euro – but the FX market has reflected selective reasoning when it comes to this region’s fundamentals. The economic docket clears out for the Euro over the coming 24 hours, but currency traders will do well to follow the local equity indexes – which have so far avoided critical breakdowns.

Japanese Yen Weigh their Risk Link Through Carry as Equities Dive
The short-term (5-day) correlation between EURJPY and the Nikkei 225 is exceptionally high at 0.95. That sets this pair – and truly all yen crosses – in a position to be exceptionally sensitive to risk trends. That relationship should put traders on edge, however, until the US dive escalates into a global rout; the Bank of Japan-yoked yen will refrain from structural reversals. In the meantime, the IMF warned that central bank should be ready to upgrade its stimulus effort should fiscal restraint rein in the economic recovery.

Australian Dollar Faces Inflation Survey, Employment Data
With US equities tumbling, we would expect the carry trade to be taking a sizable hit with the Australian dollar leading the way. Instead, the currency managed to gain – albeit modestly – against nearly all of its major counterparts. Carry trade levels were notably stable and the FX volatility measure was showing little of the pressure heaped on US stocks. Meanwhile, the 12-month RBA rate forecast jumped to its highest level since June 2011 (though only 9 bps). Coming up, we have September jobs numbers and October inflation expectations.

British Pound Rate Forecast Keeps Focus on BoE Through Upcoming Data
The sterling is looking at a dense round of event risk over the coming trading day. Yet, unless this data taps into deeper concerns on general risk trends and rate forecasts, pound traders may discount the calendar items to maintain focus on the Bank of England’s (BoE) rate decision on Thursday. Regardless, traders should take stock of the industrial production and trading balance figures for August as well as the NIESR’s September GDP estimate to add to assess short-term volatility impact and medium-term growth forecasts.

Swiss Franc: Effective Forward Guidance – But for How Long?
In a speech on monetary policy Tuesday, Swiss National Bank (SNB) President Thomas Jordan remarked that the policy authority hasn’t had to actively defend their cap on the currency with intervention in over a year. Indeed, we haven’t seen EURCHF at 1.2000 since September of last year. Has the SNB hit upon the most effective unconventional monetary policy effort of its counterparts? While it may be working, it is ultimately currency manipulation and thereby not replicable. As liquidity becomes more highly prized, expect the franc to gain.

Gold Building Pressure as Tight Range Faces US Fiscal Measures
The CBOE’s Gold ETF Volatility Index doesn’t give us an accurate picture of the breakout risk behind the precious metal. The implied volatility measure stands above 25 percent – above the one and three-month averages. Looking at a more price-based Average True Range (ATR), we find gold is trading with $25 average daily range which appropriate reflects the congestion we have developed between the descending trend from late August against the three-month floor at $1,275. Be on the look out for swells in volatility and a possible breakout.

**For a full list of upcoming event risk and past releases, go to www.dailyfx.com/calendar

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