Dollar rallies on news of US fiscal loosening
13/Dec/2010 • Currency Updates•
The dollar rallied against almost every major currency last week on news of an apparent agreement reached between the White House and Congress Republicans to extend the Bush tax cuts and add new ones. The greenback was also buoyed by the failure of European peripheral bonds to follow up on the previous week’s rally. Asset markets generally responded well to this apparent new attempt at priming the US economic pump through fiscal stimuli, with the unsurprising exception of US fixed income which sold off heavily on the news of the US agreement on tax cuts.
The Bank of England, as expected, left unchanged both the level of rates (0.5%) and the size of its gilt purchase target (GBP200 billion). The other news of note of the week was industrial production, which showed a better than expected increase in manufacturing production. While we expect the draconian fiscal tightening to start biting soon, it is clear that this sector of the British economy is still enjoying the updraft of past sterling depreciation. GBP traded almost tick by tick with the dollar against the euro, ending the week essentially unchanged vs the USD and up 1.6% against the common currency. This total decoupling between GBP and EUR, if it is sustained over the news few weeks, will be a very significant development in forex markets.
We finally enjoyed a relatively quiet week in Europe, free of market-jolting policy announcements or critical macroeconomic data. It is worrisome that in the absence of news, peripheral bonds generally drifted wider, with the absence of Ireland which, like Greece a few months back, has been effectively taken off the market in the short term by the bailout package. Sentiment in peripherals was not helped by the ECB insistence that its support for government bond markets would be limited in scope and duration. Markets are already worrying about the heavy funding news of Spanish and Portuguese public and private issuers in the first half of next year, and the euro sold off slowly but steadily to end down nearly 1.5% against the greenback.
In a week where economic releases were thin, traders were focused on the agreement between the White House and Republican leaders in Congress to extend the Bush tax cuts, which are due to expire at the end of this in the absence of Congressional action. The agreement was surprisingly loose in fiscal terms. In addition to extending the tax cuts for all income brackets, the planned agreement would cut estate taxes and temporarily reduce social security tax on salaries by 2% and extend unemployment benefits. It is clear that the United States refuses to join the Eurozone in ramming through fiscal austerity at a time of high unemployment. Market reactions to these news were telling, though (to us, at least) unsurprising. Equities and commodities rallied, ignoring the news that China would tighten this weekend. Treasuries fell sharply, and the dollar rose strongly, ending the week up nearly 1% in trade-weighted terms. For all the hand-wringing about the US fiscal pictures, it is clear that investors are focusing on the positive effects that fiscal loosening will have on economic performance in the United States.
The near one-to-one correlation between the Japanese yen and US rates is back in full force. After news of the US fiscal agreement hit the tapes, US rates rose all week long, and the Japanese yen sold off in tandem. Our bearish view of the JPY panned out nicely last week, as the JPY lost nearly 1.4% of its value against the greenback to end near the 84 level.
The New Zealand dollar suffered heavily after the RBNZ meeting. It left rates unchanged, as expected, but sounded a distinctly downbeat note on the statement it released and the December Monetary Policy Report. The kiwi sold off sharply as expectations for further hikes receded into the future, ending the week down 2.5%. The Australian and Canadian dollar held up much better, as their respective Central Banks essentially validated market expectations for further hikes. Another of our views has been nicely validated by the markets, as the cross rate between the AUD and the NZD traded above 1.32. We shift to a neutral stance on this currency pair.