USD Recovers Amid Broad Pullback in Risk

The U.S. dollar starts this holiday-shortened week in broadly positive territory after sliding on in the wake of Friday’s uninspiring jobs report and dismal services sector ISM data. Overnight, a Wall Street Journal story reported that July’s European bank stress test failed to paint an accurate picture of the holdings of many large banks in the 16-member bloc. The renewed concerns about the continent’s fragile banking sector prompted investor to pare back on riskier assets accumulated over the past weeks and trim their short-USD positions amid a broad flight to safety across financial markets. Despite the mounting signs that America’s economy is losing momentum, the dollar should continue to benefit from concerns about the health of the global economy and from lingering worries about Europe’s banking and debt issues. 

The single currency slid across the board after the Wall Street Journal story rekindled worries about Europe’s banks. Data showing a steep slide in German manufacturing orders as a result of soft foreign demand added to the euro’s heavy tone and highlighted the dependence of the bloc’s recovery on still shaky external demand. The euro should remain vulnerable amid a backdrop of global growth concerns and diminished risk appetite.

The Aussie gave up some if its recent gains after Labor Prime Minister Julia Gillard formed a coalition government with independent and Green Party members. The Labor/Green coalition greatly increases the risk of the government going ahead with a controversial 30% mining tax and new initiatives to limit carbon emissions, both seen as undermining Australia’s economic strength. 

The Bank of Japan expectedly left monetary policy unchanged overnight. Governor Shirakawa said that monetary authorities could not control exchange rates, signaling a lower risk or market intervention by the BOJ.

USD: The greenback once again benefited from the broad pullback in investors’ appetite for riskier assets. The Wall Street Journal Story highlighting the flaws in Europe’s bank stress tests reignited concerns about the health of the continent’s banks and prompted investors to pare exposure to stocks, commodities and higher yielding currencies. The low yielding, safe haven dollar was boosted by the broad flight to safety, despite the mounting signs that America’s recovery may be faltering. The dollar should continue to outperform most of its rivals amid a backdrop of growing concerns about the global economic recovery, increasing worries about European debt and banking issues and a general decline in investor sentiment. An increasing risk of a double dip recession would dull some of the greenback’s safe-haven allure, but is not likely to trigger a wholesale abandonment of dollar assets. Under a scenario of declining risk appetite throughout global markets, the yen and Swiss franc should also outperform.

EUR: A Wall Street Journal story reported the flawed design of Europe’s bank stress tests allowed some of the continent’s largest banks to conceal their true exposure to risky government debt of peripheral euro zone nations like Greece, Spain, Portugal and Ireland. Consequently, the surprisingly rosy results of the stress test failed to paint an accurate picture of the health of Europe’s banks. The story came on the heels of an announcement from Germany’s banking body that said the nation’s largest banks may need another 100 billion euro’s in capital under proposed banking reforms. Data overnight added to the single currencies heavier tone. German industrial orders fell by 2.2%(m/m) in July as a result of a sharp decline in foreign orders. The drop in external demand coincides with a rise in the price of the euro this summer and suggests that Europe’s recovery is likely to lose steam into the year-end.

AUD: Australia’s Labor Prime Minister barely held onto power by forming a coalition government with independent and Green lawmakers. The new government is likely to push ahead with a controversial 30% tax on the nation’s dominant mining sector and could go ahead with a new initiative to limit carbon emissions. Both plans are seen as anti-business and could stifle the nation’s recovery. Separately, the Reserve Bank expectedly left lending rates unchanged at 4.5% for the fourth month in a row.

GBP: The broad decline in risk appetite across global markets and the steep slide in equities undermined the appeal of the pound, which fell to a six-week low overnight. Last week’s batch of soft U.K. economic data highlighted concerns about a loss of momentum in Britain’s recovery. Additional weakness in global markets should keep the pound vulnerable across the board. 

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