The U.S. dollar rallied aggressively, leading many investors to believe that the greenback has finally found a bottom. We remain skeptical because the fundamental dynamics have not changed materially but at the same time, we have to respect the strength of today’s reversal and acknowledge that continuation tends to follow such strong moves. The dollar recovered against every major currency with the largest gains seen against the euro, Australian and Canadian dollars. Although profit taking contributed today’s moves, there are 3 primary factors behind the dollar’s rise:
1. China Hikes Interest Rates by 25bp
The initial sell-off in higher yielding currencies and rally in the U.S. dollar was triggered by China’s surprise decision to raise interest rates by 25bp. The Chinese central bank provided no details following their rate announcement but the timing provides many clues. Tomorrow night, China has a number of key economic reports due for release including GDP, consumer prices, retail sales and industrial production. There is a good chance that China's recovery has gained momentum and its strength may have driven inflation to intolerable levels. The government also wants to clamp down on the housing market with property prices rising 9.1 percent in September from the year prior. Recent initiatives from China including the recent reserve ratio hike and the requirement of a 30 percent down payment for first time home-buyers shows the government's urgency to cool their over-heated economy. In reaction, investors bought back dollars aggressively on the fear that the rate hike will slow Chinese growth and in turn the global recovery.
2. Fed Officials Express Skepticism about Need for More Stimulus
The rally in the dollar gained momentum after Fed Presidents Fisher and Kocherlakota expressed skepticism about the need for further asset purchases. Fisher said the Fed is not committed to further asset purchases and that the debate on possible easing may not be completed in November. He also suggested that Hoenig’s hawkish views deserve consideration. Kocherlakota on the other hand does not believe that additional Fed purchases will be enough to boost the economy. However Fisher and Kocherlakota are not voting members of the FOMC this year, which means their views have less sway on Fed policy. On the other side of the spectrum is Evans, who is also a non-voter. Evans believes that not only does the Fed need to increase stimulus but the central bank needs to engage in numerous large scale purchases to boost inflation. The only voting member of the FOMC to speak this morning was Dudley who reiterated his view that the U.S. needs more stimulus. Later this evening, Bernanke and Board member Duke will be speaking. After Friday’s speech, we know that Bernanke believes there is a case for further action but Duke has been on the fence regarding QE and so we will be watching her comments closely.
3. Other Central Banks Take a More Moderate Stance
At the same time, other central banks are taking a more moderate stance towards normalizing monetary policy. The Bank of Canada left interest rates unchanged this morning and sounded fairly pessimistic after lowering their GDP forecasts for 2010 and 2011. Even the Reserve Bank of Australia has grown a bit more wary of their strong currency, saying that the appreciation of exchange rates has tightened domestic financial conditions and therefore reduced their urgency to raise interest rates at their last meeting. Comments from Bank of England Governor King suggest that the central bank is growing more willing to ease monetary policy because in their eyes, inflation indicators are “extremely subdued.” The ECB on the other hand is comfortable with their current monetary policy. Trichet reminded us today that inflation is their primary objective and right now, inflation expectations remain firmly anchored. Nonetheless, the more moderate comments from central banks have contributed to the rally in the U.S. dollar and the sell-off in other currencies. - Courtesy of FX360.com