The Hawks Are Circling
Last week's sharp mid-week decline in the U.S. equity markets was closely related to the rise of the 10-year U.S. Treasury yield and the rally in the U.S. Dollar. Now the greenback is suddenly on the warpath, hitting two-month highs after reaching a multi-year low vs. the Euro within the past few months (see figure 1).
Figure 1: Euro trades at lowest point vs. U.S. Dollar in two months. Source: Saxo Bank
The daily chart of GBP/USD has a similar look to that of EUR/USD, as "Cable" falls away from the much-lauded 2.0000 milestone (see figure 2). A reasonable question to ask at this point would be, "What has changed?" Let's take a look at the reasons for these moves, and delve into the dynamics of intermarket relationships.
Figure 2: Great Britain Pound slides back vs. the U.S. Dollar. Source: Saxo Bank
All of these events occurred as a response to interest rate concerns, as expectations have now made a complete u-turn since the beginning of the year. Back then, the consensus was that Ben Bernanke and his cohorts at the Federal Reserve would cut rates at least once by the end of 2007. Then something changed - over the past few months, signs of a U.S. economic rebound began to appear, and inflation proved to be stubborn. The expected rate cuts – which were boosting stocks but crippling the U.S. Dollar - were slowly ‘priced out' of the markets.
Fast forward to June of 2007 - now the hawks are circling. Bernanke said on June 5 that while inflation will "moderate gradually over time, the risks to this forecast remain to the upside." On June 6, Cleveland Fed President Sandra Pianalto said that prices are rising too quickly. Now we have come full circle, and for the first time this year a rate hike now seems more likely than a rate cut before year's end. As if to drive this point home, the yield on the 10-year U.S. Treasury note briefly touched 5.25 percent last week, its highest level since May 2002.
The idea of higher interest rates is anathema to the equity markets, as companies must borrow money in order to facilitate business. If the cost of borrowing rises for these companies, it will cut into their bottom line and profits will suffer. So last week's stock sell-off in reaction to the Fed's hawkish stance came as no surprise.
The bond markets also fell, and it's easy to see why. Suppose you are holding a 10-year U.S. Treasury note (often called a ‘T-note') that yields 5.00% interest. Several months ago, this might have seemed like a good investment, since traders assumed at that time that rates were going lower. Now that interest rate expectations have changed dramatically, so has the perceived value of such an investment. Why own a fixed income investment with a 5.00% yield when 5.25% is available? The lower yielding 5.00% investment is now less appealing, and as a consequence it falls in value. Falling bond prices serve to make fixed-income investments more attractive, because as bond prices fall, their net yields climb. The price of a lower-yielding 5.00% bond must fall in order to compete with a higher-yielding 5.25% return. When taking the change in rate expectations into consideration, its easy to see why last week's slide in the 10-year T-note was its biggest weekly decline since 2005.
Ah, but while stocks and bonds were taking it on the chin last week, the buck suddenly awoke from its slumber and hit a two-month high against the Euro. Why did the greenback respond in this manner? While many other trading vehicles react negatively to higher interest rates, currencies tend to flourish when borrowing costs rise.
Earlier we mentioned that the U.S. 10-year T-note reached a yield of 5.25% last week, its highest point in about five years. How does this affect the U.S. Dollar? Investors around the world see that attractive 5.25% yield, and they want to obtain it. Can an investor from Japan purchase U.S. Treasuries? Yes, but not with Japanese Yen. Bond buyers will have to sell Yen in order to obtain the U.S. Dollars needed to make this purchase. When investors sell a large quantity of Yen, the Japanese currency falls, and when they purchase U.S. Dollars with the proceeds, the greenback begins to rise. In this manner, international capital is driven toward countries with higher yielding fixed income investments, and away from countries that offer lower-yielding instruments.
One more reason to get excited by the greenback's strong performance last week - a quick peek at the U.S. Dollar Index shows that the rally has brought us right up through resistance to a two month high, peaking just below 83.00. The U.S. Dollar Index measures the buck vs. a basket of currencies that includes the Euro, the British Pound, and the Japanese Yen, among others (see figure 3). As a caveat, keep in mind that the recent USD rally and possible rate hike do nothing to improve the fundamental woes of the greenback.
Figure 3: The U.S. Dollar Index gaps and rallies up through resistance. Source: FX Trek
Intervention
Speaking of higher interest rates, the Reserve Bank of New Zealand (RBNZ) gave that country's dollar, affectionately known as the ‘Kiwi', a shot in the arm when it boosted its benchmark rate to 8.00% on June 7. Alan Bollard, governor of the RBNZ and a reluctant hawk, stated once again that the New Zealand Dollar was "both exceptionally high and unjustified" in his monetary policy statement, and said the central bank "hopefully" won't have to raise interest rates again The RBNZ has already raised rates three time this year, and may do so again at their next meeting on July 26.
Then on Monday, June 11, the RBNZ shocked the markets with an intervention, causing the Kiwi to plummet from a new 22-year high vs. the U.S. Dollar (see figure 4). The RBNZ pushed NZD/USD down by over 100 pips by buying U.S. Dollars on the open market, and they may not be finished. The central bank has $7 billion set aside to influence the currency, and used only a small fraction of that amount on Monday. Here's some food for thought – wouldn't it be interesting if other central banks followed suit?
Figure 4: NZD/USD falls hard on RBNZ intervention. Source: Saxo Bank
Question of the Week
Q) Hi Ed, could you shed some light on mini accounts? Since I have very limited funds, I'm considering starting off with a mini account.
Ed Ponsi) Thank you for your question. Many traders are not aware that very small Forex trading accounts are available, and that an account can be opened with as little as a few hundred dollars. This is in sharp contrast to U.S. stock traders, who are forced to maintain a balance of at least $25,000 USD because of the Pattern Day Trader (PTD) rule. Mini accounts are offered by most Forex brokers, and allow traders to gain valuable experience trading real money while risking little capital. The typical lot size of a mini account is one-tenth the size of a standard lot, although some brokers allow traders to customize the size of one lot to their own specifications. These accounts are perfect for new traders, or for anyone who wishes to limit risk, and I highly recommend that traders gain experience on a mini account before graduating to a standard sized account.
Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading. |
Ed Ponsi is a globally recognized name as a lecturer and teacher and is the former Chief Trading Instructor for Forex Capital Markets. An experienced professional trader and money manager, Ed has advised hedge funds, institutional traders, and individuals of all levels of skill and experience. He is a regular contributor to TradingMarkets.com, SFO Magazine and FX Street, and is currently writing his first book for Wiley Finance.