Global FX

Movements in the foreign exchange were relatively small in the past fortnight, reflecting partly the dearth of market moving events, and the lack of conviction among investors as to how to trade the dollar.

In the past several months, investors would tend to sell the dollar whenever positive economic reports were released.  The dollar was viewed as a safe haven, a place to park money in volatile times.  In contrast, improving economic outlook would increase investors' appetite for risk, leading to stronger demand for riskier assets such as equities and higher yielding currencies such as the Australian and New Zealand dollars.

But recently, there are signs that investors might be moving away from the risk appetite theme, with some starting to focus on the dollar's own fundamentals.  An improving US economic outlook could be positive for the dollar, particularly when prospects for the European economies remain clouded by uncertainty over the banking sector.  According to the European Central Bank. euro zone banks would need to write down another USD283 billion on bad loans and securities, in addition to the USD366 billion that have been written down since the start of the financial crisis in mid-2007.  It will be interesting to see how investors react to the Fed statement due for release after its policy meeting on June 24.  The Fed would probably say that the economy has bit bottom but recovery is still far off.

In addition to the tug of war between the risk theme and economic fundamentals, the dollar's outlook also depends on how investors see the dollar's future as a world reserve currency.  More emerging countries, led by Russia and the Mainland are talking and actually taking action to diversify their reserve portfolios away from the greenback. 

Interest Rates

With financial market strains showing clear signs of easing and the release of more positive economic reports, in particular the better than expected May nonfarm payroll report on June 5,  there has been growing optimism that the global recession might be easing.  Some were convinced that the Fed would have to depart from its near-zero interest rate policy sooner than expected.  In the interest rate futures market, investors at one time priced-in an over 80% chance of a rate hike to 0.5% in December.  Such expectations caused US Treasury yields to surge with the two-year rate rising to 1.4% on June 8, their highest levels since November 2008.

It is true that financial strains are easing, as evidenced by a narrowing spread between what banks and the US Treasury pay to borrow three-month funds, commonly known as the TED spread.  Economic sentiment has also been improving.  Nevertheless, it seems that the recent optimism about a worldwide economic rebound might be premature.

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