The US dollar and broader capital markets were jolted Monday by Standard and Poor’s revised outlook for the United States’ sovereign credit rating. This unprecedented shift in confidence for the long-established safe haven for the global financial markets accompanied dramatic volatility in equities, commodities, fixed income and especially currency markets. However, not all of these price developments fit the standard model for what would be expected for just a situation. Furthermore, a few of these moves didn’t actually sync up to the fundamental fireworks during the early hours of the New York trading session. We need to dig a little deeper into the meaning of this event and its implications on the US-based assets as well as the broader sense of investor sentiment market-wide.
First, we need to understand what happened. It is important to recognize that this was not a downgrade for the country’s sovereign debt rating. The ratings agency lowered its outlook for the nation’s benchmark rating from ‘stable’ to ‘negative’ which means the next change is most likely to be a cut (which technically guaranteed because it cannot be further boosted from its AAA status). According to Standard & Poor’s approach, this revised view means there is a one-in-three chance that the sovereign credit rating will be lowered in the next two years. The reasoning for the drop in confidence is pretty straightforward. The group suggested there were “material risks” that the country will fail to deal with its rising deficits and debts over the next few years and see its financial health deteriorate further. So, what this boils down to is a warning. Yet, for a market that has long ignored growing risks in all corners of the financial world; a threat like this to stimulus and the steady climb in prices is unnerving.
In terms of actual impact, we would expect the constant fear of a US downgrade to hit the value of the nation’s assets as well as undermine sentiment as would be expected from a threat to the world’s safe haven. Indeed, we saw that the news was met by a sharp decline from S&P 500 futures; but was that more a concern about investing in the US or a blow to bullish positioning globally? For an answer, we can look to the US dollar. We would expect the greenback to tumble with a direct risk to its role as the world’s safe haven. Instead, the currency leveraged its biggest rally since January 5th. Upon reflection, the probability of a downgrade is still quite low; and even a one-step move will not depose the greenback as the most frequently-used reserve currency. Alternatively, this is another reminder that the capital markets are facing considerable headwinds and running on considerable levels of temporary stimulus at the same time. We are at a tipping point. Should risk appetite continue to falter from here, the greenback will maintain its gains and likely appreciate further despite its new troubles. Alternatively, a rebound in investor optimism will leave the currency with another burden to put it at the bottom of the pack.
Euro Tumbles as Confidence Falters, Leverages Region’s Growing Financial Troubles
Given the bombastic headlines the US outlook downgrade made, it would be easy to assign the euro’s troubles Monday to the crosswinds from EURUSD. However, a look at intraday activity shows that the euro was selling off well before the US news hit the wires. There is no shortage of outlets for uncertainty when it comes to the euro. Over the weekend, a Greek newspaper quoted an unnamed IMF official as saying Greece had already formerly requested an approval for debt restructuring. The country’s Finance Ministry denied this tale; but the market didn’t seem to be concerned about it legitimacy. The yield on the two-year government note surged above 20 percent while the five-year credit default swaps (essentially insurance against the country backing out of paying its obligations) rose to a record 1,297 basis points. In other news, Portugal repaid a 4.2 billion euro maturing bond; while concern grew that its next 5 billion repayment on June 15th would require assistance. And, even Spain was dealt a blow when its 12 and 18 month bill sales met weaker demand and higher rates. With interest rate expectations falling back to earth, it is difficult to ignore these troubles. In the upcoming session, we’ll keep an eye on the PMI figures as a gauge for economic health.
Canadian Dollar Stirs on US Activity, Rate Watchers Look Forward to CPI Data
When we gauge correlations, the Canadian dollar often takes the same bearing as its Australian and New Zealand counterparts thanks to demand for the nation’s natural resources. However, the yield on the loonie is still quite low; and this keeps USDCAD volatility under country and holds the currency back from outperforming its higher-yielding counterparts. Yet, it should be noted that the 12-month rate forecast for the Bank of Canada is actually now the highest amongst its major counterparts. With the market pricing in 91 bps of cumulative hikes over the coming 12 months, potential for yield appreciation is higher than that of the euro. For this reason, we should pay close attention to Tuesday’s CPI figures. Despite rate forecasts, FX traders have paid little heed to rate expectations. If we combine price pressures to the mix, we could have a catalyst.
New Zealand Dollar Tumbles as 1Q Inflation Figures Offer Little Hope of Near-Term Hikes
If the US were running year-over-year inflation of 4.5 percent, the greenback would be soaring. However, for the New Zealand dollar; this clip is not considered fast enough to force RBNZ Governor Alan Bollard’s hand with a near-term rate hike. With a 0.8 percent climb in prices through the quarter, the data missed the official consensus and left one week market rates (Libor) at their lowest level in 12 months.
British Pound Holds its Ground Well Despite Monday’s Blow to Risk Appetite
The economic docket was not exactly impressive for the British pound; and yet the currency still performance remarkably well through Monday’s trading session. Where the dollar managed substantial gains against most of its counterparts and the euro dropped like a stone across the board; the sterling was steady throughout. A tempered interest rate outlook seems to work both ways for the currency.
Hits a New Record High as Dollar Alternative Role Leveraged by Standard & Poor’s
A move towards risk aversion sparked by Standard & Poor’s lowering its outlook for the US could have hurt gold as investors scrambled raised liquidity to cover their losses in other asset classes. However, there is a genuine threat to the appeal of the US dollar with this development; and while that concern is obscured with capital flows within the FX market, it quite clear when we see the fresh record high for the fiat alternative.
