Narrowing deficit, Euro zone rates and risk aversion prop the dollar

Bad news, bad news and bad news is all that has being heard about the US economy! Employment has fallen, consumption is down, and exports have been hit. But, the US dollar seems to be ignoring all this and quietly strengthened early this week.

A few key factors seem to be driving the dollar up, including a huge fall in the US trade deficit and the expectation that the Euro zone is likely to lower interest rates. The third factor is driven by emerging risk aversion due to weak economic performance across most major economies. The fall in the US trade deficit may be viewed as a positive development as it had grown to unsustainable levels and could have resulted in an economic catastrophe leading to global economic repercussions. The ensuing economic recession seems to have cushioned that eventuality by reducing the purchasing power at the hands of Americans resulting in lowered imports and a reduction in the trade deficit. Softer oil prices have also helped reduce America’s import bill and helped reduce the trade deficit. The US trade deficit fell by nearly 29% to $40.4 billion as per official data released for November 2008.

Economic woes in Europe also appear to be forcing Euro zone policy makers to cut interest rates. This would automatically lead to the Euro becoming less attractive and pare some of its value. Euro’s loss seems to be the dollar’s gain and has led the greenback to firm up. The weakening position of Euro zone has also been accentuated by Spain’s economic performance. The Spanish economy which had AAA long term sovereign credit ratings, seems to be in for a downgrade. Spain’s economy, which has been the engine of Euro growth, is now tipped to enter a recessionary phase.  November data for Spain revealed that industrial output fell 15.1%, which was the biggest fall in 15 years. The 15.1% fall was on the back of a 12.8% decline in October 2008 and the eighth consecutive month of falling output. One of the worst hit sectors was the auto sector, which recorded a steep fall of 39.3% in November. Spain’s auto sector is the third largest in Europe and a cutback in the sector is resulting in job losses. The fall in industrial output has also started denting the consumer sentiment, with consumer demand dropping 9.4% in November.

The emerging economic uncertainty across Asia, Europe and the Americas seems to be making investors take a hedge in US treasuries as a safe haven. This is resulting in them dumping local currency holdings and buying US dollars to buy US treasuries. All major currencies including the Canadian dollar, Australian dollar and the Euro lost value to the dollar due to the risk aversion phenomenon. The spreading risk aversion is also likely to prop the Yen, which is considered another safe haven currency. Latest news suggests that stock sell off in Asia is leading to a fall in the bourses. It appears the money recovered from the stock sell offs is finding its way into the Yen as well, and the currency appears to be strengthening.

Thus an appreciating US dollar and a strengthening Yen may find short term favor as economic weakness persists. Let’s also recall that poor annual corporate results are widely anticipated which is likely to accentuate the stock sell off. This may further spike up the dollar and the Yen in line with the expected trend.