The USD Link

Was Friday's dollar rally a sign that the economic illogic of the past months and the dollar risk trade is coming to an end? Or was it only some seasonal profit taking? Three connected markets, currencies, gold and Treasuries, had significant price reversals after the jobs release. Each market moved in the direction that associates an expanding US economy with higher interest rates and a stronger dollar.

In the currencies the dollar index gained 1.7%, the yen depreciated 3.1% against the dollar, more than in any single session since last October, and the euro dropped more than two hundred and fifty points. Gold fell $79 from its record high of the day before and Treasuries sank farther than any day since the summer. The Dow gave back most of its 150 point gain after reaching a new high for 2009.

The Employment Situation Report from the Bureau of Labor Statistics (BLS) was an unexpected dose of positive news. Payrolls shrank by 11,000 in November, far less than the 125,000 most economists expected. It was the best reading in over two years. The unemployment rate improved 0.2%, to 10.0%, equally unpredicted. The 11,000 reduction in payrolls was small enough so that the BLS officially considered the payrolls unchanged for the month. The American economy may well have produced jobs in November when the revisions are calculated next month.

For many currency traders Non Farm Payrolls (NFP) was a simple indicator to convert year end profit. But if the United States economy really is in rehabilitation and markets are beginning to reassert traditional economic and interest rate linkages then the price directions established Friday should continue. The dollar would not remain wedded to the risk trade, gold (and commodities) will lose much of their trading luster, Treasury prices will decline further and US interest rate will climb. A higher dollar, lower Treasuries and lower gold are rational and historical reactions to an improving economy.

For the past ten months the anomaly has been dollar. Since March the currency markets have been selling the greenback whenever risk falls and rewarding the dollar when risk rises. This has produced the odd and illogical equation of poor US economic results generating a strong dollar and the reverse.

In the context of the financial crash last fall and the almost universal fear of capital loss that reaction was logical; in the current economic conditions it is not. But for a number of reasons this response has been hard for traders to shake. First, in the back of many traders’ minds, if not in reality, lurks the possibility of a reoccurrence of last fall’s dollar panic. Second, in the absence of a credible US economic recovery there is no reason to buy the dollar; the Federal budget deficits and very low interest rates are good, if currently disconnected, reasons to sell. And lastly there are the reliable trading profits from the risk aversion trade.

The euro has been unable to break above 1.5140 for two related reasons: the EMU economy offers no better potential for recovery than the US; the ECB seems no closer to a rate policy change than the Fed.

Normally economic growth influences the currency markets through the central bank rate policy. Economic expansion, in time, brings on inflation and a higher Fed Funds rate; the dollar rises.

But since the financial crash the Fed had deliberately and carefully broken that expansionary--inflation link. Mr. Bernanke fears deflation and the effect of tight money and rising interest rates on incipient economic growth. The Fed Chairman has said so often that rates will stay low for an extended period that the markets have taken it as fact; the Fed will not raise rates. This belief has dulled the normal anticipation that economic recovery and improving statistics would put into the dollar--at least until Friday.

Mr. Bernanke has not changed his tune but traders may have gotten tired of listening. The currency markets have had similar positive dollar reactions to improved US economic news several times in the past six months. But each time traders returned to the risk trade, selling the dollar on good US information. The dollar did not gain any long term benefit from encouraging US prospects.

But on Friday it was not only the currency markets that responded normally and logically; so did gold and, most interestingly, so did Treasuries. If bond traders feel free to sell then there is no better long term predictor of a Fed rate increase.

We shall see in the weeks ahead if this positive American news sustains. The recent US ISM numbers, manufacturing and services, were unexpectedly weak. Retail sales and the holiday shopping season do not appear to be generating the kind of strong results that prompt anticipatory business expansion; there is still much to worry about in the real estate market.

The dollar could turn out to be a leading indicator, provided the economy continues to recover. If the currency, gold and Treasury markets are no longer waiting for an official change in Fed policy, Mr. Bernanke may not have to make up his mind traders will do it for him. But the odds are still that Friday’s moves were an early present-- from traders to themselves.