Friday, December 04, 2009

About The Unusual Dollar Reaction To The Employment Report

Virtually always during the latest year, the U.S. dollar has reacted in a way to U.S. economic reports which would at first glance seem odd. Stronger than expected numbers have weakened the dollar-weaker than expected numbers have strengthened the dollar.

The explanation for this can be found in this analysis that I made of the yen (and then elaborated upon in this dollar specific analysis), which just like the U.S. dollar have been a "negative beta asset", moving in the opposite direction of stock markets. To summarize, because exchange rate movements are largely driven by interest rate movements, and because America is deemed to be farther away from rate hikes than other countries (except for Japan), and because other economies are expected to correlate positively with the U.S. economy, this means that a stronger U.S. economy are considered to be more likely to prompt other central banks to raise interest rates than to prompt the Fed to raise interest rates.

However, after today's stronger than expected U.S. employment numbers, the dollar reacted in an unusual way. While the particularly strong rally relative to the yen is consistent with the above analysis, the dollar also rallied significantly against other currencies (though somewhat less than against the yen), including the euro and the pound. What's up with that?

Well, it seems that market participants this time believed that the strong employment report raised the odds of a U.S. interest rate hike more than it raised the odds of foreign interest rate hikes, something which is confirmed by market interest rate movements, with the yields of 2 to 7 year securities rising about 12 basis points.

It remains to be seen whether or not reactions will be similar in the future. Because the key is whether or not Fed rate hikes are possible in the foreseeable future, bullish surprises are more likely to generate similar reactions than bearish surprises, something which increases the likelihood of a stronger dollar because that is what both a "positive beta" response to bullish news and a "negative beta" response to bearish news will mean. Because today's movement could be a temporary aberration, that is however less certain than the reactions of the more safe “negative beta” currency the yen or the more safe “positive beta” currency the Australian dollar.