USD strength signals more trouble ahead

The financial markets are so confused these days that one may find it very hard to distinguish between noise and the big move. In July, I had highlighted that USD index was breaking above its downtrend line, which could lead to an upside rally (here). However, the rally did not materialize due to concern about a US government debts default (here).

Last week, USD again broke above its downtrend line at the 74 mark and continue to rise to close the week at 77.19. The rise of USD coincided with heightened fear of a default in Greece. It seems that everybody has given up on Greece (here). My fear is that the G7 finance ministers meeting last week was to trash out contingency plans in the event of a Greece default.

One very interesting article was published by Macronomics, entitled "Chandrasekhar Limit" in which the publisher, Martin quoted a friend from the Credit space which agrees with Martin's take that the Credit Market is fast approaching Terminal Velocity. The friend wrote as follows:

“European banks seems to be facing a US dollars funding problem as no investors is willing to lend (buy a CP/CD) with a duration over 1 week. That information, if confirmed, is of significant importance as it has major implications not only in the money market (the spread OIS/Libor is at the widest for almost 2 years and keeps on worsening- 1rst confirmation), but also FX basis market (the basis swap between currencies has been deteriorating significantly and stands at -60 bps versus -10 bps 4 months ago -2nd confirmation). IF the trend remains unchanged in the coming weeks, the casualties may be the following:

1) a US dollar rally against most currencies as there is both a lack of US dollars in the funding market, but also because most of the players are short US dollars versus currencies with higher yields ( Haaa … the famous carry trade may suffer a blow, and unwinding positions may be costly and create dislocations).

2) a leg down in the commodities universe (except for Gold) as a most of those are US $ denominated.

3) a leg down on the equity market as the losses from a higher US dollar will have to be offset by some unwinding on liquid assets (Welcome margin calls !!!). In addition, a higher US dollar versus Euro means lower earnings for the US corporations (non-withstanding slower growth in Europe, a major trade partner for the USA).

4) a worsening credit market as banks funding problems have a direct effect on the overall spectrum of the economy.”

I agree with the above scenario. Based on this & the sharp fall in global equity markets last Friday, I expect our market to drop this week. You should exercise caution in the face of the current global financial turmoil. Be prudent & avoid taking unnecessary risk.

Chart: USD's daily chart as at Sept 9, 2011 (Source: Stockcharts)