Opinion: US bailout hopes are boosting the US dollar

By BNZ Currency Strategist Danica Hampton The NZD/USD edged lower last night, falling from above 0.6900 to below 0.6800, pressured by a generally stronger USD. In stark contrast to the heavy USD selling seen yesterday afternoon (following reports the Chinese regulators had instructed Chinese banks not to lend to US financial institutions), the USD rebounded last night amid hopes US Congress is close to passing US$700m bank bailout package. The news sparked a 2.0% bounce in the S&P500 and saw US 2-year government bond yields climb 20bps to 2.15%. The recovery in US equities also helped bolster risk appetite a little, which encouraged a bit of demand for growth sensitive currencies like NZD against "˜safe-haven' currencies like JPY. While NZD/JPY demand helped lift NZD/USD off its lows, investors are generally reluctant to get overly optimistic towards the NZD ahead of today's Q2 GDP release. Today's Q2 GDP release will likely confirm the NZ economy is in recession. We look for GDP to contract 0.4%q/q, broadly in line with the -0.5%q/q market consensus and weaker than the -0.2%q/q projected by the RBNZ in its September MPS. After today's release, attention will shift quickly to the prospects for Q3 growth and this early stage we think things are on track for another sub-zero reading. It's on basis that we continue to look for further RBNZ interest rate cuts "“ starting with another 50bps in October and continuing until the OCR troughs at 6.00% next year. Overall, while a recovery in risk appetite (or another bout of USD weakness) may underpin NZD/USD, the local backdrop of slowing NZ growth and falling NZ interest rates should limit the topside in NZD/USD. For today, we suspect bounces will be limited to 0.6860-0.6880. Initial support is seen ahead of 0.6780, a break below this level will open up the downside towards 0.6700. The USD strengthened against most of the major currencies last night, bolstered by a recovery in US equities amid news Congress is nearing an agreement on the US$700m bailout package. Senate negotiators report that both parties have reached a general agreement to move forward with the Bush Administration's proposed US$700b bailout plan. The finalised plan will likely be a slightly watered down version of the initial proposal and is likely to include caveats like dispersing the US$700m in instalments and limits on executive compensation at financial institutions seeking government assistance. Nonetheless, hopes that the plan may be finalised by the end of the week sent US financial stocks higher. The S&P500 financial index climbed more than 3.0% and the S&P500 is currently up 2.0%. Despite lacklustre US data (durable good fell 4.5% vs. -1.9% forecast and new home sales fell 11.5%m/m to 460,000), the recovery in US stock markets and reduced "˜safe-haven' demand for US government assets prompted a rebound in US interest rates. The 2-year government bond yield climbed 20bps to 2.15% last night. The extra interest rate support, combined with hopes the bailout package will help the US economy avoid recession, underpinned the USD. Last night's USD sentiment starkly contrasted that seen yesterday afternoon, where the USD was sold heavily following news the Chinese banking regulators had told domestic Chinese banks to stop lending to US financial institutions. EUR/USD slipped from above 1.4750 to below 1.4600 and USD/JPY bounced from 106.00 to 107.00. In the near-term, the main focus across global financial markets will be on whether or not US Congress passes the bailout package and what this means for global equity markets, risk appetite and currencies. While the bailout plan will likely stave off a breakdown of the financial system it is unlikely to materially bolster global growth or prevent recession in the Eurozone or UK. While concern over the financing of the bailout package does suggest some downside risks to the USD, we suspect the USD will remain well supported over the coming months. After all, against a backdrop of slowing global growth we are likely to see repatriation of overseas held investments back to the US. Meanwhile, the clear determination of the US authorities' to do all they can to head off a downward spiral in US asset markets suggests the USD will come off looking the best of a bad bunch. * Danica Hampton is BNZ's Currency Strategist. All of the research produced by the BNZ Markets team of economists is available here.