Dollar Strength Will Pose Unforeseen Risks

Well, then, is the market expecting the rate gap to resume moving in favor of the euro? No, the forward curves of fed funds futures in the U.S. and EONIA (Euro Overnight Index Average) futures in Europe are sending the opposite message.

Looking For The Gap To Close

Source: Bloomberg

The fed funds market is expecting the Fed to start rescinding its rate cuts in May, and that should begin narrowing the rate gap. The euro's rise will be stemmed thereby, if not beforehand.

The Other Ocean

The story across the Pacific has been quite different. The dollar and Japanese yen almost never traded at interest rate parity. Why? Regardless of where the interest rate differential was with Japan, the permanent trade imbalance between the two countries meant that U.S. importers eventually had to buy (lend) the yen to pay their bills.

Japanese investors seeking higher returns and the Bank of Japan both sold yen and bought dollars -- the latter still doing so in massive amounts, more than 20 trillion yen in 2003 alone by official scorekeeping -- to keep the yen from strengthening further against the dollar. My concern is this: What will happen to U.S. bond yields and, by extension, to both the stock and real estate markets once this artificial source of stimulus for the American economy -- the almost-reckless purchase of Treasury coupons by the Bank of Japan -- is removed? If they no longer fear a plummeting dollar, will they cease their interventions on its behalf and inadvertently trigger a financial selloff once the dollar appears stable?

One of the lessons from 1994, repeated in July-August of 2003, is that only small changes in either the actual fed funds rate or expectations therefore can produce big changes in other markets as leveraged positions, particularly in mortgages, are unwound. The huge carry trade in Treasuries is dependent on both the low level of fed funds themselves and on the buying of foreign central banks to keep yields at the long end relatively low. Should the dollar start to rise in anticipation of the first wave of Federal Reserve tightening, a scenario for a massive repricing of long-dated bonds -- and of all financial markets -- could result.

The conventional wisdom sees the dollar and its present course as a problem by itself. The conventional wisdom, by definition, knows what everyone knows and therefore knows nothing. If technical analysis teaches us anything, it is that markets move most violently when "everyone" was wrong.