Dollar Bears May Be Overreaching

A run on the dollar is under way. While momentum suggests there is scope for additional near-term losses, the risk is the dollar bears are getting ahead of themselves.

Rather than jump aboard what appears to be a southbound dollar express, traders might be better advised to take some profits and wait for the next train.

In London trading, the dollar was recently trading at 115.75 yen vs. 116.30 yen late Thursday, while the euro traded above $1.30 for the first time since April 2005 and was recently at $1.3088.

The dollar's selloff is taking place in relative thin market conditions and there is reason to suspect that as full liquidity returns, the bears will have a more difficult time. The move already is extreme. Consider, for example, that the major foreign currencies (euro, British pound, Swiss franc and Japanese yen) rarely move more than two standard deviations away from their 20-day moving average. The European currencies are currently trading at more than three standard deviations from their 20-day moving average while the yen is just shy of the three-standard-deviation mark, which comes in near 115.48 yen to the dollar.

While the edges of the dollar's range may fray, a true and sustained break may be more difficult to achieve than it might appear. It was only about six weeks ago that the market was contemplating an upside break for the dollar. The euro was pushed through the $1.2500 level and the dollar recorded its high for the year against the Japanese yen just shy of the 120 yen level. Several banks revised their dollar forecasts higher. But alas, there was no breakout, which only served to deepen the gloom among speculative players.

On a related note, there are many new participants in the current market attracted to what seemed like easy money. Barriers to entry to the foreign exchange market have been reduced by the advent of technology and in particular, numerous electronic platforms, some of which extend leveraging virtually unheard of before, like 100 to 1 and even more.

In order to justify the lucrative fees being paid to hedge funds and commodity trading advisors, these market participants need an increase of volatility and ideally a strong trend. And lo and behold, over the past few days, volatility has increased as the dollar has been sold off to the bottom of its five-to-six month trading range.