Dollar Bears May Be Overreaching

Europe and Japan

Beyond the Fed, European politicians and finance ministers may increasingly voice their objections to further euro appreciation. Already the French President and Prime Minister have protested. After meeting with the Spanish Prime Minister last week, French President Chirac intimated that his concerns about euro appreciation are shared by others.

The risk is that the best of the euro-zone cyclical recovery is behind it. A combination of higher taxes, higher interest rates and a stronger euro will likely undermine growth in the quarters ahead.

Meanwhile, the Japanese government downgraded its assessment of their economy for the first time in nearly two years. As I have argued, Japan continues to be plagued by its perennial problem: strength of the corporate sector has not trickled down to Japanese employees in the form of income, which in turn deters consumption.

This leaves the economy heavily dependent on capital expenditures and exports. Yet both of these sectors are flashing warning lights. In the third quarter, exports accounted for nearly 80% of Japan growth. The October trade balance, released on Nov. 21, was well below forecasts because exports were weak. Recently there have been signs that capital investment has weakened, despite surveys picking up strong intentions. Bank lending has also slowed.

Although Bank of Japan Governor Fukui had purposely kept the door ajar to a December rate hike, the recent data prompted him to acknowledge that the odds of such a move are slight. That means that most likely the overnight rate will remain a lowly 25 basis points for at least a while longer.

By the time the hike is delivered, it is likely that several central banks, including the European Central Bank, will have raised official rates at least once, maintaining interest rate differentials, which provide traders with powerful incentive to use the yen as a financing currency.

In recent days, the low-yielding Japanese yen and Swiss franc, have fully participated in the move against the dollar. This does not appear to be an indication of unwinding carry trades because the other side of the carry trades have held up well.

The Australian dollar is near its year's high and the New Zealand dollar is near its best level in nine months. Equity markets, which may have been financed through the sale of the yen and/or Swiss franc, have continued to rally (except in Japan). Most emerging market currencies have also held up better than one would have expected if the carry trades were truly being unwound.

Carry trades -- borrowing a lower-yielding asset to invest in a higher-yielding one -- arguably make sense when the dollar is range bound. However, during a run against the greenback, there is less of an appetite to be short the yen and Swiss franc.

By buying these currencies back, traders in essence are using the dollar as a financing currency -- betting that the dollar's decline more than offsets the less favorable interest rate pick-up. However, if the dollar snaps back and returns to its previous ranges, the yen and Swiss franc carry trades may return to popularity.

1 What would best describe your stance heading into the coming week of trading? Bullish Bearish Neutral 2 Which of these sectors do you think is set to move up in the coming week? --Choose One--Aerospace and DefenseAirlinesAutomobilesBeverages and Food ProductsBiotechnologyCommercial BanksComputers and PeripheralsConsumer NondurablesEnergy Equipment & ServicesHMOs and HospitalsHomebuildingInsuranceIntegrated OilInternet, Software ServicesInvestment Bankers and BrokersMediaMultiline RetailPharmaceuticalsPrecious MetalsSemis, Semi EquipmentTelecom EquipmentTobacco and AlcoholWireless CommunicationsUtilities 3 Which of these sectors do you think is set to move down in the coming week? --Choose One--Aerospace and DefenseAirlinesAutomobilesBeverages and Food ProductsBiotechnologyCommercial BanksComputers and PeripheralsConsumer NondurablesEnergy Equipment & ServicesHMOs and HospitalsHomebuildingInsuranceIntegrated OilInternet, Software ServicesInvestment Bankers and BrokersMediaMultiline RetailPharmaceuticalsPrecious MetalsSemis, Semi EquipmentTelecom EquipmentTobacco and AlcoholWireless CommunicationsUtilities View the results without voting