What the Dollar Bounce Does Not Mean

We need to see more factors develop before we see a long-term rally in the greenback.
By Marc Chandler ,

As regular readers know, I have been looking for the U.S. dollar to begin performing better. I have argued that the greenback had already bottomed against half of the four G7 currencies -- the Canadian dollar and the British pound -- and that its main weakness was cyclical in nature, not structural as the pessimists maintain.

With the recovery in recent days, the U.S. dollar is trading at its best levels since late March against the euro and its best level since late February against the Japanese yen and Swiss franc. Its recovery has been predicated on ideas that the

Federal Reserve

paused after easing monetary policy since last summer, that the financial crisis is easing, and that there is a greater appreciation of the economic challenges being faced by other major industrialized countries.

One might expect strategists with my views to be jumping up and down about the dollar's better tone. And indeed the technical and fundamental backdrop for the dollar has improved markedly. Yet prudent traders and investors need to keep things in perspective and take it one step at a time.

The Euro Tests a Key Level

The euro has barely achieved the minimal technical retracement of sharp advance that I would date beginning Feb. 7 near $1.4440. After breaking above $1.60 in mid-April, it has now slumped a little more than 5.5 cents, and just shy of the 38.2% retracement of advance which comes in near $1.5420. A convincing break of this level is needed to sustain the downside momentum, from a technical point of view.

At the same time, it is important to note that the technical tone of the euro has deteriorated. I have often used the five-day and 20-day moving averages as guides for the underlying trend. For the first time since late February, the five-day moving average of the euro has fallen below the 20-day moving average, and also for the first time since then, the euro has finished the North American session below its 20-day moving average (since April 24).

Ideally, corrective upticks in the euro should hold below the 20-day moving average, which comes in today near $1.5750 and all the better if the $1.5650 cap proves sufficient.

The pendulum of sentiment has swung clearly and distinctly to a prolonged Fed pause, but market psychology is fickle and is unlikely to remain there for long. The risk is that soft economic data for the second quarter spurs speculation that the Fed may chose to take additional insurance in the form of another rate cut. This in turn would weigh on the greenback. I am not convinced at this juncture that such a move will materialize, but the optimism that the worst is behind us seems shallow and without much conviction.

There are a number of thoughtful observers who are not persuaded that anything more than a long overdue upside correction for the dollar is taking place. They claim that the diversification of central bank reserves will still undermine the value of the greenback.

Hold the Blame

Back in the last 1980s, when there was an inexplicable move in the curerncy markets, observers would often blame Bank Negara, Malaysia's central bank, which at the time was beleived to be a large speculator in the foreign-exchange market. In the 1990s, an inexplicable move in the currency markets was often blamed on the ubiquitous hedge funds.

In recent years, the Asian or Middle East or Russian sovereign wealth funds or central banks are often cited to be the driving force behind curerncy moves, rarely letting the facts get in the way of a good story.

And the facts of the matter are clear. The International Monetary Fund is the most authoritative source for the composition of central bank reserves, and there is not a shred of evidence that there has been a net sales of a single dollar. In fact, as a group, central banks hold more dollars today than ever before. They also hold more euros than ever before. Reserve accumulation is not a zero-sum exercise presently.

As the demand for reserve assets grow, central banks can and do hold more dollars

and

euros. Indeed, if there has been a shift in reserve holdings outside of short-term fluctuations, its appears that it has been a modest shift away from the yen and toward sterling.

The Treasury's monthly portfolio investment flow report, the Federal Reserve's weekly custody holdings and the government's quarterly balance of payments report, which captures other portfolio flows and dierct investment, all concur that U.S. capital account surplus is more than enough to cover the current account deficit.

Recently I met with more than a dozen asset managers in Tokyo. My far-from-scientific survey confirmed what the newswires have picked up, namely that life insurers are not too enthusiastic about U.S. Treasuries. But the significance of this observation is the real issue.

Consider gold. It will be readily recalled that the Bretton Woods system of fixed exchange rates was toppled by a few European allies of the U.S. demanding gold for Treassury obligations at a rate that was too great for the Nixon administration. Twenty-five to 30 years later, lo and behold, the Europeans say they have too much gold and have been engaged in an orderly liquidation of a large part of their holdings. And what has gold done in the face of these official sales? Rally, of course, until very recently.

The anticipation and reality of the Federal Reserve being on hold is a necessary but insufficient condition for a strong dollar rally. More developments are needed. These, I think, include evidence that the enormous monetary and fiscal easing (with nearly half the federal checks to be mailed this month) will support the economy. And frankly, this remains in the realm of hope still. Many won't be convinced that the economy has turned until the housing market stabilizes, and this too is not at hand yet..

Developments elsewhere are important too. The ECB has backed away from harsh rhetoric that had sent the euro above the $1.60 level, and this clearly helped take the steam out of it. Yet ECB still appears to be willing to sacrifice the economy for the sake of its inflation credentials, though it has overshot its self-picked and defined inflation target consistently for nearly a decade.

More evidence of economic slowing will encourage the centrists and moderates at the ECB to have greater confidence that price pressures will ease. This will take time.

Just like the dollar's recent gains do not mean that it has entered a bull market, it also does not mean that the rally in commodities is necessarily over either. Despite the talk, I do not find stable and consistent correlations between the U.S. dollar and commodity prices in general.

While oil prices have pulled back from their peak, we are still talking above more than $110 a barrel. The dollar's decline may have been a contributing factor to the rally in oil, but it is not the only factor. The same argument can be made for industrial metals and foodstuffs. For example, the doubling in the price of rice has little, if anything, for example, to do with the decline in the dollar's value.

Watch the Euro

What does this all mean for curerncy market participants? Although I am looking for the dollar's bottom to broaden out, it may be premature to count the perennial dollars bears out quite yet. While the euro's techical tone has deteriorated, it has hardly fulfilled a minimal retracement yet.

Rather than sell in the hole, short-term and intermediate-term traders may be better served selling into the next euro bounce. In this environment, I would imagine that the yen will be relatively range-bound, making the yen crosses, like those against the euro or sterling, more a function of them than the yen itself.

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback;

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