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.
While these players have successfully broken the dollar out of its well-worn ranges, it has yet to be seen whether it will force the hand of corporations and investors. The low-volatility environment may have made some corporations and investors complacent about hedging their dollar exposures.
Getting them to sell dollars would extend the greenback's selloff, and finally reward the speculators trading prowess. But I recommend money managers and U.S. corporations take advantage of the recent market action to hedge a greater portion of their exposure to foreign currencies.
It Ain't Going to Be Easy
The dollar's gyrations have once again coincided with swings in the pendulum of expectations of
policy. A week ago the fed funds futures were pricing in about a 1-in-6 chance of a Fed rate cut in March. The odds have since increased to almost 50%.
But there is good reason to take the Federal Reserve's tightening bias seriously. As one money manager told me in recent days, the consensus for the better part of two years underestimated the magnitude and duration of the tightening cycle. Remember the start of the year, the consensus was for "one and done" under former Chairman Alan Greenspan?
Ahead of the next FOMC meeting on Dec. 12, there are about 10 public speeches scheduled for Fed officials, including several from among the more hawkish members. Another three speeches will be delivered by Chairman Ben Bernanke and Vice-Chairman Donald Kohn, both of whom should stay on message: the risks of inflation are still greater than the downside risks to growth.
Moreover, Richmond Fed President Jeffrey Lacker seemed to have indicated the price of giving up his dissent against the Fed's recent decision to pause: tougher talk against inflation.
While price pressures have eased a bit, they still are elevated. As data for October begins to come in, it is likely to provide preliminary signs that the economy is performing better in the fourth quarter than in the third. And we might learn in a few days that third-quarter GDP was revised slightly higher. The labor market is tight and early estimates for November non-farm payrolls (reported Dec. 8) are for an increase of 125,000.
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.
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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