The Dollar Story: Where We Are Now

When it comes to the Fed, market sentiment has probably swung as far as it can go.
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This column was originally published on RealMoney on Oct. 20 at 3:20 p.m. EDT. It's being republished as a bonus for readers.

In recent days, the U.S. dollar's price action has been significant. Essentially, this week's developments indicate that the greenback's recent advance is probably exhausted, and a new period of weakness will likely unfold. Yet, in the bigger picture, we are talking about a move from the upper end to the lower end of its five- to six-month trading range.

For the euro, this translates into gains in the coming sessions toward $1.2700 to $1.2750 and near $1.2900 before year-end. Short-term players will likely prefer buying on pullbacks now instead of selling rallies. Support is now seen in the $1.2580 to $1.2600 area, and only a break of $1.2550 would jeopardize this constructive outlook.

Against the Japanese yen, the dollar is likely to break below the JPY118.00 level, around where stops and option structures have reportedly been placed. A break could see a quick move toward JPY117.30 to JPY117.50. The dollar should stay below JPY119.00 to JPY119.30.

As is often the case in moves against the dollar, sterling is leading the way. Sterling has moved sharply higher off a strong base built in the $1.8520-40 area. There seems to be little in the way of a test on the $1.90 area once $1.8860 is convincingly breached. Before year-end, sterling could even challenge the $1.9143 high from early August.

The Dollar Saga

Broadly speaking, the dollar had been confined to narrow, uninspiring trading ranges against the euro. The $1.2700-$1.2900 trading range in August melded into a $12600-$1.2800 trading range in September. The breakdown took place in early October, a move that may be linked to the Oct. 4 comments from

Federal Reserve

Vice Chairman Donald Kohn. At that time, he suggested that he and, by implication, the Fed were not nearly as sanguine as the market was about the timing and direction of the next FOMC move.

The performance of the March 07 Eurodollar futures contract illustrates the shift in market opinion. The contract fell from a high of 94.93 on Oct. 4, before Kohn's speech, to a low last Friday of 94.665. The Commitment of Traders showed that since late August, speculators have been reducing their record long euro exposure.

However, this phase seems to have been completed. The euro approached the lows from the summer, which corresponds to a retracement objective of the euro's advance from last November's low near $1.1650 to the early June high near $1.2980. It also coincides with the 200-day moving average, something the euro has not traded below since late March. The fact that this area held again reinforces its significance.

When Kohn spoke, the March 2007 Euribor-Eurodollar spread reversed its narrowing trend. In mid-June, the spread stood at almost 200 basis points, but it narrowed to 131 basis points on the day that Kohn spoke. It has since widened back out to about 150, and further significant widening seems unlikely.

Throughout this year, I have been more hawkish on the Fed than the market. While this yielded favorable results in the first half, the pause is longer than I expected, and it will probably continue a while longer. However, I'd still attribute greater risk of a rate hike in the first quarter of 2007 than the market has priced in.

The weakness in a number of recent economic reports (including the Philadelphia Fed survey), industrial production and the sharp drop in housing permits means that the data are still not adequately persuading most people of my view's merits. Thus, the pendulum of market sentiment has probably swung as far as it can go until there is more and substantial, real sector data.

Other Side of the Coin

While the pendulum was swinging away from a Fed cut in the first quarter of 2007, some observers were beginning to doubt that the European Central Bank would hike rates in early 2007. Previously, ECB President Trichet and Bundesbank President Weber had cautioned the market against believing that the monetary tightening cycle, which only began in December 2005, would be completed this year. Yet in subsequent remarks, there has been little guidance for policy next year.

The debt market didn't seem as concerned as the foreign exchange market. The March '07 Euribor futures contract is implying a higher interest rate now than it was after Trichet's press conference that followed the early October ECB meeting.

The market has had a tougher time with the Bank of England this year. It cut rates in August 2005, over the objection of the governor. At the start of this year, many were expecting another rate cut. Instead, after a prolonged pause, the bank took back the cut and hiked 25 basis points in August.

Despite disappointing retail sales, which were likely skewed by the drop in petrol prices, the market continues to expect another hike in early November. The short-sterling futures strip also implies a strong chance of a hike in the first quarter of 2007, too.

Until Oct. 13, most participants also didn't expect the Bank of Japan to hike rates again this year. However, comments from BOJ Governor Fukui explicitly warned the market that such a move this year should not be ruled out. Subsequent comments by other BOJ officials underscore the central bank's commitment to gradually raising interest rates. This, coupled with indications from Russia that it would add some yen to its currency reserve holdings, helped reinforce the ceiling near JPY120.

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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