The Dollar's Reversal of Fortune

Amid intense trading, the Fed and the Bank of Japan trigger a bear trap.
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The dollar has suffered a stunning reversal in the past two days, and although it may be premature to draw any firm conclusions, the greenback's seven-month-old uptrend against the euro could reasonably be considered complete. The dollar has also fallen toward the lower end of its four-month trading range against the yen. A reversal of the dollar's fortunes can have significant implications for monetary policy and investment patterns.

As strange as it may seem, no single factor appears to have triggered the dollar's slide against the euro yesterday or the follow-through today. Arguably, key macroeconomic factors had already shifted -- that is to say, the growth differentials between the U.S. and the eurozone had already begun narrowing. Interest-rate differentials have collapsed: The 10-year bond spread between U.S. Treasuries and German bunds imploded to below 100 basis points yesterday from the decade-wide 178 basis points recorded in mid-June.

As we all know, a change in fundamentals is necessary but often insufficient to alter the trend. Psychology needs to change as well, especially when the trend has been as relentless as the euro's decline.

First, sentiment needs to reach an extreme, and indeed some of the most respected market surveys have picked up the nearly universal bearish outlook for the euro. Economists, who at the start of the year were bashing the dollar, have been more recently tripping over themselves to come up with cute slogans for their increasingly lower downside targets for the euro.

A study of the price action itself often lends insight into market sentiment. Technical evidence is accumulating that a bottom of some significance may be in place for the euro. Yesterday, the euro recorded an important upside reversal. Early in the session, it fell through the previous session's lows and then closed above the previous session's high. It is the first time this chart pattern has been recorded in the euro, and chartists find such a pattern near market turning points. Momentum measures have been showing what chartists refer to as bearish divergence: They have not confirmed the euro's recent fall to new lows. Today's extension of yesterday's advance has convincingly violated the euro's downtrend.

Many market participants will view the stronger euro as simply a long-overdue corrective bounce. They will be licking their chops to sell the euro again. Anxious to jump back on the trade that was relatively easy money in the first half, those bearish on the euro will likely make a stand between $1.0450 and $1.0500.

Investors not in the business of guessing the next hiccup in the foreign-exchange market will be closely monitoring the price action, and any move in the euro above $1.05 could trigger new portfolio allocations toward Europe. Recent

U.S. Treasury Department

data for the January-April period show U.S. investors sold $25.2 billion of European equities this year, almost matching last year's total. Portfolios must be underweight European exposure, and if these allocations are adjusted, assuming the euro has bottomed, it could sap some flows that have otherwise been going into the U.S. stock market.

A Surprise in Japan

Meanwhile, the

U.S. Federal Reserve

and the

Bank of Japan

have sprung a trap on dollar bears. Yesterday, the BOJ did not intervene while the dollar slid nearly 4 yen. The market wrung its hands in disgust because the BOJ had indicated it would defend the dollar near 120 yen. Many market participants had bought dollars ahead of that area, expecting Japanese officials to be right behind them. They weren't. Market observers were crying foul. Then out of the blue, the Federal Reserve stepped into the market and bought dollars on behalf of the Bank of Japan in several rounds.

The market had rightfully doubted that

G7

coordination and cooperation in the foreign-exchange market was as strong as Japanese officials had suggested. After all, there was the indisputable fact that despite repeated rounds of BOJ intervention, none took place during U.S. trading hours.

Numerous press reports have suggested U.S. reluctance to curb the yen's strength. Today's intervention will succeed in securing more respect for officials. It may not strengthen the dollar very much, not beyond the top of the four-month trading range, which comes in near 124 yen. However, if you believe -- as I do -- that what officials want is stability, this tactical intervention is likely to be successful.

Marc Chandler is the chief currency strategist for Mellon Bank. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

commentarymail@thestreet.com.