For Rallying Dollar, the Race Looks Run

The dollar has proven this year that it can rally farther and for longer than all but the most contrarian observers believed possible. But with the greenback up 6.5% year to date vs. a basket of other major currencies, and trading near a seven-month high vs. the euro on Friday, the rally is looking a little long in the tooth.

"The easy money's been made," said David Greenwald, one of the dollar bulls cited here in mid-March and a partner at Scalene Partners, a currency-focused hedge fund with over $100 million under management. "I'm not as gung-ho to be long the dollar from here."

Greenwald is far from bearish and thinks "it's not unreasonable" to think the euro could retest the $1.20 level over the course of the summer -- potentially sooner if voters in France and/or Holland reject forthcoming referendums regarding the adoption of the European Union constitution. Still, he views the $1.2430 to $1.2530 range as "meaningful support" for the single currency, which was trading at $1.2564 late Friday in New York.

EU referendums are but one wild card for currencies, perhaps the most difficult asset class to handicap. And there are a lot of factors working in the dollar's favor these days, most notably Europe's sluggish growth and the Federal Reserve's tightening campaign, which has made shorting the dollar far less attractive to speculators as overnight lending rates have risen. Still, the so-called twin deficits remain long-term concerns to currency traders; short-term, there is the seemingly rapidly approaching showdown over China's currency regime.

To recap, the Treasury Department last week effectively demanded that China widen the renminbi's trading band by October or risk being branded a "manipulator." Such a designation would likely be accompanied by trade sanctions and/or passage of the Schumer-Graham Bill that would impose an across-the-board tariff of 27.5% on Chinese imports.

At this point, the conventional wisdom is that all the tit-for-tat quotas, tariffs and verbal threats thereof will not lead to an outright trade war, which would be potentially disastrous economically for both countries -- and for the entire global economy, for that matter.

"On the surface, the rhetoric sounds harsher than reality," says Michael Woolfolk, senior currency strategist at Bank of New York, who notes that China is putting into place the technical factors necessary for a more flexible exchange rate. "China won't take any drastic steps to threaten their growth."

Assuming a trade war is averted, the widespread opinion is that if the Chinese widen the trading band in which the renminbi floats, the currency will rise vs. the dollar despite ongoing concerns about China's banking system. In anticipation, the current bet these days among many currency traders is to go long Asian currencies, which have performed relatively better vs. the dollar this year than the euro.

"You want to be buying Asian currencies and equities," Woolfolk said. "The best thing to do, while there is this risk-averse behavior, is to buy Asian equities on dips. As they rise and Asian currencies rise, you get a double return" if you're a U.S.-based investor.

Many Asian nations, such as South Korea, Thailand, Malaysia and the Philippines, would like to see their currencies appreciate vs. the dollar. But they "want the Chinese to act first, because a pre-emptive move would erode their market share of exports to U.S.," he explained. "As soon as China moves, everyone else moves in lockstep" by either adopting wider trading bands or slowing down the buildup of dollars in their currency reserves.

Indeed, on some level, China is the linchpin on which all major currency movements will hinge in the next six months, and the lever seems to be pointed generally toward a weaker dollar. Last week alone, the Hong Kong monetary authority announced plans to widen the trading band on the Hong Kong dollar, a move viewed as a preliminary step toward Chinese revaluation. Meanwhile, South Korea said it does not plan on accumulating any more foreign reserves, a statement later retracted but seen as a harbinger of a day when South Korea stops or severely limits its current practice of buying dollars to help keep the won artificially low.

Mr. and Mrs. America

For argument's sake, assume the dollar will decline in the coming months or at least level off from its recent ascent. What would that mean for other assets?

Treasuries would likely be hurt by weakness in the dollar, especially if it's accompanied by or attributed to weaker demand for dollar-denominated assets by foreign central banks, which sold $15 billion of Treasury securities in March, the most since August 1998, according to the Treasury International Capital System data. But fears of foreigners dumping Treasuries have proven to be premature (to be kind), and predicting the future for the Treasury market is very much a conundrum for even the most celebrated economists.

Commodities, such as oil and gold, would be most directly (and positively) affected by a weakening of the greenback.

Woolfolk, for one, believes oil prices will move back toward the $60 level "on a sustained basis" and -- while it's a chicken-and-egg conundrum -- he believes "that will be viewed as a dollar-negative."

If, as he believes, a rebound in oil prices occurs in conjunction with a Chinese revaluation sometime in the third quarter, "we'll see how far people want to sell the dollar."

Despite a lot of hand-wringing to the contrary, a weaker dollar has generally been good for stocks in recent years, particularly small-cap, technology and commodity-focused stocks. Those anticipating a pause from the Fed could be in for a rude awakening, but the recent outperformance of the Nasdaq Composite and improvement in the Russell 2000 could be a sign of traders sniffing out a slowdown in the tightening campaign, a dollar-negative possibility that could eventually presage a new conundrum, this time for stocks.

Aaron L. Task is the co-executive editor of TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to atask@thestreet.com.

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