Dollar Down, but Bears may be Over-reaching

A run on the US dollar is underway. 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. Money managers and corporations should consider taking advantage of the run-up in foreign currencies to increase hedge ratios.

The dollar’s sell-off is taking place in relatively 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 3 standard deviations from their 20-day moving average while the yen is just shy of the 3 standard deviation mark, which comes in near JPY115.48.

Micro-Structure

To grasp what is taking place in the foreign exchange market, one needs to appreciate the fact that there are many new participants that were attracted to what seemed like easy money. Many banks have scaled back their proprietary currency trading operations, leaving many traders high and dry. 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.

The combination of the lucrative fees being paid to hedge funds and commodity trading advisors, the access to liquidity and leveraging, and the egos of traders made it seem as easy as shooting fish in a barrel, as they say. Part of the problem is that many traders confused their positions at banks with their trading prowess. This is important because banks make more money from their market-making function than from out-guessing the market. At a bank, one has access to private, proprietary information, like buy and sell-orders and this may give some players an edge. In addition, bank dealers benefit from the spread between bids and offers.

Just What the Doctor Ordered

Far from easy money, currency speculators have had a rough time of things. Deutsche Bank’s index that tracks commodity trading advisors, hedge funds, and mutual funds that trade foreign currencies have lost 2.8% in the year through early November. Unlike corporations and asset managers, these speculators like currency market volatility and there hasn’t been much this year. In fact as recently as the start of the month, a standard measure of volatility, like three-month implied volatility was near record lows for the dollar against the euro and yen.

In order to justify their plumb fees 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 5-6 month trading range. Little wonder speculative players are licking their chops at the prospect of a turn-around.

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 vol environment may have made some corporations and investors complacent about hedging their US dollar exposures. Getting them to sell dollars would extend the greenback’s sell-off, and finally reward the speculators trading prowess.

It Ain’t Going to Be That Easy

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 JPY120 level. Several banks revised their dollar forecasts higher. But alas, there was no breakout, which only served to deepen the gloom among speculative players.

Once again the dollar’s gyrations within the established range have coincided with swings in the pendulum of expectations of Fed policy. A week ago the Fed funds futures were pricing in about a 1 in 6 chance of a Fed cut in March 2007. The odds have increased to almost 50%.

There is good reason to take the Federal Reserve’s tightening bias seriously. As one money manager told us in recent days, this is not the consensus view, which we point out, for the better part of two years under-estimated the magnitude and duration of the tightening cycle, Remember the start of the year, the consensus was for “one and done” under Greenspan? This seems to be near the limit of how far the sentiment can reasonably swing in favor of a cut in Q1 2007.

Ahead of the next FOMC meeting on December 12th, there are about 10 public speeches scheduled for Fed officials, over half are from members who are perceived to be among the more hawkish members. Another three speeches will be delivered by Chairman Bernanke and Vice-Chairman Kohn, both of whom should be expected to stay on message: the risks of inflation are still greater than the downside risks to growth. Moreover, the lone dissenter at the Fed, Richmond President Jeffrey Lacker seemed to have indicated the price of giving up his dissent: 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 Q4 than in Q3. And we might learn in a few days that Q3 GDP is revised slightly higher. The labor market is tight and early estimates for November non-farm payrolls (December 8th) are for an increase of 125k.

Europe and Japan

Increasingly, European politicians and finance ministers may voice their objections to further euro appreciation. Already the French President and Prime Minister have protested. After meeting with the Spanish Prime Minister, 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. That the combination of higher taxes, higher interest rates and a stronger euro undermines growth in the quarters ahead.

The Japanese government downgraded its assessment of their economy for the first time in nearly two years. As we 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 Q3, exports accounted for nearly 80% of Japanese 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 BOJ Governor Fukui had previously pursued a course of strategic ambiguity, purposely keeping the door ajar to a Dec 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 bp 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 U.S. dollar. This does not appear to be an indication of unwinding of carry trades because the other side of the carry trades has 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 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.