The Dollar Saga: Where we are now

The US dollar’s price action in recent days 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 to be clear, in the bigger picture, what we are talking about is a move from the upper end of its 5-6 month trading range to the lower end.

For the euro, this translates into gains in the coming sessions toward $1.2700-50 and $1.2900 in before the end of the year. Buying on pullback backs now rather than selling rallies will probably be the preferred tactic of short-term players. Support is now seen in the $1.2580-$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 and a break could see a quick move toward JPY117.30-50. The dollar should stay below JPY119.00-30.

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 the $1.8860 is convincingly breached. Before the end of the year maybe sterling could even challenge the $1.9143 high from early August.

The Dollar Saga

Broadly speaking the dollar was 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 break down took place in early October. We would link the move to comments by the Federal Reserve’s Vice Chairman Donald Kohn comments on October 4th.

Parenthetically, there are many Fed officials that speak to the public, but we suggest paying special attention to Kohn. He not only has more experience on the Federal Reserve Board than every one else put together, but he also heads up a committee on Fed communication. In early Oct Kohn suggested that he, and by implication, the Federal Reserve was not nearly as sanguine the market was, judging from the term structure, about the timing and direction of the next FOMC move.

Kohn’s comments influenced the way the market reacted to the jobs data (remember disappointing headline, but impressive back month and benchmark revisions). 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, prior to Kohn’s speech, to a low last Friday (Oct 13) of 94.665. That pendulum of market sentiment swung away from a rate cut in Q1 to a prolonged pause is also evident in the Fed funds futures strip.

The dollar’s gains appear to be fueled by this shift in expectations of Fed policy. The Commitment of Traders showed that since late August, speculators have been reducing their record long euro exposure. There is also anecdotal evidence that as Q3 drew to a close asset manages also either adjusted underlying positions or hedges and also were thought to have been sellers of euros.

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 the narrowing trend that had seen the premium the US offered over the euro-zone trending lower since mid-June. In mid-June the spread stood at almost 200 bp. The spread narrowed to 131 bp on the day the Kohn spoke. It has since widened back out to about 150 bp. Further significant widening seems unlikely.

Through this year, we have been more hawkish the Fed than the market. While this yielded favorable results in the first half, the pause is longer than we expected and it is likely to continue a while longer. However, we would still attribute greater risk of a rate hike in Q1 2007 than the market has priced in. The weakness in a number of high frequency economic reports in recent days, including the Philadelphia Fed survey, industrial production and the sharp drop in housing permits (more than offset the counter-trend rise in starts), means that the data is still not there to persuade the majority of the merits of our view. Thus the pendulum of market sentiment probably has 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 Q1 07, some observers were beginning to doubt that the ECB would hike rates in early 2007. You will recall that previously ECB President Trichet and Bundesbank President Weber had cautioned the market against believing that the monetary tightening cycle that did only began in Dec 2005, would be completed this year. Yet in subsequent remarks, there has been little guidance for policy next year. The debt market did not seem as concerned as the foreign exchange market. The March 07 Euribor futures contract are implying a higher interest rate now than it was after Trichet’s press conference that followed the early Oct ECB meeting.

The market has had a tougher time with the Bank of England this year. Remember they cut rates in August 2005, over the objection of the Governor. At the start of this year, understanding that central banks do not things just once, many were expecting another rate cut. Instead after a prolonged pause, they took back the cut and hiked 25 bp in August. Despite disappointing retail sales, which like the US report, were likely skewed by the drop in petrol prices, the market continue to expect another hike in early November. The short-sterling futures strip also implies a strong chance of a hike in Q1 07 too.

Until Friday 13 October, the most participants also did not 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.