How Now Greenback

We can identify thee main considerations when trying to ascertain the near-term outlook for the US dollar: market positioning, interest rates and the G7/IMF. Let’s review each, but to cut to the chase, the first two seem dollar supportive, though the third may exert pressure in the other direction.

Market Positioning
The market had amassed substantial short dollar position. Of course the net speculative position at the IMM is a readily available and is a good place to start. However, it is only a small subset of the currency exposures. One aspect of market positioning that seems exceptionally relevant is that according to industry reports, emerging market took in about $33 bln in the first few months of this year on top of the $20.3 bln all of last year. Clearly some of this money has been repatriated. It is difficult to know with any degree of confidence the extent the investment and speculative market is still short dollars, but whatever it is, it appears to be less than a week ago and two weeks ago.

Interest Rate Considerations
The hawkish rhetoric by many Fed officials in recent days, especially Chairman Bernanke’s comments on Monday, has prompted the market to reassess the likelihood of a June hike and now assesses the offs at above 80%. In addition to the adjustment of the pricing of the Fed funds futures, there have been two other interest rate developments that are often associated with a stronger dollar: First, the US yield curve, as measured by the difference between the 2-year note yield and the 10-year note yield, has become inverted for the first time in three months. An inverted curve has tended to coincide with a stronger dollar.

Second interest rate differentials have widened in the US favor. Specifically, the spread between the June Euribor and June Eurodollar futures and the September spread has widened to new cyclical highs. The June 06 spread, which stood at 194 baisis points at the end of last year now stands at more than 237 bp. This week alone it has widened by about 13 bp. The September 06 finished last year near 183 bp and as of this writing stands above 220 bp, the widest thus far in the cycle. It represents more than 16 bp rise this week.

One other relevant observation here is that at the end of last year, the difference between the June and Sept spread stood at 11 basis points and now its stands at 17 bp. This indicates that the market continues to expect short-term interest rate differentials between the US and the euro-zone to narrow going forward. This might help explain why the dollar has not reacted as one might have expected to the widening of the interest rate differential.

In our understanding of what drives the euro-dollar exchange rate, we have suggested that the most traded currency pair moves cyclically relative to short-term interest rate differentials. We have found that the dollar moves through the cycle sequentially. When first presenting this in our December quarterly, we located the dollar in Phase II, when the interest rate differentials were widening in the US direction and the dollar was strong. We had anticipated that the dollar would move into Phase III later in 2006 as the interest rate differentials narrowed and then entering the bear part of the cycle (the lower two quadrants) toward the end of the year.

But something happened that appears to be offsetting the monetary channel which seems to be consistent with a new cyclical high for the dollar against the euro. Our hypothesis is that the G7 /IMF have politicized the foreign exchange market and that is what is blunting the supportive interest rate influences

Politics
The G7 and IMF sent two important signals to the market. The first was that with the world economy growing robustly, this would be an opportune time to address the global imbalances. Previously the strategy called from the US to boost savings; for Europe and Japan to boost domestic demand and for Asia and other current account surplus to adopt more flexible capital markets.

the fact that no country has seriously or significantly implemented the strategy gave rise to the second important signal from the G7/IMF. The foreign exchange should bear a greater burden of the adjustment process. And this signal was driven home by the US Treasury’s report in early May, which though did formally cite China as a currency market manipulator did put a great deal of emphasis on the currency market to adjust the global imbalances.

The danger posed by the large US trade deficit was that it theoretically could inject extra volatility into the foreign exchange market and de-stabilize global capital flows. But the markets were coping and for various reasons, volatility in the equity, bond and currency markets were if not at historical lows, fairly close. Volatility has increased, bond and stock markets have sold off as have emerging markets and commodity markets, not because of the US deficit but because politicians lacked the political will to enact structural reforms and signaled a greater reliance on the currency market—understood as a depreciating dollar.

The informal model of the foreign exchange market that many of us have in the back of our heads is one in which numerous profit-seeking actors battle it out, through the price discovery process, and out of that emerges a clearing price. The problem with this conceptualization is that it is far too simple. In reality, many if not most, participants are most certainly not profit-maximizers in the currency market. Corporations are largely hedgers. They are seeking for the most part to reduce risk and exposures. Mutual funds, especially equity funds, tend to view foreign currencies a vehicle for transaction. They might be profit-maximizers in their respective asset markets, but seem to be mostly passive in the foreign exchange market. For their part, central bankers are not profit-maximizers in any sense that is meaningful to private investors, even though some governments, like Germany, depend on the central bank turning over their profits to held finance budget deficit.

That leaves the speculators as the main profit-maximizers in the currency markets. The G7/IMF statements essentially exposed the dollar to greater downside risks. Speculators seeking the path of least resistance took the bait. To say that the G7 is committed to letting the markets determine currency values is disingenuous. From the point of view of many foreign exchange speculators, they heard the G7 say sell the dollar.

As it happens there is a G8 meeting (G7+Russia) this weekend. Only finance ministers are invited and the word from officials is that the foreign exchange market is not on the agenda as central bankers will not be in attendance. This too might be misleading insofar as in 5 of the G8 countries (US, Canada, UK, Japan and Russia) the finance ministries have the currency responsibilities. The remaining three (Germany, France and Italy) appear to have abdicated to the European Central Bank, but not en toto. The Eurogroup (of the region’s finance ministers) discuss currency matters frequently, arguably too frequently. Part of the reason that the currency market is not on the agenda is that many officials, though perhaps not the US contingent, are surprised by the damage that has been inflicted in the markets since they last talked about the currency market.

The lack of formal foreign exchange discussions may also reflect the possibility that the April statement was largely a creation of the US. With Treasury Secretary Snow in attendance but as lame of a lame duck as possible, there is greater scope for other officials to resist the US pressure. Moreover, it is possible that in some of the chats with the media, Canadian, European and Japanese officials try to distinguish their currencies and China, developing Asia and the Middle East.

These factors: widening interest rate differentials, the inversion of US curve and the reduced G7 politicization of the foreign exchange market helped the dollar recover trade higher in recent days. The near-term risk is for additional dollar gains. However, those dollar gains will likely prove to be contrary to the underlying trend. Although the euro’s risk extends toward $1.24, a move toward $1.2500-50 might prove sufficiently attractive to bring in buyers again.

Resistance is pegged near previous support around $1.2700. The dollar encounters resistance against the yen near JPY115 and then near JPY116. We expect dollar sellers to emerge on further greenback gains. Initial support is seen near JPY112.50-80 and then JPY111.30-50.