Will the Euro See $1.60 and the Dollar JPY80 ?

Sentiment toward the dollar is clearly negative. Some observers cite structural factors; other cyclical. But how negative is market sentiment?

The first place to look may be surveys. News wire surveys put the consensus for the euro in Q4 09 and Q1 10 around $1.45. This is close to the forward rate of about $1.46 for both periods. However, there are a number of calls by individual forecasters for $1.50 by year-end and for a move to re-challenge the record high near $1.60 in Q2 10 or Q3 10.

Another place to look for insight comes from the options market. Based on current spot price and implied volatility, the pricing of one-touch structures imply the odds are roughly speaking, almost 1 in 8 that the $1.60 level is seen before the end of the year, but a little more than a 1 in 4 chance that it is seen before the end of Q1 10.

Turning to the dollar-yen rate, the surveys suggest that a consensus of forecasters expect the dollar to rebound toward JPY94 by year end and JPY95 by the end of Q1 10. The forward rate is about JPY90 for both periods. The recent Tankan survey picked up a consensus of Japanese manufacturers for the dollar to average JPY94.50 during the current fiscal year. In the first half of the fiscal year, the dollar has averaged JPY94.64.

The pricing in the options markets, again based on current spot prices and implied volatility, suggests the odds of seeing JPY80 this year is about a 1 in 11 chance and it rises to almost 1 in 4 by the end of the fiscal year (31 March 2010).

With the G7 and G20 meetings ending with no clear protest of the dollar's weakness, and short-term interest rate differentials still rewarding investors to be short the US dollar--extending its attractiveness as a funding currencies, we see the downside pressure on the dollar continuing near-term.

On the other hand, the yen's strength appears to be driven primarily by two other key factors--the repatriation ahead of fiscal half year end, encouraged by tax incentives--and initial signals by the new Japanese government. The fiscal half year is past and the new government has modified its signals. While we do not think intervention on the dollar-yen or euro-dollar is likely, should the dollar approach JPY80 in short-order, we would suspect the BOJ would seriously consider intervention.

Generally speaking over the next six months, we do not expect to see either $1.60 or JPY80. We would expect heightened expressions of concern if the euro rises above $1.50 and if the dollar slips below JPY85. The extreme dollar bearishness by some forecasters appears based on a double dip recession in the US and/or an earlier recovery in the euro zone and an earlier rate hike. Both the scenarios seem exceptionally unlikely to materialize in the next 3-6 months.