What is Moving the Dollar? New Driver Around the Corner ?

There have been many developments in the past couple of weeks, including Dubai and Greek woes, generally stronger than expected US economic data, and further confirmation of the unwinding of the Fed's liquidity provisions that could help account for the dollar's broad based strength. It is up, since the Dec 1, almost 3.75% against the euro, 3.5% against the yen and 1.6% against sterling. Since the start of the month, the dollar has also appreciated against most of the emerging market currencies save the Mexican and Philippine pesos.

We are reluctant though to attribute the dollar's strength to a shift in expectations for Fed policy. On the day before the US Nov jobs report was released on Dec 4, the June Fed funds implied a yield of 28.5 bp. Last Friday after the stronger retail sales data, wholesale inventories and consumer confidence figures that prompted some economists to revise upward Q4 GDP forecasts, the June Fed funds finished the session implying 29.5% average effective Fed funds rate. Currently the June contract implies a 29 bp average.

It is timely to take another look at our correlation matrix and check the recent patterns. As usual, we look at correlations on the percentage change. For this exercise, we just look at the euro-dollar exchange rate against a host of other instruments.

One of the biggest changes in our matrix is the correlation between the euro-dollar exchange rate and the 3-month implied volatility. The correlation which may be an indicator of the strength of trend has steadily eroded in the recent period. For the year as whole, there is a 3.2% correlation between the euro and implied vol. Over the past 6-months , it is negative 9.4% and the past 3 months it is negative 29.1% and over the past month -50%. This could point to a reversal of the trend or simply the magnitude of the spot move in the opposite direction of the underlying trend.

Despite the euro's slide, its correlation with the S&P 500 is relatively stable. For the year to date the correlation is 50.2% and over the past month it is 50.7%. However, the correlation over the past month is down from the past 3 month (57.1%), and that pattern is evident with the euro's correlation with commodity prices (CRB). It is stable near 43% for the year-to-date, but over the past 3 months it is 60.6%. The same is true for the euro's correlation with oil. Over the past month it is about 46%, while year-to-date it is closer to 35%. However, over the past 3 and 6 months it was near 58%.

The one instrument that the euro enjoys a higher correlation with is gold. Year-to-date it is near 30%, but over the past 6 months it is 62% and over the past 3 months, the correlation is nearer 72% and for the past month it is near 80%.

The correlation between the euro and US debt instruments (Eurodollars, the 2-year note and the 10-year bond) are not statistically significant. However, the correlation has increased and this suggests that the euro-dollar exchange rate may become more sensitive to US interest rate developments.

It is premature to reach any hard and fast conclusions, but that is what our hypothesis has anticipated. That the main factor weighing on the dollar is not structural and the abandonment or diversification of the dollar as much as the low US interest rates and the ample liquidity officials continue to provide. We expect those considerations to diminish long before there is a substantive reform in the international monetary regime, or the convertibility of the yuan, for that matter. And as those interest rate and liquidity conditions change, we expect the dollar to get better traction.

Our point here is that the changes in US interest rate expectations have been too minor to indicate that that is what is being experienced at the moment. Instead we continue to believe that the primary factor behind the dollar's rally in recent weeks is largely technical in nature having to do with year-end considerations. In turn that implies that the foreign currencies are likely to bounce back in early 2010 before a more sustainable dollar rally ensues.