By Andrew Johnson
- Five-day average of the daily sentiment index shows just 6% dollar bulls
- But dollar bulls also say they have some data on their side, most notably a booming stock market
- The announcement of a Greek debt restructuring could roil European bond markets and prompt money to flow from euros to dollars
The beleaguered dollar can’t seem to escape a huge one-way market bet on its decline, but with the currency slumping to fresh lows this week, a few dollar bulls are starting to snort.
Data on currency futures due Friday afternoon are expected to show a market that is heavily short dollars. That raises the potential for a sudden “short-covering” rally if something were to spur buying. Potential triggers can be defined as positive–progress on a plan to reduce long-term U.S. deficits, for example–or negative, such as an external event that prompts a flight of capital into the safety of dollars.
Ultimately, however, the market will look for any signals from a hitherto reluctant Federal Reserve that it is ready to more aggressively unwind its ultra-loose monetary policy, the overwhelming factor behind the dollar’s descent.
Although Fed Chairman Ben Bernanke made it clear [last week] that the Fed would likely end its $600 billion bond-buying program at the end of June as planned, he was highly cautious about the prospects for actual monetary tightening. That message was taken as a signal to pummel the currency. The dollar rout has now been so pronounced that some were wondering whether it faces a full-blown crisis.
And yet various currency market participants say the market is now so heavily geared against the dollar that it simply can’t go any lower, making a rebound a strong possibility.
“The five-day average of the daily sentiment index shows just 6% [dollar] bulls,” said William O’Donnell, head of U.S. government bond strategy at RBS Securities in Stamford, Conn. “That’s about as extreme a bearish reading for any commodity that I’ve seen over the years.”
“The bar for the market is low,” for the dollar to make a comeback, said David Woo, head of G10 global rates and currencies research at Bank of America Merrill Lynch in New York. His bank is counting on a comeback.
Dollar bulls also say they have some data on their side, most notably a booming stock market whose confidence in the U.S. economy runs counter to the very notion of a “dollar crisis.” The rebound in stocks is one of the mechanisms through which the Fed has been successful in re-inflating the U.S. economy, these people say. The Dow Jones Industrial Average has risen almost 100% from its March 2009 low, as excess liquidity has gone in search of returns.
There are also innumerable ways for the dollar to benefit from bad news in other markets. The announcement of a Greek debt restructuring, increasingly the topic of speculation, could roil European bond markets and hurt euro zone banks’ balance sheets, prompting money to flow from euros to dollars. Actions by China to cool its overheating economy could undermine the currencies of emerging markets that sell to the Asian giant. And any sense that speculators are dumping oil and other commodities that may have risen too far could hurt currencies tied to those commodities and boost the dollar.
The dollar’s trade-weighted index has fallen more than 6% since August, when Bernanke first broached the idea of a second round of “quantitative easing” bond-buying. It is now lower than it was before the financial crisis of September 2008 and closing in on its lowest levels ever.
Notably, the selloff has worked mostly in lock-step with a deterioration in the Treasurys market, where fears have grown that foreign investors will dump dollar-denominated assets because of their mistrust of both the Fed’s monetary policy and the federal government’s fiscal planning. Meanwhile, Newport Beach, Calif.-based Pacific Investment Management Co. has dumped all U.S. government-related holdings from the Total Return Fund, the world’s biggest bond fund. PIMCO’s Bill Gross argued that unchecked spending on Medicare and Social Security will add to the nation’s ever-growing debt load. Such comments have helped the dollar to sink further and faster.
But if there are concerns about the U.S. government’s balance sheet, U.S. corporates appear to be in a much healthier state. Companies such as Ford Motor Co. (F), United Parcel Service Inc. (UPS), 3M Co. (MMM) and many others have reported strong results this week, helping to lift equity investors’ spirits. The weakened dollar is bolstering U.S. exporters’ financial results by making their goods more competitive in the global market.
The question is, which is sending the right signals for the dollar, bonds or stocks?
Dollar bulls say that the bond market is a red herring. They point to the resilient euro, which has soared to 15-month highs against the dollar despite an ongoing crisis in the euro zone’s sovereign debt markets. And if bondholders start taking haircuts on their loans to Greece or other peripheral euro-zone countries, that trend could rapidly reverse.
Meanwhile, there is some hope that Standard & Poor’s recent announcement putting the U.S’ AAA credit rating on negative outlook could spur a deal in Congress to rein in fiscal deficits, a move that could spur confidence in the currency if it doesn’t do too much harm to the economy in the process.
According to Bank of America Merrill Lynch FX research this week, a one percentage point improvement in the U.S. structural budget balance as a share of gross-domestic product data has been associated with a 7% appreciation of the dollar against the euro over the last 40 years.
If no positive or negative news is forthcoming to boost the dollar and it continues to fall in contradiction of what policymakers see as the more positive fundamental backdrop, there’s always the remote possibility of central bank intervention to prop it up. But even if talk of a “crisis” grows, such a policy response is seen as unlikely, not only because a weaker dollar helps achieve the Obama administration’s stated goals for increasing exports, but also because it would entail a rare, politically fraught coordinated move by the world’s major central banks.
Such actions have occurred only a few times in the past. In July 1995, the Fed and other central banks bought dollars for yen and Deutsche marks, but that was mostly aimed at weakening the yen. It was only back at the Louvre Accord of 1987 when there was truly a concerted effort to boost the dollar. And even that was launched to undo the dollar-weakening effects of the 1985 Plaza Accord.
The real barrier to a sharp dollar rally are the low yields that investors earn on it. Near-zero interest rates have severely limited the dollar’s appeal and instead set it up as a funding vehicle for investments into higher-yielding, riskier assets. Changing that scenario depends on the Fed.
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