Five Reasons Why the Dollar Rallied

07/31/2009 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

The US dollar is back! A quick look across the foreign exchange market today will reveal broad-based dollar strength with no major currency able to remain in positive territory as traders piled back into US dollars. The Australian dollar lost the most ground, followed by the euro and Swiss franc. It is days like today when we really get to see how diverse the currency market truly is as market participants buy dollars for different reasons. Some traders parked their money in US dollars for safe-haven purposes, while others are closing out excessively long EUR/USD positions, and a few central banks, on the other hand, needed to meet their IMF obligations. Whatever the reason, the market’s overall bias was to buy dollars, and we believe that the demand could remain intact for the remainder of the week.

The strength in the dollar is not due to a single factor, but rather, a combination of five reasons:

1) Weak Earnings, Durable Goods Orders, Fed’s Beige Book Report

Overnight, Chinese stocks sold off aggressively on concerns that the Chinese government may take steps to curb growth. This set a negative tone for the premarket US equity session, which was exacerbated by the weak earnings from Time Warner and then by the sharp decline in the durable goods report. Orders for items made to last for more than three years fell 2.5% last month, the sharpest decline since January. The drop came primarily from transportation, and in particular, non-defense aircrafts, which fell 38% in June. Boeing was hit by a wave of cancellations as their 787 Dreamliner is delayed further. For the year to date at June 30, Boeing had 85 gross orders and 84 cancellations, for a net total of one plane for 2009. Mortgage applications also fell 6.3%, the first decline this month. According to the Beige Book report, the recession in the US economy is easing, but there are still a lot of problem areas. Retail sales have been sluggish, commercial real estate weakened in most regions, the labor market remains extremely soft, and lending in the various regions has either weakened further or remained unchanged. The lack of a recovery in consumer spending will stifle the recovery in the US economy. For the Federal Reserve, the Beige Book report is extremely important to their monetary policy decision. We believe that given the tone of the latest report, the central bank won't be making changes to their quantitative easing program or interest rates anytime soon. Looking ahead, jobless claims are due for release, and it will be important to see if claims creep back towards the 600k level.

2) IMF Asks Central Banks to Choke up Dollars

The IMF also announced that it will be drawing on bilateral loan agreements with Norway, Japan, and Canada after Ukraine requested a $3.3 billion loan. These central banks will be required to give up US dollars or their special drawing rights. This demand for US dollars may be part of the reason why the dollar rallied against the Japanese yen and Canadian dollar despite overall risk aversion.

3) Disappointing Bond Auction

This week is a big week for Treasury auctions, but unfortunately, the US government’s attempt to sell a record amount of five-year Treasury notes was met with extremely disappointing results. The bid-to-cover ratio for the five-year Treasury auction was 1.9, which means that for every offer accepted, 1.9 bids were put in. In general, a bid-to-cover ratio of less than 2.0 is considered weak. As a result of the lackluster demand, the government had to sell the notes at a yield of 2.69%, well above the 2.635% forecast. The weak results drove equities and currencies lower.

4) Trader Positioning

Last Friday, we talked about how traders were extremely long euros and short dollars on the futures market. In fact, net long euro positions surged from 13,899 contracts a week earlier to 34,722 on July 21. This is the largest amount of long positions since March 2008 and the sharpest gain that we have seen in a very long time. Whenever there is such a strong increase in net long positioning, it suggests that the currency pair is prone to profit taking on any hint of bad news. It also suggests that those traders who want be long euros are already long and that few buyers are left in the markets.

5) Technical Exhaustion

From a technical perspective, the hesitancy in the currency markets over the past week suggested that a breakout was imminent. The failure of pairs like the EUR/USD and GBP/USD to break their year-to-date highs also indicated that those levels are strong resistance. Stochastics in the EUR/USD were in overbought territory, and when combined with the extremeness of trader positions, the odds were skewed towards a downside breakout.

By Kathy Lien, Director of Currency Research at GFTForex.com

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