Analysts and even big hedge funds are predicting a US dollar rally, and traders who get caught playing the short side of the battered currency could soon fall victim to quite a squeeze.
In April, I declared that the dollar would rally when QE2 ended. That date (June 30) is now only a few weeks away, which means it won’t be long before we know whether or not I was right.
Meanwhile, the dollar is close to pre-credit-crisis levels on a composite basis, and has already fallen to record lows against a handful of specific currencies. In other words, it’s now “do or die” for the US dollar.
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Since my last update, a number of things have happened. Commodity prices have continued to rise, and inflation has ticked up slightly. GDP growth has moderated, the unemployment rate has stagnated at 9%, and the S&P has fallen slightly as investors brace for the possibility of an economic downturn. Finally, long-term interest rates have fallen despite concerns that the US will be forced to breach the debt ceiling imposed by Congress.
From the standpoint of fundamentals, there is very little to get excited about when it comes to the dollar.
While the US is likely to avoid a double-dip recession (the case for this was most convincingly made by TIME Magazine, of all sources), GDP growth is unlikely to rebound strongly. Exports are growing, albeit slowly.
Businesses are investing (in machines, not people), but they are still holding record amounts of cash. Consumption is strong, but unsustainable.
The government will do what it can to keep spending, but given that the deficit is projected at 10% of GDP in 2011 and Congress is playing hardball with the debt ceiling, it can’t be expected to provide the engine of growth.
Meanwhile, Fed Chairman Ben Bernanke has implied that QE2 will not be followed by QE3. Still, he warned that “Economic conditions are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”
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|pagebreak|With low growth, high unemployment, and low inflation, there isn’t any impetus to even think about raising interest rates. In fact, Bernanke and his cohorts will continue to do everything in their power to hold down the dollar, if only to provide a boost to exports.
Bill Dudley, head of the New York Fed, intimated in a recent speech that the Fed’s current monetary policy is basically a response to emerging market economies’ failure to allow their currencies to rise.
In short, if I were arguing that fundamentals would provide the basis for renewed dollar strength, I would have a pretty weak case. As I wrote a few weeks ago, however, there is a wrinkle to this story, in the form of risk. You see, the dollar continues to derive some significant support from risk-averse investors, as evidenced by the fact that Treasury yields have fallen to record lows.
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Ironically, demand for the US dollar is inversely proportional to the strength of US fundamentals. As the US economy has rebounded, investors have become more comfortable about risk, and have responded by unloading safe-haven positions in the dollar.
With the US recovery now faltering, investors are slowly moving back into the dollar, thus re-establishing safe-haven positions. While the dollar faces some competition in this regard from the Swiss franc and the Japanese yen, it still compares favorably with the euro and pound.
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In fact, some traders are betting that the dollar’s fortunes may be about to reverse. It has fallen 15% over the last year, en route to a three-year low. With short positions so high, it would only take a minor crisis to trigger a short squeeze.
Said the CEO of the world’s largest forex hedge fund (John Taylor of FX Concepts): “We see a big upside USD catalyst in the next ’3 or 4 days’ on the grounds that…’Our analysis of the markets has shown that they are very, very dangerous.’”
For what it’s worth, I also think the dollar is oversold and expect a correction to take hold at some point over the next month.
By Adam Kritzer of ForexBlog.org
