The forex report for Dec. 17

A message to the U.S. dollar bears

A sea-change seemingly swept the fortunes of the dollar right back onto the rocks Tuesday following the Fed’s de facto adoption of a zero-interest rate policy. The additional confirmation that it will also monetize the nation’s debt and ease monetary policy in a more quantitative fashion through the purchase of various government, mortgage and agency bond instruments is apparently the thing that rumbled dollar bears from their torpor. Currency option volatility is back in fashion hot on the heels of a declining greenback, while options players took a contrary position in the euro currency as they established sizeable positions hunting for continued euro weakness by mid-2009.

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Since one week ago, the dollar has lost 15 pennies against the euro to $1.4200, while it continues to lose out to the yen dropping 5.8 yen to ¥88.28 this week. Against the pound, the dollar has dropped 6 pennies to £1.5377.

As analysts start to ponder their predictions for 2009, there are few dollar bulls left. Each seems to be in unison when they say the Fed has done a great job of satiating the demand for dollars by taking the lead on liquidity provision. And with the potential for massive fiscal stimulus they argue that the spotlight is back on the twin deficits, budget and trade. The dollar won’t be able to survive, they argue with such heavyweight blood-brothers in the family.

It’s amazing to have lived-through a very prosperous era for the dollar throughout 2008 when those same arguments were trashed as the world cashed in asset decimation for the sanctity of the dollar. Our point is this: If the dollar’s strength was purely based on risk aversion with slumping equity markets a convenient smokescreen, then what is the point in predicting a gentle decline against the euro to anywhere in the $1.40s? If the market was correct in its assessment of the dollar back in March when the dollar reached a record low against the euro at $1.60, then why not boldly state as much today? If the fiscal and monetary measures adopted by the Fed and in progress with government are that bad, then the fortunes of the dollar are resigned to historic lows in 2009. Further record lows would then be clearly mapped out on the table for the dollar, much to the contentment of the rudely awakened bear.

However, one has to try and see through such myopia. Our argument remains that precious little is mended despite the abandonment of interest rates by the Fed. Lower interest rates have cushioned the blows to the real economy making it less expensive to borrow. But the reality is far different. Lenders are not actively lending because demand for expansionary projects is not there. What demand is there seems to exist in order to shore up balance sheets, cash flow and preserve ones corporate or personal existence. Note the recent surge in housing refinancing as mortgage rates plunged. It should not be a shock to anyone to learn that lower interest rates aren’t exactly what is needed to undo several years of excessive lending practices.

The world’s largest economy is still in a huge mess. That’s a polite way of stating it. We see no positive data having emerged that instills confidence in a rebound. We would still argue that where the US is heading, the global economy is not far behind.

Where the focus has changed in the world of currency trading is that investors seem to have found some nirvana in taking the view that, while monetary policy requires active reduction, fiscal policy requires prudence. In that regard the dogma surrounding the slow-to-act European Central Bank wins the day. However, both policies require the passage of time before we see results. What we feel is more likely to happen is that the Europeans’ reservation to use enough fiscal or monetary stimulus will come back to haunt them in terms of a rather messy economy bogged down under the weight of sliding consumer and business confidence and activity.

The yen remained the unit of choice again – proving that risk aversion has not gone away despite the fact that the world’s equity markets rallied. The pound rallied against the dollar, despite recording record weakness against the euro. Arguably the pound is far more susceptible to punishment than is the dollar. It’s a far smaller market and easier to herd than the dollar. It makes no sense that the dollar should decline against the pound at this time if the dollar’s loss of popularity is based upon fear of burgeoning deficits. On this score the pound can hold its own with the dollar!

A sliding dollar would bring us full circle back to where the equity markets were positioned in March before Bear Stearns gave way. Back then the dollar was in the same boat as other toxic debt assets driving the tone of the negative environment. Since then the dollar’s rally has forced a capitulation in equity markets, aided and abetted by weaker economic activity. As investors discount a recovery it would be all too easy to take us right back to the original scenario of a weaker economy inspired by a run on the dollar. That in turn would logjam the credit markets further, undermine economic activity and create fresh waves of selling. In turn that would bring on demand for the safe haven of the dollar. Therefore, predicting dollar weakness is a circuitous argument that ultimately ends in calamity. Analysts should be careful what they wish for.

We can’t help noticing that despite being dragged higher against the dollar, the Canadian and Australian dollars are not reflecting any better fortunes for demand for commodities. If they were, it might instill some confidence in a global rebound, which encourages us to use the adage that this is merely a dead-cat bounce.

Investors have recently been bound up in what one might call bad news fatigue. They can’t feel any worse than they did a month or so ago when truly bad news made them respond by selling stocks and made consumers stop in their tracks as employers fired workers. Right now we are in a phase during which our expectations are being framed for the future. As that happens, the equity market’s failure to push lower is mistakenly interpreted as the end of bad news. As that happens more investors seem willing to hop on board for fear of missing the boat leaving the harbor.

We can’t reiterate enough that nothing has changed when it comes to measuring the performance of the economy. What has changed is the perception that the euro is a better place to be than the dollar. Simply put, it’s not. But the perception has created an active market place for currency trading and as such has boosted volatility. On the euro, there was heavy demand late last week for June puts around the 119.0 strike, which has boosted the reading of open interest by around one-third during the week to 116,000 contracts. Implied volatility rose from 18% one week ago to 24% today.

In Australian dollar options, investors were smart to make a 180-degree turn when they shunned open bear positions in the March contract where they were long of 15,000 puts at the 60 strike. About two-thirds of those positions were closed during the week while call buying appeared in the January 67.5 strike where open interest grew from zero to 14,600 contracts. The Aussie unit is back above 70.0 cents against the US dollar for the first time in six weeks.

Andrew Wilkinson

Senior Market

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