The U.S. dollar: Too big to fail?

August 31, 2009 07:00 PM

Lien expects more consolidation in the next few months. “Volatility picks up in the currency market in August and September, but there’s no major trigger for that volatility because central banks aren’t going to increase interest rates any time soon. Any rate hike from a central bank won’t come until the latter part of 2010. There are no real surprises left out there in the market, and because of that, more consolidation and range-trading is likely,” she says.

Dolan says the countries with commodity currencies, Australia, New Zealand and Canada, are more likely to tighten rates before the United States does. He expects the Eurozone to be on hold for all of 2010, and the UK to begin to increase rates in the first half of 2010. He notes that most of those expectations are already priced into the various interest rate markets.

CHINESE CHECKERS

As the largest foreign holder of U.S. Treasury securities, with an estimated $801.5 billion as of May 2009, China’s influence on the currency market
is huge.

Unless it moves to a significant revaluation of the yuan, Dolan expects China to keep buying U.S. Treasuries. “We have a massive amount of Treasury debt to be issuing and that’s the major negative hanging over the dollar over the next year,” he says.

Wilkinson thinks that China’s buying spree is positive for the dollar. “The Chinese are giving America’s fiscal policy a thumbs-up. If they didn’t agree with what the Americans were doing, they would be foolhardy to continue buying debt at a record pace. They seem to understand the fiscal stance and the prospects for deficits going forward perhaps better than the market does. That would be supportive of the dollar,” he says.

“Currency traders should buy what China’s looking to buy,” Lien says. “The hunt for resources has been their main focus and that’s going to continue, especially in terms of gold. The Bank of Canada is watching commodity prices in China because commodity prices are helping to offset the rise in their currency.” She says that if the dollar continues to weaken, the BRIC nations (Brazil, Russia, India and China) could start diversifying their reserves out of dollars.

Cook agrees. “China, Russia and Brazil are the most vocal about the world moving away from a reserve currency. Despite voicing concerns regarding U.S. policy, China continues to buy massive amounts of U.S. debt so any devaluation of the dollar is going to hurt their overall holdings. They keep buying commodities, which will help the Aussie against the dollar, but it will hold it pretty stable against the euro and the pound,” he says.

Frey says that China has more incentive than anyone to maintain the value of the U.S. dollar. “On a long-term basis, they’re going to be a big player. In the short term, there’s very little they can do. They’re not about to sell U.S. Treasuries.”

CRUDE AWAKENINGS

The correlation between crude and currencies is always strong, particularly with commodity currencies such as the Canadian dollar (see “Loonie for oil”). With the U.S. dollar, there’s typically an inverse correlation — the weaker the dollar, the higher crude goes. Lien notes that the strong correlation between the Canadian dollar and crude is the reason for the fall in the USD/CAD from $1.16 to $1.08 as of the end of July. She expects the USD-CAD to reach $1.10 by October.

“Correlation levels have reached significant highs and at some point there’s going to have to be a little bit of a breakdown. The level of economic activity is going to be subdued enough that commodity prices should not run away on the upside and if they do, we’re looking at the potential of a double-dip recession,” Dolan says.

Wilkinson notes, “There’s confidence displayed through the price of crude oil that the worst is over and we’re not going to roll over in terms of economic activity, so that’s supportive of the commodity currencies.”

Cook does not expect a massive run-up in oil. “Oil is going to go right with the U.S. dollar. I’d look for oil not to get above $75 or below $58. We’ll see a choppy market there and that’s going to translate to a choppy dollar trade, particularly as it relates to the euro and the pound,” he says.

Analysts agree that currency traders should be focused on rates, economic recovery and protecting themselves from risk.

“If we get some surprises and someone’s short the U.S. dollar, they could get hurt. [Traders] should take it day to day; protect profits when they have them, moving stops up to make sure they don’t let it all disappear. The fundamentals right now are mixed and they look to be mixed moving forward the next three months,” Cook says.

Dollar weakness could prevail as risk appetites improve and the dollar is sold off, Dolan says, adding “There are relative growth differentials, and the U.S. is going to do better than the other mature G-7 economies. Europe is going to be the laggard. We’ll put in some dollar lows ahead of September and from there the dollar will start to move a bit higher.”

Frey is not so sure. “As we get into the fall of 2009, it’s not a very pretty outlook for the U.S. dollar in the short-term and we can see some more dollar weakness [through the end of the year],” he says.

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