Dollar off the ropes

FUNDYS

After nearly breaking the intense bullish sequence of 27 consecutive closes higher than the previous daily low on Friday (as we had projected), the Euro finally officially broke the sequence on Monday in dramatic fashion, dropping some 70 points in the final hour of trade. As per our analysis in previous commentary, the break of this sequence could now open a further drop of some 300-400 points before we see any real resumption of Euro buying.

Relative Performance vs. USD Tuesday (As of 10:35GMT)

  1. EURO-0.14%
  2. AUSSIE -0.17%
  3. SWISSIE-0.19%
  4. YEN-0.26%
  5. KIWI-0.33%
  6. CAD-0.33%
  7. STERLING-0.60%

The recovery in the US dollar over the past few days has been brought on by a scaled back expectation for a second round of quantitative easing from the Fed, which had initially accelerated following the Bernanke speech on Friday. While it is certainly true that the Fed Chair outlined the possibility for another round of quantitative easing, the fact that he did so should not have come as a shock to market participants with the subject of the speech being "Monetary Policy Objectives and Tools in a Low-Inflation Environment.” However, the fact that Bernanke failed to hint at any timing for such measures, or offer any real specifics on the policy, while also reminding investors of the “if necessary” language in the monetary policy statement, was indeed unexpected (not by us), and therefore resulted in some profit taking on USD shorts. This was the set-up for the anticipated reversal and fundamental catalyst for the start to the comeback in the Greenback.

So from here, what then would be the next market event to trigger additional USD buying and help build momentum for the current USD rally? Well, that came late Monday when Treasury Secretary Geithner was out with some rather strong language on the US dollar that we believe should send a clear message to the markets.

While it is certainly true that the United States has maintained a questionable strong US dollar policy in light of what appears to be actions on behalf of the government that would be anything but USD positive, to us, it is highly telling that Treasury Secretary Geithner went over and beyond on Monday with regard to the official stance on the US dollar. Should the Treasury Secretary have wanted to keep things status quo, he simply could have just said that the United States maintains a strong USD policy. However, Geithner came out swinging after saying that the USD would remain the reserve currency in our lifetime, the United States supported a strong dollar, and the United States would not resort to policy to force a devaluation in the currency.

We believe this should send a strong message to the markets that just maybe, the United States does really maintain a strong USD policy, and as we have said in previous commentary, the fact that the USD is weaker right now is more a function of loose monetary policy in order to stimulate growth, rather than a specific desire or mandate to weaken the currency in order to rebalance the economy.

We need to remind ourselves that the world relies heavily on a stronger US dollar. The system works because the United States is able to consume product from abroad at attractive prices because the US dollar is stronger and other currencies are happily weaker. Other major economies heavily rely on their export sectors and therefore are encouraged to have a weaker currency in order to promote their product. This is why quantitative easing measures (that devalue currency) in other economies can be more easily justified and why we feel the Fed should be much more sensitive (and we believe they are) to the longer-term impact and inflationary threats from the implementation of additional quantitative easing measures.

We acknowledge and commend the Fed for their efforts to this point and feel they have done an excellent job at managing the economy and prioritizing the immediate threats over the longer-term fallout from such policy. However, from here, the risks for any additional QE measures should be weighed heavily, as we fear that if the Fed goes too far, it will pass that hyperinflationary point of no-return just like Japan did several years back. But in this case, the fallout will be more substantial and threatening to the global economy.

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