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Wednesday May 26, 2004 - 13:48:46 GMT
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Dollar Lower...Wait A Minute (FXA)

Dollar Lower...Wait A Minute (FXA)

Plenty of damage done to dollar technically on Tuesday with the break of key bull t-lines in dollar index, versus euro and stg while versus chf dlr broke channel support and went through big retracement (50% from Jan-Feb lows). Price action is flushing out a dollar bearish story as I noted in yesterday's alert. Oil is seen reducing Fed need to hike, Fed rate hikes and then some (more than Fed has in mind) are fully priced in at the short-end of the Tsy curve. And the US structural imbalances are again receiving attention (current account funding problem).

So why my hesitation?

Lower dollar has always been in my long-term forecast. So I welcome the return of the weak dollar. But I am hesitant to embrace building a strategic short dollar trades at these levels, especially in front of a/ a long weekend (US, UK and some of Europe), b/ June03 OPEC meeting and c/ June04 US May jobs report (payrolls). The cyclical story is about as dead as Freddie Kruger (of Nightmare On Elm Street fame). OPEC agreement to up production next week could take some of the pressure off oil prices (have said before that we may be in a new period where the demand curve has shifted out, and less a function of supply). And when it comes to May payrolls anything can happen (my random number generator). Indeed another payroll advance in excess of 200K would throw a 50 bps June30 rate hike in the mix especially if it followed lower oil prices on OPEC meeting. Granted these are not outcomes one can forecast with any confidence...they are risks. And the risks are sufficiently high to say wait a minute on selling dollars at new lows. Next week is critical for sustaining the current trend of selling dollars...and events/data are sufficiently significant to warrant caution for short sellers.

Nonetheless, the cyclical story of the Fed hiking with the ECB on hold may be a necessary condition for a stronger dollar in the current environment,but it is far from sufficient. The dollar fell for most of 1994 when the Fed was raising interest rates 300 bps. Moreover, more than a few specs are eager to punish the Fed in Tsy and FX market for being behind the curve on tightening. So some Fed tightening could turn quickly into a dollar negative and measured rate hikes over time in the aggregate may not aid the dollar as 1994 showed. Moreover, the credit market is still structurally long (credit derivatives and mortgage backed mkt...also GSE risk). A beat of a butterfly's wing could generate a rogue wave and capsize this market in a hurry. This would send market rates up sharply, perhaps force a Fed rate cut and sink the dollar (a risk not a forecast). My point is higher rate story is no path to higher dollar.

Lastly, I think the dollar rally from the February low is mostly about unwinding deflation trades (sometimes called reflation trades or carry trades) and less about the direction and extent of Fed rate policy. Sure Fed's desire to remove accommodation set the unwind in motion (backed by mostly payrolls and then inflation data, with some help from retail sales). The unwind of trades built around the assumption US inflation was a non-issue, US rates would stay low and return involved leveraging up in commodities (and commodity currencies), equities, emerging market debt/equity (Asia/Latam), financially engineered yield (credit derivatives), REITs, borrowing short-lending long (carry trade) and buying high yielding currencies (FX carry trade). So the foundation of the dollar rally through Apr-May was built on a weak foundation...repositioning dressed up as Fed tightening.

I like the dollar lower, but not sure the market is fully aware now of the dead end in buying dollars on the cyclical story (relative growth rates and relative official interest rates). Hence the caution. Next week will be telling and if OPEC gets oil down and payrolls come in strong, sell the rally and think about building a strategic short dollar position with say 1.35 in mind in euro/dollar by the US election.

David Gilmore


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