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Monday May 3, 2004 - 15:37:55 GMT
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Dollar Thoughts

Dollar Thoughts

It is hard not to notice that the big run-up in the dollar through mid-April can be partly explained by the unwinding of large currency "reflation trades", namely short dollars and long high yield and commodity based currencies (AUD, NZD, GBP, CAD and ZAR to name a few). With the US labor market emerging from the shadows of darkness in March and the Fed awakening to future inflation risks after putting deflation risks to rest, the assumptions that underscored these reflation trades were snapped from underneath the market in fairly short order. As these trades unwound, especially through the first half of April, the dollar spiked versus the commodity and high yield currencies, and it also advanced versus the euro and yen. But by the end of trade last Wednesday, following the call by China's Premier to cool an overheating economy (and demand for commodities), the high yield/commodity currency trade was gone...game, set and match. And with it the flow into the US currency slowed dramatically leaving the dollar longs accumulated on the speculative side vulnerable. A strong GDP report if not as strong as most expected and evidence of rising core prices, could not keep the dollar rally going. More strong data last Friday did little to reverse last Thursday's dollar losses as well.

It's a correction okay and I think the dollar high has yet to be reached (versus yen, euro, stg, C$, A$ and chf). But the going from here is likely to be more difficult now that one major prop has been pulled...arguably one of the market distortions created by ultra-accommodative monetary policy.

Looking ahead at next week, the FOMC meeting Tuesday will likely jettison "patience in removing accommodation" language, upgrade the assessment of growth and labor market conditions and give equal weighting to the balance between inflation and deflation (or disinflation) in the statement issued at the end of the meeting. A week ago this would have been good for a percent or two for the dollar. Now? Considerably less and arguably very little as it is largely priced in. Then, it is on to Thursday's rate meetings by the ECB and BoE. Surely the ECB will not cut as little has changed in the Euro Zone data since the April01 ECB Council meeting to warrant a cut. So it is all about what Trichet has to say in the press conference. Some sign of a thorough consideration of a rate cut is needed to get the dollar rally back on track. Then again the BoE is expected to hike on Thursday and this will dull dollar demand somewhat (note growing quite nervous over stg outlook given risks to housing market correction). However, even in the event that the BoE does not hike and Trichet confirms the ECB is considering a rate cut, the dollar upside should be checked by Friday's release of US April payrolls. Thank the Fed for making this random number generator the most significant monthly data release and arguably more significant than rate decisions by G7 central banks, especially in today's world of telegraphing rate changes.

No I am not turning dollar bearish near-term (remain dollar bearish longer-term), but the angle of ascent for the dollar ahead should be flatter by a few degrees thanks to the full unwinding of the currency component of the reflation trade.

David Gilmore
FXA

 

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