4 Reasons To Buy Back The Dollar

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 |  Includes: FXB, FXE, FXI, UDN, UUP
by: Tim Clayton

The long-term economic and structural cycle is still dollar bullish based on a stronger relative growth potential and improving fundamentals. Much-reduced asset flows into emerging markets also strengthen the case for a dollar advance. The key question is whether it has corrected far enough from an over-bought position, and there is now a strong case to suggest that it has following the retreat to four-month lows on a trade-weighted basis. After pricing in too much, too soon, the dollar again offers good value at current levels, especially above 1.3350 against the euro and weaker than 1.57 against sterling.

1. The latest IMM positioning data recorded a sharp reduction in euro shorts to a net figure near 7,000 compared with over 50,000 the previous week. The euro did gain ground during that period, although advances were measured, which suggests that there was plenty of supply to absorb the buying pressure. The data is only to June 11th and there is likely to have been a further reduction in positions since then. Indeed, there may now be a net long euro position, which will provide important dollar protection against further selling.

2. The Federal Reserve FOMC meeting is, of course, the critical focus this week with the Fed facing a very important balancing act in its Wednesday policy statement. A key message from the Fed is that they want to differentiate between interest rates and quantitative easing. There is likely to be further reassurance that interest rates will remain extremely low throughout the next 12 months and that any reduction in the rate of bond purchases does not mean that interest rates will increase.

The Fed is also certainly extremely wary of reducing quantitative easing too quickly given the risk that this would trigger a sharp slowdown in growth and could risk a fresh recession. Policymakers are, however, also acutely aware that markets need to be weaned off the bond-purchasing program. There needs to be some pricing-in of a tapering of bond purchases in order to avoid a more severe market dislocation later. In essence, a modest amount of pain now is much better than more severe pain later. The Fed is unlikely to take an ultra hawkish tone, but it also can't afford to be too dovish and the overall tone is likely to be neutral to slightly dollar positive.

3. To some extent, the euro has had a free rise over the past two weeks with the currency gaining support from the ECB's refusal to sanction additional monetary easing. Underlying eurozone fundamentals remain precarious at best with a high risk that Italy will become the principal focus over the next few weeks with unemployment at a 30-year high. The depth of despair is also illustrated by the fact that Greek youth unemployment rate of over 60% is almost accepted as the new normal. It is not possible to predict exactly when there will be a decisive surge in political opposition against the current austerity mechanism, but the euro has not priced sufficient risk at current valuation. The eurozone banking sector remains extremely weak with the FDIC, for example, calling Deutsche Bank "horribly under-capitalized." Pressure for balance sheet adjustment throughout the eurozone will keep lending extremely weak and put fresh pressure on the ECB.

4. China's economic policies will remain an important focus, especially given the impact on emerging-market assets flows. The evidence continues to suggest that the new government under President Xi and Premier Li have decided that an attempt to stabilize the financial sector is a greater priority than looking to boost growth at all cost. If there is no move to stimulate the economy, underlying growth is likely to slow further which will tend to curb capital inflows to China, particularly with new banking-sector capital requirements and fellow BRIC countries. There will also be downward pressure on commodity prices, which will support the dollar.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.