Seeking Alpha
Recommended for you:
Profile|
( followers)  
If you read enough blogs and most of the mainstream media out there, you would think that the dollar was like a Pepsi can sitting under the bottom of a 400 lb. gorilla. Really? That's spoken like someone who reads a lot of headlines and blogs away, yet has never put on a currency trade in their life.

Let's put it all into perspective.

Most will quickly point to the USD index as "evidence" that clearly the dollar is getting clobbered. Here's the chart to solidify that argument:

click to enlarge
dollar

Yup. The backside to can ratio is enough to make a dent. But, in order to really get an understanding about this chart, you need to know what it is. The USDX is an index of the U.S. Dollar vs. all of the majors: Australian, Canadian, Japanese, Euro, Swissy, and Pound. There's only one real problem with this whole thing. The Brits and the Swiss have, over the years, taken great strides in achieving stability with their euro counterparts. In fact, at some point, both currencies are likely to go the way of the French Franc, Italian Lira, Spanish Peso and such, and disappear forever. So, it kind of begs to question.... why are these currencies still involved in the index? After all, all three represent 50% of the entire weighting. Seems a tad unfair and impractical. In fact, if you were to take out the pound and the swissy, the European currencies would fall from a weighting of 50% (three of six) down to 25% of the index. The weighting from Europe is far too great, seeing how all three of those currencies basically move in concert with each other.

If you were to look at the other three majors in the index, the dollar's move over the past few days looks far better than most headlines would lead you to believe. In fact, the dollar is quite stable against the yen and has even appreciated against the Canadian. The Aussie is up a few cents. The picture looks a lot brighter.

But there is still weight on the dollar. Why?

Tom Graff asked me that question last weekend. I sort of shrugged the entire move off as a holiday inspired move. After a nice little road trip down south, I was able to do some quality, nowhere-near-any-distractions thinking. I thought my answer to Tom could use a little more depth.

Let me introduce you to a term that isn't so very new. Hopefully.

Arbitrage.

Back in "the day" when currency trading was in its infancy, it was very possible to call a bank in New York and get a quote from a dealer for whatever currency, only to find that if you called another bank in London (perhaps even with the same logo on the building) you'd get a different price. Arbs made a killing until the EBS came about and all banks started sharing their prices with each other. The arbs lost their day. Banks are funny about not liking being taken advantage of.

Now, here's some of the meat and potatoes of currency trading where I'm very likely to lose a few bloggers who love to post just about anything about just about everything. But, us currency traders can relate and are very likely to get this concept fairly well. How many of you out there have ever put on a EUR/JPY trade, and actually thought you bought EUR/JPY? The thing is, the currency itself doesn't exist. It's a mathematical figment of the market's imagination.

Enter the arbitrage situation again. The banks, instead of letting the market fix the price of EUR/JPY, decided to get rid of any arb situations. Instead of letting the market fix the price, the computers mathematically calculate the price of what EUR/JPY (and every other cross against whatever currency) would be dealt at based on the price of EUR/USD and USD/JPY at the time of the trade. The arbs lose their day again.

If you were to pick up the phone and call your broker up and ask to buy EUR/JPY, you aren't actually going to be buying that currency. You are buying a cross. The value of that cross rate is determined mathematically by the price of EUR/USD and USD/JPY. In fact, you are actually buying EUR/USD and selling USD/JPY simultaneously. Didn't know that, did you? But, now you know why when the price of EUR/JPY hits, you aren't necessarily filled. No matter how much you ague with your dealer.

So, what's this got to do with the price of dollars?

My answer to Tom probably wasn't enough to get the information that he was looking for. Most in the industry that I talked to could barely come up with a response other than holiday movements. There was no real catalyst for the recent price activity. But, instead are now on the "dollar is getting clobbered" bandwagon. I thought about that a little on my drive, and realized that there in fact was a big catalyst to what was going on. It's just not where anyone was looking. It lay in the EUR currency against the yen.

The fundamentals are quite simple in this scenario. The FOMC is sitting on their hands with interest rates. The BoJ? They moved all the way up to 0.25% and appear to be sitting on their hands. All other Central Banks appear to be sitting on their hands as well..... except for the ECB. Their rates are sitting at 3.25% for now, and are likely to go higher in the foreseeable future. We just don't know how high.

That should prompt somewhat of an 'A-ha' to your thinking. Interest rate arbitrage is a big deal in this industry. It's probably the biggest deal, really. If interest rates are moving higher in Europe, and largely flat as a board in Japan, wouldn't you want to take advantage of that kind of move? Most likely, yes. Other Central Banks have already moved. It's the ECB that is FINALLY getting off their butts and doing something. And, now the arbs are biting in. They are borrowing in Japan, and moving their currency into the euro in hopes of interest rates that are on the rise.

Now, think about the price movement necessary to move the EUR/JPY that I mentioned earlier. To begin with, it's a mathematical equation. Take this:

{EUR/USD * USD/JPY}

What's that equal? You have two fractions there. Cross out the USD in both, and the remainder is EUR/JPY.

Now go back to the original concept of buying EUR/USD and selling USD/JPY. In order for EUR/JPY yen to move up, you need to buy EUR/USD and simultaneously sell USD/JPY. The effect will be to push up EUR/JPY. Here's the chart:

click to enlarge
dollar

Every new price listed on this chart is an all-time new high. The EUR/JPY has been on a tear. I'll say this again: In order for this currency to be bought, you must buy EUR/USD while simultaneously selling USD/JPY. Here's the latest chart on USD/JPY:

click to enlarge
dollar

USD/JPY has largely been rangebound, although there's been some gang warfare related moves lately because most assume the dollar is what is actually getting clobbered. Here's the latest chart on EUR/USD:

click to enlarge
dollar

Now you know why the euro looks so bought up. It's because of the move in the EUR/JPY. Money is rushing in to the EUR/JPY -- not out of the dollar. The dollar is merely the catalyst to get into the EUR/JPY. Bet you didn't know that. In fact, if the dollar itself were not the safe bet that I've been touting, and Tom, then why would money be flying into the U.S. debt market, sinking the yield?:

click to enlarge
dollar

Money is standing pat here in the U.S., and the dollar is not getting clobbered. Someone is just taking advantage of a yield differential between the Europeans and the Japanese.

In order to profit in this scenario, you need to take into account all the possible scenarios: Is the ECB really going to push rates up higher and higher? Is the lower dollar vs the euro going to prompt the FOMC to raise rates themselves? And will the BoJ sit on their hands for another 10 years? These are the scenarios you need to be weighing in order to figure out future price movement. It has nothing to do with the trade deficit. It has everything to do with someone making some money via the interest rate arbitrage. Soon, the currency moves will have been so great, that any profit potential between the interest rates will be null. Then, the euro will decline. Also, if there is any wavering in the ECB, the euro will get clobbered.

And now you know the reason behind the latest moves. Keep this in mind if you are sitting on any euro trades. It's not a one-way bet, and it likely has nothing to do with the reasons why you even put the trade on.

Source: Dollar Decline? What Dollar Decline?! It's Arbitrage.