The Easy-Money Days of Dollar Shorting May Be Over

US dollar

For the longest time dollar bears and commodity bulls have been able to virtually print money by shorting the dollar. Only during the period of monetary tightening from the Fed was the dollar really protected from a half-decade long decline in value. These days it’s been a case of a widening yield differential that’s seen the dollar shift from a yield premium to a discount to the euro rather than a simple loss of confidence in the American economy. Backing the euro has been an easy wager for many currency speculators thanks to the fact that the dollar has been handicapped by its weakening economy and crippled financial system.

Now that the Fed has eased the fed funds target to 2%, the debate heading into the June FOMC meeting will be far more contentious as to whether the Fed should reduce policy further or not.

So for the longest time those backing the euro are finding that the dollar is a far more attractive proposition than it was a couple of months ago. And with good reason.

• Banks have most likely written down the vast majority of their bad lending decisions.
• It’s becoming clearer that the US recession is largely confined to the housing market.
• Friday’s labor data showed a 5% unemployment rate, which is still a far-cry from the 6.3% reached in the 2001 recession.
• Interest rates have fallen 3% in just nine months
• Fiscal policy is providing consumers with a shot in the arm

So as far as the dollar goes, any trader weighing up the payoff at the printing press these days has a far harder challenge. The easy trade-of-the-week is therefore to sell the dollar rebound. However, the harder trade is to buy the potential turning point in the dollar and look forward to a summer of strength for the greenback.

Euro

The single currency is where the dollar has suffered most. But look at the following chart, which shows the dramatic decline from a (euro) bearish wedge formation as it broke down on April 24 through approximately $1.5790. For euro bulls, this chart is worrisome due to the fact that the break down from a wedge formation in a rising market is extremely bearish. While we’re displaying the spot chart below, the target that the formation calls in the futures market is for a new contract low. Just to give you some food for thought, the historic low for the June 2008 euro currency futures contract stands at around $1.3092.

Now we’re not saying for one minute that the euro is set to tumble that far ahead of expiration in around five weeks, but what we are saying is that there is a strong probability that its days are numbered and that lower prices are ahead.

We say that the easy trade is potentially to sell the dollar’s rebound in search of a knee-jerk pullback, which in order to test the break point at the trendline could see a rise back to $1.5790 according to the chart.

British pound

Although the pound rallied against the dollar on Monday, investors have appeared sanguine over the risks to the British economy. Last week the ruling Labour Party under the leadership of Prime Minister Gordon Brown gave posthumous credence to the Captain of the Titanic as the party came away with a severe bruising in local council elections. According to current polling intentions, Labour would lose its majority in a general election today. The pound doesn’t really trade on political fears these days but we wonder whether a government in crisis will become part of traders’ agendas going forward.

The tax treatment of corporate Britain has overnight become fuzzy as the government attempts to boost tax receipts. The problem is that companies no longer see what they were accustomed to, which is a transparent tax regime. Slowly, small companies and even some large ones are seeking out lower tax regimes to perform their business. Mr. Brown needs to understand the huge impact that this could ultimately have on tax receipts, business confidence, employment and the external value of its currency.

Already investors are being overly generous in the price they assign to sterling and seem more focused on dollar weakness. If and when the tide turns in favor of the dollar, you can see how sterling might plummet in value as a new wave of economic and political risks are factored in.

Canadian dollar

During the previous six weeks the Canadian dollar has ranged between US$1.00-$1.03. You have to look back beyond a six-month period for a break outside of the range of $0.97-$1.04. Blame the credit crisis and assumption of a major economic slowdown for the run on the Canadian unit towards the end of 2007.

So where now? The Bank of Canada has eased policy in order to handle the wave of weakness across its economy. Yet commodity prices continue to rise thanks to global pressures. Although the U.S. is Canada’s main trading partner, demand for oil, gold and other minerals currently translates into higher demand for the Canadian unit to finance necessary demand.

The stagnation of the Canadian currency is leading to lower option implied volatility meaning that traders don’t assign a strong probability that the recent range will give way. That might be a premature conclusion to draw should the current environment favor the U.S. dollar. That’s because a rising dollar would alleviate commodity price pressures going forward and could hurt the Canadian unit despite the potential for a pick-up in commodity demand. In that case we’d expect to see a break up out of the US$/Cad 1.03 ceiling. In currency futures terms, we’d expect to see weaker Canadian prices shown in the following chart and to breach support at Cad 0.97 cents.

Notice in the chart below how option implied volatility recently fell through 11%, indicating a quiet trading environment ahead.

Australian dollar

There has been little change in the attitude towards the Australian dollar, whose value was insulated in the latter part of 2007 thanks to evidence that the Australian economy had far more commodity outlets in Asia to support it. As has been shown with the Canadian dollar, volatility is dissipating while the Aussie is fast closing in on a 52-week high in the following chart.

We were formerly of the opinion that the global credit crunch would ultimately bite down under and that the Reserve Bank would be left with little option but to slash interest rates to revive a flagging economy. However, that prospect seems to be dissipating as the U.S. economic contraction becomes more transparent. The prospects for the Aussie dollar do look more appealing today. The trade to take then would be short Canada and long Australia as a way to dissect the commodity dollar space.

Comments

[special1person]

"It’s becoming clearer that the US recession is largely confined to the housing market."

*79% of Americans think we are in a recession.
money.cnn.com/2008/05/...

*We have already seen four straight months of payroll job losses--our economy needs at least 125,000 new jobs per month to keep pace with labor force growth.

*Japan didn't experience sustained deflation until nine years after its asset bubble burst in 1989.
money.cnn.com/2008/05/.../

*There is a 0.4 percent annual decline in real final sales of domestic purchasers, which is considered a solid measure of economic health since it is essentially real GDP without inventories or net foreign trade.
ap.google.com/article/...

Between now and the November election, Republicans will swear up and down that we are not in a recession.

Let them eat cake!

[bhakta]

Sorry, I most strongly disagree. Unless the US Govt spends only what it earns and the US stops the gargantuan trade deficit, the Dollar is on a one way street to the lower levels. there may be "rallies" but they will be short lived and futile. The dollar is not looked upon with respect in the world any more.

[Kunst]

"It’s becoming clearer that the US recession is largely confined to the housing market."

Wrong, wrong, wrong!

The US consumer is tapped out, broke, unable or unwilling to go much more in debt. Everyone is cutting back, minimizing expenditures, trying not to get swallowed up by insolvency. With 2/3 of the US economy based on consumer spending, a very dark cloud looms.

The debt-based over-consumption binge has just about run its course. When American consumers stop buying things they don't need and/or can't afford, the whole US economy unravels.

Maybe then we can start talking about producing things other countries want to buy.

[philly jim]

When Bush is voted out of office, the dollar and U.S. economy in general will rally just on that fact! The world's investors are salivating to get back into U.S. equities and investments in general; the Europeans are delusional thinking that Germans will bear the burden of keeping the Euro economy in check which will lead to political and economic instability in the Eurozone; the pound is bogus:check out Britain's debt levels, in the trillions! The only rallies against the dollar will come from ASIA where GoldminerSacks suggested they are undervalued still at 25%! When the Goldmans pump and dump these currencies a little further it will put tremendous pressure on the already frail Asian economies and further give the dollar strength going into 2010. Just my thoughts.

[Silver-Bullet]

I think the US$ may be seeing some reprieve, and Mr. Wilkinson may be true.

However, realize the above analysis was juxtaposed against other currencies. To put things in perspective, every other country is printing loads and loads of money (M3):

www.financialsense.com...

Bottom line - the US$, together with currencies with run-away M3 are still fundamentally flawed. It may be less flawed than the others this time around, nevertheless, it is still flawed.

[nickgogerty]

Discussions of Debt:GDP and Debt+underfunded legal obligations to GDP would make this a more interesting debate.