Time to buy the dollar?

Some strategists believe reports of the greenbackÆs demise have been much exaggerated.
Some observers are saying that events like the famous case of the Brazilian super model refusing dollar in favour of euro payments means that the dollar is on the verge of a rebound. The theory is the same as that postulated by stockmarket genius Joe Kennedy, father of JFK, who sold all his stock when his shoe-shine boy told him he was in the market.

ôThe talk about decoupling is overdone. Maybe itÆs a long-term structural trend, but at the moment, itÆs just a lag in the business cycle,ö says a currency expert for a leading investment bank in London. The expert is making the point that when the rest of the world weakens, their own currencies will also weaken, thereby relieving some of the ongoing pressure on the dollar.

Patrick Bennett, a currency specialist for SG in Hong Kong, asks: öWhoÆs left to be bearish?ö

ItÆs all about timing, of course: öThe dollar might remain weak for now, but that could easily change,ö adds Bennett, who reckons that the current dollar weakening cycle started in 2002, and that the downturn is ready to bottom out. ôThe dollar cycle is typically five to seven years,ö he points out.

The US dollar has certainly made huge gains against the euro and the sterling û not surprising given that countries in Europe follow old-fashioned, hands-off policies towards their currencies. But the gains against EuropeÆs two principal currencies could be on the point of peaking, given that the euro, especially, is also being clobbered by Asian central banks. These banks, although they are currently permitting a very limited appreciation against the dollar as a guard against rising oil prices, diversify their foreign currency holding by buying euro, and to a lesser extent, sterling.

China, for example, diversifies the dollars it buys into euro by a factor of around 30%. That creates huge additional pressure on the euro even as the dollar weakens under the weight of AmericaÆs macro problems. But itÆs a paradoxical policy by the Chinese central bank, since the effect is counter-productive: selling dollars to buy euro obviously pushes down the dollar. ThatÆs contrary to the original objective of buying the dollar in the first place, of course. So the Chinese government is hoist by its own petard, some would argue, and is paying the price for its currency manipulation. But the malign effect on Europe is clear: the currency surges not just on its own fundamentals but because the Asian central banks are gaming the dollar.

ôA punt on the euro is therefore based on an expectation that the European Central Bank will intervene to protect the euro,ö says one trader.

The London-based specialist estimates that the dollar is within 5% of its historical weakness against G10 currencies, at least since the 1970s, but was wary of predicting an inflection point. However, the probability was of a rebound, he says.

While strategists concur about the major currencies retreating from some of their gains, there is a certain amount of division about the Asian currencies. Traditionally, Asian central banks propped up the ailing greenback, because weak domestic currencies supported their export-driven economies. But, Bennett, points out, Asian central banks have recently been playing both sides.

Irene Cheung, a currency strategist at ABN AMRO in Singapore agrees. ôWe see the ringgit, the rupee, the Singapore dollar, and the Philippine peso as appreciating. ThatÆs appropriate given the rising levels of inflation these countries are seeing.ö

But Asian currencies could also start to fall against the dollar, despite central bank intervention. ôAs you can see from the dramatic easing of capital flows into Asia, their own currencies will be less well supported by portfolio inflows,ö says one specialist. The benchmark Hang Seng Index has shed an astonishing 4,000 points to almost 26,000 in the past few weeks, erasing the gains of the past three months. But Asian currencies, compared to other emerging markets worldwide, have been laggards in terms of appreciation. In addition, other specialists deny that the rise in the Asian stockmarkets after the Fed summer rate cuts is due to foreign capital. ôIt was actually reckless local investors buying too heavily into the decoupling argument,ö says one.

AmericaÆs macro situation should also turn, with the current account already narrowing. This should provide some impetus for dollar strengthening. Bennett is relatively bullish on the US economy, despite expecting a softening in the fourth quarter. ôI expect the Fed to resume tightening monetary policy by the middle of next year, and for interest rates to rise to 4.75% by the end of the year, 50 basis points more than off the expected low of 4.25%,ö he says.

So perhaps the message is that one should wait for a little more blood in the streets û Rothschild's favourite indicator before buying û before betting too heavily on a reversal of the dollarÆs dismal fortunes.
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