With the Easter weekend out of the way and the start of the second quarter firmly in sight, two key questions must now be asked. The first is whether the dollar’s recent revival is based on renewed optimism about the US economy or has simply been caused by an unwinding of dollar funded leveraged trades? If the latter is true then the second question to be asked is whether there have been any similar moves seen at other points in the dollar’s multi-year downtrend?
The answer to the first question would appear to be fairly straightforward. It is clear that few asset markets have benefited over the past few weeks. In particular it is noticeable that it has not just been many of the previously favoured trades in emerging market assets, commodities or “high” yielding currencies that have suffered, but US markets as well. Since early March the S&P 500 has lost 4.1 per cent while the Nasdaq composite is off 4.6 per cent. Given that these losses are not dissimilar to those seen elsewhere in other major markets, this hardly suggests that investors have been increasing their bets in favour of the US growth story at the expense of other markets.
Instead it indicates that the dominant pattern since early March has been a pullback by investors from most major asset markets. As the only significant change to the investment picture over that time has been the growing awareness that the Federal Open Market Committee (FOMC) is becoming increasingly concerned about the inflationary outlook in the US, it seems clear that recent market activity has been initiated by a wholesale unwinding of leveraged trades funded out of dollars rather than anything else. This, then, leads to a second question of whether this dollar recovery is similar to any others seen during the greenback’s downtrend since January 2002?
It is clear that there have been two periods of sustained dollar strength over the past three years. The first occurred between June and September 2003 and seemed to be prompted by a run of stronger than expected data from the US. The catalyst for the second period of sustained dollar strength (which came between late March and mid-May 2004) was the growing realisation that the FOMC was preparing to finally start tightening policy from its highly accommodative levels. On both occasions, previously favoured trades such as emerging market bond and stock markets (along with the respective currencies), commodities and “higher” yielding currencies all suffered as speculative positions were unwound (as evidenced by Commodity Futures Trading Committee data).
Given this, it is difficult not to see the activity in global markets over the past month as essentially being a repeat of these patterns. Moreover, as each of these previous episodes proved to be no more than a correction within the dollar’s broad downtrend, it seems likely that the current move will prove to be one also. This therefore leaves only one final question to be asked; namely how long should we expect the current period of dollar strength to continue for?
In 2003, the dollar correction took 11 weeks to occur while in 2004 the correction lasted nine weeks. This suggests that the current move could continue for some time yet given that it has only been underway for three weeks. In short, although we remain firmly in the camp of the dollar bears in the medium term, for the moment at least we continue to recommend a defensive stance.
Neil Mellor is a currency strategist at The Bank of New York
Researched and published in association with The Bank of New York
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