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Short US Dollar Positions Increasingly Risky

Currencies | Dec 08 2009

By Chris Shaw

As GaveKal Research notes, at the beginning of last week the market was pricing in just an 18% chance the US Federal Reserve (Fed) would hike the official interest rate in that economy to 0.5% by June of next year. This had risen to a 42% chance by Thursday of last week. After a better than expected employment report on Friday, the market was pricing in a 68% chance of the cash rate being at 0.5% by next July, a change in view that contributed to a sharp rally in the US dollar.

The rally in the greenback made sense as GaveKal notes the better employment report, which fell only 11,000 for the month in its smallest decline since December of 2007 against expectations of a fall of closer to 100,000, implies a lower rate of unemployment in the US economy. This in turn suggests less deficit spending on jobless benefits, while also implying greater purchasing power for US consumers and a stronger foundation for the US housing market.

While GaveKal cautions against reading too much into a single month of data given overall the US labour market remains in poor shape, the analysts do consider the data as encouraging, particularly given other leading indicators such as temporary employment have been trending better for a few months.

The analysts conclude on the back of the data that the cost of protecting against a rebound in the US dollar is now at its highest level for the past year, which in GaveKal’s view shows investors are losing confidence in the idea further weakness in the US dollar is still the one-way bet it has been viewed as for several months.

Commonwealth Bank chief currency strategist Richard Grace agrees, suggesting the risk is now the US dollar edges higher over the next few weeks as speculators reduce net short positions and as changing interest rate expectations set a higher base for US yields.

For this increase in yields to be sustained Grace suggests upcoming economic data and Fed commentary needs to be supportive, but if this proves to be the case he sees the currency moving higher and carry trade positions involving the US dollar being scaled back, with the Japanese yen the likely replacement currency for those in the carry trade.

GaveKal similarly suggests a reversal of the US dollar could also be on the cards as the currency at present is cheap on a purchasing power parity basis, while the real trade-weighted dollar is near a level of historic support. As well, GaveKal analysts point out there remains the risk growth in the US economy could surprise on the upside in coming months.

In GaveKal’s view any earlier than expected increase in US interest rates on the back of an improving economic outlook could unleash a violent reversal of the carry trade, while any signs of an increase in global trade volumes could force foreign producers to scramble for US dollars as they attempt to meet working capital needs.

On balance then GaveKal suggests the short US dollar position is an increasingly risky one to take. In Grace’s view, however, it still remains too early for a fundamental shift in policy guidance by the Fed. This means the first lift in interest rates in the US is still not likely prior to the second half of 2010.

Grace agrees the short US dollar position is less attractive at present and so suggests investors reduce any short positions, while also looking to take advantage of the current market volatility by establishing positions such as a US dollar/Japanese yen call spread with a top side knock-in strike.

In straight currency forecast terms, Grace sees upside for the Aussie dollar against the US dollar, forecasting a rate of US93c by the end of the year, rising to US95c by the end of March 2010 and US98c by the end of June. Against the yen, Grace sees the US dollar closing 2009 at around 88 yen, rising to 90 yen by the end of March next year and 95 yen by the end of June.

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